Responsible Homeowers: Your Bailout Has Arrived

Mortgage rates have never been so low (5% 30 Yr. Fixed or Better). If you are one of the millions of responsible Americans with good credit scores who are able to pay their mortgages and still have jobs, your bailout has finally arrived in the form of record low mortgage rates. If you are paying anything over 5.75% and plan to stay in your house for several years it is definitely time to refinance with a fixed rate mortgage to lock in these cheap rates. Check out Bankrate.com to find someone offering a low rate in your state. You can also use their refinance calculator to determine if refinancing is a good deal for you.

Should I Pay Down My House Early If I Can?

Assume you just inherited a bundle of capital from your long lost uncle and you could pay off your house today; should you do it? I don't think there is really a right answer to this question, but what I will do here is walk you through how I think about it.

First, what is the current rate you are paying on your mortgage ? Take this rate and then multiply by 1-your tax rate. This should be your after tax cost of debt. So let's say you have a fixed mortgage at 6%. If you are in the 25% tax bracket then your after tax cost of debt should be 6% * (1-25%) or 4.5%. You need to have a safe investment that has a better after tax return than to justify not paying off your house.

Next, consider your investment options. I would look only at nearly risk free investments. For instance 10 year treasury bonds trade at 4.58%. Multiply this by (1-25%) to find your after tax return which would be 3.43%. Based on this analysis you are better off paying your house off than putting money into 10-year treasuries because you get an after-tax risk free return of 4.5% by doing it. Likewise, it looks like most CDs don't have enough of a yield today to suggest that you shouldn't pay off your house.

But what about putting the money in the stock market? After all doesn't it return 8% or so on average? In general the answer is yes, but the reason that you get an 8% return instead of 4.5% from treasury bonds is that there is more risk associated with this decision. In general if you were to just invest the money and pay off the house later you should be better off in the long run. However as a conservative Armchair Fiduciary, I feel like doing this would be taking too much risk. You can always pay off the house and then take what you would have been paying in monthly payments on the mortgage and invest it in the market. This may lead to somewhat less long-term wealth on average, but it is the much less risky option in my opinion. Better safe then sorry in my opinion. Got a better idea? Leave a comment.

Home Buying Series Part IV: Avoiding Junk Fees on Your Mortgage

When you go to get a loan your mortgage broker should give you a good faith estimate before you agree to go with them for the loan. This estimate tells you your rate and lists a number of other fees. What many people don't know is that many of these fees are highly negotiable. The fees usually don't represent anything specific but actually cover your mortgage broker's overhead. Especially if you are already agreeing to paying any "points" you should definitely not pay much more in the way of junk fees.

Here is a list of common expenses on the good faith estimate that are widely viewed as "junk fees":

• Processing Fee
• Underwriting Fee
• Document Prep Fee
• Settlement Fee
• Bank Inspection Fee
• Lenders Inspection Fee
• Application Fee

"Real" fees typically include title fees, government recording fees, an appraisal fee (you should get a copy of the 3rd party appraisal).

Now it should be made known that you probably cannot get all junk fees to go away, but when you are comparing lenders don't look at the amount of the different fees, just sum them up and view the total junk fees as a point of comparison. See if you can negotiate these total junk fees down, it doesn't matter which specific ones go away. You will likely get some song and dance about how they do have to process your application, etc. but don't budge. Junk fees are a direct cost to you and the lower they go the better off you are. Play two lenders off each other on the junk fees and get them way down especially if they are offering essentially the same interest rate.

Home Buying Series Part III: How Much House Can You Afford?

How much house can I afford? It seems too many home buyers forgot to ask that question before they got caught up in the buying bonanza of the last few years. That's why foreclosure rates are spiking. A lot of people fell in love with a house and then asked their lender how they could afford it. During a period of incredibly loose credit lenders were happy to oblige and put people in houses they couldn't afford using low or no doc loans, interest only loans, neg am loans, and little or nothing down.

How Not to Become a Statistic

There are generally three criteria for getting a conventional loan without mortgage insurance:
1) You have to make a 20% down payment on your house
2) Your monthly mortgage payment (including interest, principal, taxes, and insurance) can't be more than 28% of your gross income.
3) Your total expense obligations (i.e. your mortgage + all other debt payments) can't be more than 36% of your gross income.

It turns out if you stick to these rules you are much less likely to end up in foreclosure than someone who strays from them. For instance, if you look at the most recent Mortgage Banker's Association survey you can see that subprime and FHA borrowers (who typically have bad credit and make minimal down payments) have much higher delinquency rates (around 13%) than those with conventional mortgages (less than 3%). Now this is probably not an entirely fair example because subprime borrowers usually have bad credit to begin with so they are probably more likely as individuals to default on their mortgage anyway, but general idea is correct. Prime borrowers could afford their mortgages and subprime borrowers generally could not which is why 13% of them are delinquent.

Many people will tell you that you don't need a 20% down payment on your house. I disagree for three reasons. First, if you can save the 20% down payment, you probably have the financial discipline to make your mortgage payment. Second, that 20% provides you a cushion from an unusually soft housing market (which is what we are currently in). If you only put 5% down and then the value of your house declines by 10% you will actually owe the mortgage company money if you decided to sell right then. Real estate prices rarely fall by 20% so you should almost never run into this problem if you put 20% down. Finally, if you put down less than 20% you need to pay for mortgage insurance (typically adds 0.5% to your interest rate) which is a totally ridiculous thing to do in my opinion if you have every intention of paying your mortgage.

To get an idea of how much house you can afford, I recommend trying this mortgage calculator from CNN Money. It will tell you how much house you can afford based on your income, debt, and the interest rate you think you can get on a loan. It conforms to the 28% mortgage payment rule and the 36% total debt service rules. It also assumes you will put down 20% and avoid paying mortgage insurance as a result. For a quick view of what interest rate you might expect to pay visit Bankrate and look at the rate on the 30 year fixed mortgage.

Finally, to learn a lot more about mortgages visit The Mortgage Professor. His site is so in depth you might find yourself drowning a bit, but you will find the answer to almost any question there.

As always the Armchair Fiduciary is happy to field your quesitons. Email me at armchairfiduciary_at_gmail.com.

Home Buying Series Part II: An Introduction to Mortgages

Now that you used Zillow to help you find a good home at a good price it's time to think about how you will finance that home. That's where a mortgage comes in. At its most basic level, a mortgage is a loan from a financial instituion to you which has your house as collateral. In laymen's terms, the bank has a claim on your house and if you don't pay them their interest, they'll take the house as payment instead (i.e. foreclose).

Fixed Mortgages

Fixed mortgages are mortgages that are at a fixed rate interest rate over the life of the loan. For a 30-year fixed mortgage both interest and principal will be amortized (i.e. spread out) over 30 years so at the end of year 30 you will owe $0 to the bank and own your home outright. A 15-year fixed mortgage will result in a zero balance at the end of year 15. Typically the shorter the duration of the mortgage the lower the interest rate you'll have to pay, but the higher your monthly payment will be (because your principal is amortized over a shorter period of time). Fixed mortgages give you the security of stable payments over the life of your loan, but usually carry slightly higher rates to begin with than ARMs. If you plan on staying in your house for over 7 years, I'd advise sticking with a fixed rate mortgage.

Adjustable Rate Mortgages (ARMs)

ARMs are loans that start out at a fixed rate for a certain period of time and then begin to adjust every so often (usually once per year). Usually there is a particular interest rate to which the ARM is tied which in ARM lingo is called an index. As the index goes up, so the rate on your ARM goes up. Common ARM indexes include: COFI, MTA, CODI, Prime Rate, and LIBOR.

Most ARMs come with a period cap and a lifetime cap. The period cap is the maximum amount your rate can adjust up in any given period. For many annually adjusting ARMs this is around 2%. This means if you start out paying 5% then the most your ARM can adjust to is 7% after its first adjustment period and 9% after the second, etc. A lifetime cap represents the maximum amount your interest rate can go up over the course of the loan. For many ARMs this is 6%. So if you start out at 5% with a 6% lifetime cap, the most you can ever pay is 11% (which is a lot especially compared to the 5% teaser rate).

You may have seen 3/1 ARMs and 5/1 ARMs. These are loans that start out fixed at the low teaser rate for the same number of years as the first digit (i.e. 3 years or 5 years). The second digit represents how often the ARM adjusts after the fixed period, these loans adjust once per year as is typical.

So by now you have probably figured out that ARMs can be pretty complicated. If you plan on living in a house for only 5 years, then a 5/1 ARM can probably save you money because you will pay a low rate for the first 5 years and then sell the house (and pay off your loan in full) so you won't be paying when the chance for higher rates hits. Other than that, taking out an ARM is a gamble on interest rates which very few people can predict accurately. Generally, I would advise against ARMs unless you plan on paying off your loan in full before the ARM adjusts.

As a side note, if you need to use an ARM to afford a house, you are buying a house that is beyond your means! Do NOT do it as you are likely to end up in financial trouble by the time your ARM floats. You can always move to a bigger house later, but recovering from bankruptcy is much harder to do (i.e. takes 7 years at least). If you need an ARM to afford your house, do the right thing and find a smaller house that you can afford with a fixed rate mortgage. My next post will walk you through how much house you can afford.

Loans to Avoid: IO and Neg Am

There are also a couple of loans worth outright avoiding for the average individual. These include IO (Interest Only) loans and Neg Am (Negative Amortization) loans. These are loans that are for the most part designed to get people who can't afford a certain house into that house. They are very risky and will usually end in financial ruin for the homeowner. Indeed many financial instutions that were pushing these types of loans recently went bust when the homeowners who had these loans defaulted on them. Unless you REALLY know what you are doing these types of loans are to be avoided at all costs.