It seemed like another regular day in the life of the Mack family. It was Saturday morning, and my mother had just cooked breakfast for my brother and me. After cleaning the apartment, it was time for her to take us on the normal Saturday errands. The post office, the dry cleaners, and the grocery store were among the places that we had to pay a visit to. However, this Saturday called for a slightly different change of plans. The lease on the apartment was getting close to expiring, and Carol had been having dreams of owning her own house. So, instead of driving straight home, my mom took out her paper of previously circled properties, and drove past two or three of them to inspect the neighborhood. As she tapped on the window towards properties of preference, being only nine at the time, I remembered becoming increasingly more impatient as she prolonged my snack time. My mother had the dream that millions in the US have…the dream of owning your own home.
To own your own home is not a small venture, and requires a lot of thought. I am sure that many would agree that the process is very long, tedious, time consuming, and perpetually costly. Whichever home you purchase, you must make that decision responsibly. The amount that you pay on your home, and the payments that you are required to make to retain your property will have a huge effect on your future financial state.
If you are not wealthy but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s total annual realized income. (The Millionaire Next Door- Thomas J. Stanley and William D. Danko)
While I believe that this over-simplifies the situation, the thought behind it is very true. If you want to purchase a home, you should act your own wage. Make sure that you purchase a home within the amounts that you can afford to pay. I have seen many people go out to look for a new home without any idea of exactly how much they can afford to pay. I urge every one of you to take some time to sit down and do the math before beginning the hunt to look for a home. The bank doesn’t know your situation better than you do, so don’t let the bank do the math for you. Remember that every one who has ever filed for bankruptcy or foreclosure was initially approved for a loan from the bank. Don’t let the mortgage broker do the math, as he is pushing for the highest loan to make the most commission. He will find a way to stretch you well beyond your means, making a nice commission, while you loose your sanity and happiness trying to over-extend your budget to make your mortgage payments. “The rich rule over the poor, and the borrower is servant to the lender.” (Proverbs 22:7) Simply buying a home should not be your only goal, but rather you should be buying a home that you can keep and live in.
To live above your means by purchasing a house that is out of your range has other negative ramifications as well. People fail to realize that when you purchase a home, you are also entering into a more extravagant lifestyle. Your neighbors will drive more expensive cars, go to more expensive private schools, and live lifestyles that they are more adapt to handling. There can be a lot of pressure when put in a situation to want to “keep up with Mr. and Mrs. Jones”. If you purchase a piece of property that is more suitable to your income level, you will find that there is less financial pressure to conform. Just keep in mind that there could be a person who really is wealthy, living next door who bought his $300,000 home AFTER he/she became wealthy enough to afford it.
As stated, before you jump the gun and purchase that house, make sure you do the numbers. I can’t emphasize this enough. Below is a worksheet for you to follow. If you are able to fill in this worksheet, you will be ahead of the game when it comes to planning the purchase of your home. This worksheet was derived from The Courage to Be Rich by Suze Orman.
|Monthly House Payments|
|Price of the house||$__________|
|Multiplied by the % of sales price county charges for property taxes.||x__________%|
|Equals yearly property taxes.||$__________|
|Divide by 12 to get monthly property taxes.||$__________|
|Add $100 for home insurance||+ $100|
|Add mortgage payment||$__________|
|Add PMI premium (mortgage balance x .006/12)||+__________|
|Total monthly payments||$__________|
|Take home pay||$__________|
|Social Security payments||$__________|
|Interest and dividends||$__________|
|Total Monthly Income||$__________|
|Subtract your total monthly payments from your total monthly income:||
|Utilities, gas, oil||$__________|
|Firewood, if applicable||$__________|
|Pool maintenance, if applicable||$__________|
|Extra gasoline, if you have to drive longer to work||$__________|
|Gardener, landscaping costs||$__________|
|Water treatment of drinking-water delivery||$__________|
|Total additional expenses||$__________|
|Subtract the additional expenses from remaining income figure:||$__________|
If you have sufficient money left over after you have successfully filled in the table, then you should be able to purchase your home.
One good way to find out if you will be able to purchase your home before you buy it, is to purchase an imaginary house. Calculate how much you think you will be able to afford, then immediately open a savings account. With your house fund, put a down payment into your new account that will come as close to 20% as you can afford. From then on, each month put the calculated mortgage for your new imaginary home in the account. With out fail, make mortgage payments in your savings account for either six months; or until you have the 20% down payment that you will need for your imaginary home. If you find that you are able to make these payments, and still are able to live comfortably without over-extending your budget, then you are on your way to having that new house.
If you notice in the monthly house payments section of the table, you see a payment labeled PMI. This stands for Private Mortgage Insurance. This is the insurance that protects the mortgage lender from financial loss if the borrower decides that he won’t/can’t make the mortgage payments any longer. You can avoid this amount if you have 20% of the down payment when you purchase the home. If you have as much as 2% less then the 20% requirement, then you have to pay PMI. To figure out how much you will have to pay for PMI for the first year, multiply your mortgage by .006. This will be your first year payment (up front). If your mortgage is $100,000 then your PMI for the first year will be $600. If your mortgage is $400,000, then your PMI for the first year is $2400. This payment does not end the first year. Each month, in addition to your mortgage payments, you are required to make an additional PMI payment. This additional payment is calculated by dividing your total initial PMI payment by 12. So for the $100,000 mortgage, you would have to pay $600 up front, and $50 per month. For the $400,000 loan, you are required to pay $2,400 up front and $200 per month (again, this is in addition to your regular expected mortgage payment).
Many people fail to realize that this payment should not last for the duration of the loan. You are only required to pay PMI up until you have established 20% equity in your home. At this point, it is YOUR responsibility to call your lender and have them seize your payments. If you don’t call them and tell them, you will continue to be charged PMI on your loan. Before you sign any papers, make sure that your bank allows the PMI payments to be cancelled. Before signing the loan, have the lender put in writing that they will cancel the PMI payments when you reach the 20% equity mark. Even if the lender agrees to this in writing, make sure to call and remind them to cancel your PMI payments. They have no incentive to do it themselves. Upon canceling, you will be able to have the initial outflow of your PMI payment returned to you. Don’t forget to ask for this money back.
You should be careful of those banks that claim not to charge PMI. Many times banks will load PMI charges into the original rate of the loan. For instance, a bank will say that they will charge you a 7.5% interest rate, and you don’t have to pay PMI no matter how much you initially put down. However, they fail to tell you that they have added another 0.5% to the loan to compensate for the lack in PMI payments (they make a 7.0% loan into a 7.5% loan). Essentially, you have locked paying PMI for the duration of the loan, instead of up until you have reached the 20% equity mark of investment in your property.
Have you fully inspected that house to make sure that there aren’t any other traps that can translate to more money that you have to pay in the future? Have you checked for structural damage, termites, high asbestos levels, or flaking lead based paint. A simple checking of the yellow pages or a call to your real estate attorney to recommend a certified building inspector will help. Did you flush the toilets to test the water pressure, turn on the water in the kitchen and bathrooms to see how long it takes to get hot, or test to see that the appliances are in working condition? How old is the water heater, furnace, air conditioner, washer, refrigerator, washer, dryer, dishwasher, or stove? Are they under warranty, and if so does the seller still have the paperwork? How up to date is the electrical system? These and many other questions like them can save you a lot of headache and unnecessary cash outflow in the future.
Many people have discussed the possibilities of paying off your mortgage early. I have always been a huge fan of early mortgage payments. However, you shouldn’t start paying down your mortgage until you have established an adequate emergency fund. This is because you need to access liquidity in case of unexpected happenings. Also, paying extra principle should fall behind maxing out your contributions for your tax deferred assets such as your IRA and your 401k. There are some that say that paying extra principle contributes to extra equity that isn’t readily accessible, and that you are making a decision to not diversify your portfolio. There is also the argument that if you have a low-interest mortgage, and an opportunity to invest the principle payment in an investment with a higher return than the tax-effective rate of your mortgage interest, you should probably do that. These are all valid arguments. However, there are many reasons why I still prefer to pay your mortgage early provided that your emergency fund and tax deferred assets are in order.
If you have excess cash, and that makes you feel safe, remember that early mortgage payments have not disappeared but are in your home. For one, if you are older, there are many states that consider your home an exempt asset when it comes to qualifying for Medicare, regardless of how much equity you have in it. Also, you can always apply for an equity line of credit (preferably while you are still working and have an income). If you should use this option, make sure that you get a line of credit where you can write a check against it only if you need it. This way you will have access to the cash, but aren’t paying interest on it until you actually use it. Chances are, payments for this line of credit will be less than your mortgage payments would have been. If you are in retirement and have one less major expense to worry about such as a mortgage payment, this is one of the richest feelings there is.
There is no guarantee that you will receive a higher return than your mortgage rate in the stock market. To some, paying off that mortgage early might not make sense. However, I rate peace of mind higher that any other economic rational out there. If we can all strive for that day when we are all debt free, we can then work to put full attention towards our savings. So why not opt for that 15 year mortgage instead of that 30 year that is so popular? You can also find out from your financial planner the amount that you should increase your monthly payment to cut your mortgage in half. Many people prepay the next month’s “principal” in addition to your regular monthly payment. Imagine how much more modest your living cost will be without any debts or house payments. “Let no debt remain outstanding, except the continuing debt to love one another, for he who loves his fellowman has fulfilled the law.” (Romans 13:8)
We all want to live the dream of owning our own home. To come home to something that we own is a magical feeling. This comes at a very hefty price, however. It is very wise to take the time to make this decision wisely. Cross every “T”, dot every “I”. In the end it will be worth the time invested.
Written By: Ryan Mack, President of Optimum Capital Management, LLC
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