CESI Personal Finance Guide - Chapter 7: Housing
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Chapter 7: Housing
Cathy is a young, intelligent, single woman who can’t quite believe what happened to her, and all of it so quickly. It was only two years ago that Cathy had qualified for a mortgage and paid the down payment on her dream home. A tiny but perfect little house not too far from where she worked. She had been hearing about foreclosures and mortgage issues for a while but never believed that the warnings applied to her. All that changed when Cathy got laid off. Losing her job left her floundering. Her unemployment check was hardly enough to cover her mortgage and she still had bills to pay and a household to run. She began to struggle to make ends meet and her monthly mortgage payments were made late. As a result, late fees were promptly applied and the balance due began to rise. After three months of missing her payments, the bank sent her a notice that it would begin foreclosure proceedings. Left with no alternatives and little money in her account, Cathy’s precious home was taken away from her and she is now left with nothing.
This is just one of the many personal stories of lives affected by foreclosure. When you buy a home, the last thing you think about is having it taken away from you in such a cold, impersonal manner. But, as delinquent mortgage payments increase, foreclosures on these properties increase as well. There are many ways to prevent this from happening, but to do so we must start from the beginning: from deciding to buy a house, to managing finances and handling the purchase, and to the legalities involved in the buying process.
The Pros and Cons of Renting vs. Buying
You have finally decided what type of housing fits your needs. The next big question you have to ask yourself is: do you rent or buy? As expected, there are a numbers of reasons both for and against each option. Let’s take a look at them.
When starting out on your own, renting seems to make the most sense. When you are young, or have no immediate plans to start a family, renting might be your best option. There are rental complexes that offer amenities such as swimming pools, tennis courts, maintenance staff and even laundry units that can save you time and money. Renting also offers more flexibility like the ability to relocate more easily. Leases for renting (between the landlord and yourself) give the renter more mobility and are easier to get out of. With most leases, you can pay a penalty and “buy out” of the contract in case you need to move before the end of the lease period.
But the biggest advantage to renting is that it rarely requires a large down payment of cash. Most landlords will require a security deposit (of about 2 months’ rent) but this is still less than the down payment required when purchasing a house. Utilities might also be included in your rent, further lowering your outgoing monthly payments.
On the other hand, renting offers no control over the property. With regard to repairs, redecorating and upkeep, you are in the hands of the owners or landlords. The owner might not be prompt in dealing with any repairs (from plumbing to broken windows) or you might be forced to stay in unpleasant or unsafe conditions that are beyond your control. There may also be restrictions on pets or visitors, for example, which could be a problem. Finally, as a renter you do not build any equity. At the end of the day, the property is not owned by you and you receive none of the tax benefits of owning a home.
Buying a home gives a sense of freedom for many. There is the freedom to decorate, the security and independence associated with owning your own home, and the pride that comes along with it. There are also several financial benefits related to home ownership. You can build equity and take advantage of tax benefits like interest and property tax deductions. As you pay off your mortgage through regular monthly payments, you are slowly gaining more and more equity or cash value in your own home.
On the downside, selling a house is often complicated and you can rarely just pack your bags and leave as you might have done while renting. Finalizing a sale depends upon factors such as what type of house you own, property values and upkeep in your neighborhood, and what the market conditions are at the time. In all, selling a home can be a time-consuming and frustrating process.
Owning your own home also brings with it responsibilities like maintenance and upkeep that require both your time and money. Even redecorating can add significantly to your expenses.
Armed with these pros and cons, you can now sit down and organize your thoughts on paper:
- What are your costs, up front?
- Renting – how much is your deposit and rent due for the first month?
- Buying – how much is the down payment required and agent fees, if applicable?
- What are your monthly costs?
- Renting – what is the monthly rent and cost of utilities if they are not included in the rent?
- Buying – what is the mortgage payment per month, escrow amount for taxes and insurance, homeowner’s association dues, and cost of utilities?
- What type of housing can you afford based on your income and other outstanding debts?
This should give you a good idea of whether you should buy or rent, and what you can realistically afford, before taking the next step. There is no perfect choice, just one best suited for you at the time. Keep in mind your career, your income, how often you travel (or relocate), and your personal relationships before you reach any conclusion.
How Do I Know If I'm Ready to Buy?
Buying your own home is a dream for many people, but how can you tell when you are ready to buy? If you visit a real estate agent or mortgage lender, the odds are that they will convince you that the payments are within your reach and encourage you to go ahead and buy.
But often what seems manageable on paper becomes more difficult in real life. Only you know your financial status and your real spending habits. Before you begin looking for a home, or even approach an agent, read on to see if you are ready to buy.
You will first need to review your financial situation. Calculate your income, all of your debt and your Debt-to-Income ratio. Most lenders will require this information. This is the time to approach the three credit bureaus for your recent credit reports and review your latest credit scores. If you find anything unfavorable in these reports that can be fixed, try to resolve these issues promptly. If, however, you have a history of late or missed payments, now may not be the best time to apply for a mortgage loan. If you have a below average credit score, you may not be approved, or you may pay a higher interest rate on the loan that will make a huge difference on the total amount you pay for your home overall.
You may be ready to buy when:
- You have been employed in the same job for the last two years and have a source of income that is reliable.
- You plan to stay in a particular city for a while. Moving costs and selling your home again can mean more expenses in the long run.
- Your credit score is good.
- You can manage your other debts along with the new monthly mortgage payments.
- You are in control of your spending and handle your finances responsibly.
- You have access to a lump sum of money required for the down payment and closing costs.
- You have accounted for additional costs related to maintenance, insurance, taxes, etc.
- If you are married: you and your spouse have enough life insurance to pay your mortgage in case one of you passes away.
- You do not foresee any major lifestyle changes or cost-cutting in order to meet your monthly payments.
- You have thought about the repercussions and expenses in case your family grows in size.
- You have a clear idea of future expenses whether it is a retirement fund for you and your spouse, an education loan for your children or even the cost of a wedding.
If these items describe you, now might be a good time to explore buying a home.
Now that you know you are ready, the next steps involve consolidating your financial position in order to avoid any problems later on. These include:
- Increasing your credit score – aim to clean up your credit history and fix any problems on your reports, if possible.
- Look for a house you can really afford – not just one you want. The general rule of thumb dictates that an affordable cost of a house is one that is about two and a half times your annual income. You could also use one of the many online calculators available to estimate this figure.
- Make provisions for the down payment needed – this is approximately twenty percent of the total cost. In case you do not have this amount easily available, there are some lenders that offer mortgages with smaller down payments if you qualify.
- Opt for professional help. Ultimately, you will need professional assistance in closing your sale. Start looking for an agent, whether online or through referral of others as soon as you have made the decision to buy.
- Get pre-approved. Pre-approval for a loan can save you time and effort and put you in a better negotiating position to buy the right house. This pre-approval entails a lender checking your income, credit history and all your debts.
While owning your own home means no longer having to pay rent, it also comes with a host of responsibilities and financial decisions. Before taking the next step, think carefully once again and make an informed choice.
Calculating What You Can Afford
You have looked high and low and finally found the house of your dreams. It’s the right size, in the right location and you hope, available for the right price. But the real question is whether you can actually afford it. There are a number of factors that go into answering this question. And, just because your agent says you can, it doesn’t necessarily mean you should. After all, buying a house is only one part of your entire financial picture. You have other expenses as well, including day-to-day spending, education loans, car loans, retirement funds, and insurance costs among others. Spending all your income on a house, no matter how perfect it seems, is not the wisest thing to do and is often a recipe for disaster.
The following are some easy guidelines to determine how much you can afford and what you should be spending on your dream home.
- Get real – to save time, money and heartache, it pays to be realistic when looking for a home. Do the groundwork before you start looking. Get estimates from various agents and lenders and get pre-approved for a loan. You can then figure out what loan amount you can qualify for.
Most lenders will take two ratios to assess your qualification for a loan. The first is your Debt-to-Income ratio. Here, the sum total of all your debts should not exceed 38% of your gross income. Secondly, lenders calculate the ratio of your total monthly housing costs with your monthly gross income. These housing costs include your mortgage Principal, Interest, Taxes, and Insurance (PITI). The ratio should ideally not exceed 28% of your income.
However, if these ratios do not match your financial profile, don’t lose hope. There may be programs specially designed for consumers with poorer credit or who fall within a low income bracket that can help you obtain an affordable mortgage. Knowing which loans you can qualify for will help you further narrow your search for the most affordable house for you.
- Beware of ALL the costs – If you think that there is no difference between the cost of buying a house and the cost of owning a house, think again. There is a lot of money that goes into purchasing your home, the sale price being only one factor. First, you will have to pay a down payment (approximately 20 percent of the total cost). If you pay less than 20 percent, you will have to pay for Private Mortgage Insurance (PMI) that protects the lender in case you default on future payments. Add to this the closing costs (2 to 5 percent of the sale price), which include inspections and lawyer’s fees. Let’s not forget what you will pay for renovations, redecorating and maintenance if necessary. So, be aware of the incidental expenses when you decide to finally buy a home.
- Plan for the future – In addition to your monthly mortgage payments, factor in future expenses such as property taxes, insurance, maintenance costs, household expenses (keeping in mind inflation), education loans, recreational expenses, car loans, retirement funds, and your savings. At the end of the day, you need to make a call – a bigger mortgage and a serious lifestyle change, or a smaller mortgage and the same standard of living to which you have become accustomed.
What You Pay to Buy a Home
- Down payment
- Mortgage principal
- Mortgage interest
- Homeowner’s insurance
- Closing costs
- Private Mortgage Insurance (if you pay less than 20% of the down payment)
- Property taxes
- Moving expenses
- Maintenance and utilities costs
- Renovation and repair costs
- Redecorating costs
These general rules and guidelines will give you an estimate of how much you can truly afford when buying a home. There are a number of online calculators that can help you reach this information as well. A financial planner or a housing counseling agency is also an effective option when looking for unbiased, well-informed advice.
How Do I Start the Process?
For many, buying a home is a nerve-racking process. Full of legalities and paper work, it’s a daunting prospect that can put you on an emotional roller coaster. This is a normal reaction, so do not worry. Take things step-by-step and you will be even closer to becoming a home-owner.
Step 1: Get Things Started
Learn all you can about the home-buying process. Research the Internet and look through the classifieds to check out what houses are on sale in the area of your choice. Drive around and narrow down the localities you are interested in. Register with a housing counseling agency for more information on the process and to get professional help to guide you through. Get your finances in order. Apply for your credit reports and get pre-approved for a loan. This is also not the time to make any big ticket purchases on your credit card or to change jobs. A steady income and a good credit history is what will get you the best interest rates on your home loan.
Step 2: Search For a Home
Go ahead and begin your hunt for your perfect house. Drive around different neighborhoods, get a feel for the location, speak to people, attend open houses, take photos and organize your comments and questions about each of your potential choices. Make a checklist of what you are looking for in your new home (see box below). You could also enlist the help of a real estate agent to make your choice more informed and less stressful.
Questions to Ask Yourself:
- Why are you buying a home?
- What features are you looking for?
- Should it be close to work/school/shopping?
- What type of home suits your requirements?
- What size home do you need?
- What condition is it in?
- What kind of neighborhood are you looking for?
- What are the applicable taxes on your new home?
You can start searching by looking for yard signs as you drive around, through the classifieds of the newspapers or home magazines, on the Internet, or by attending open houses that are regularly advertised.
Step 3: Time to Make an Offer
This is it. You have narrowed down your search and you are willing to make a formal offer. But before you do so, first ensure that the house is being priced correctly. To make sure that you are not overpaying, check out the Comparable Market Analysis (CMA) lists of recent sales in the neighborhood. If you have an agent, they will do this for you. There are also online appraisal services that can help you with similar information. Things to keep in mind while making an offer include:
- Make all offers in writing. Don’t accept anything verbally.
- Never offer full price immediately. Leave room for negotiation.
- Keep home inspections in mind. Your contract should have an ‘out’ clause in case of irresolvable repair issues with the seller.
- Your contract should also cover you in case your loan or finance options fall through.
- To take care of such legalities, employ an agent or a real estate attorney.
Step 4: Home Inspections
The next step after making your offer is to have the home inspected formally by a licensed inspector. This will determine what repairs have to be made and what needs to be replaced. A real estate agent will organize this inspection for you. If you are handling the purchase on your own, make it clear in the contract who is paying for the inspection and who is responsible for the repairs that are recommended. As mentioned earlier, there should be a contingency clause to void the contract in case the inspection reveals problems that cannot be resolved between the seller and yourself. Home inspection should include:
- Checking for termites
- Checking all plumbing for leaks, etc.
- Checking of all electrical connections – are they up to code? Do the fittings all work properly?
- Checking the exterior for cracks and paint work
- Checking the interior for leaks or structural damage
- Checking the condition of the roof
- Checking all windows and doors to see if they are in good condition
- Checking if insulation is up to code
- Checking all appliances such as heating and air conditioning units
- Checking for the presence of Radon gas
- Checking if hazardous lead-based paint has been used (mainly with older houses)
- Checking for asbestos in floors and ceiling tiles. This is a health risk and needs to be removed.
Step 5: Understanding the Transactions Involved
There are four basic transactions involved in the home buying process. They might seem confusing at first, but with some guidance and information, it’s not so difficult to comprehend.
- Title insurance. A title company is a neutral party that makes sure both parties stick to the contract and exchange funds as agreed. It will also check the chain of previous owners (or titles) to clear the property from any previous claims, pending mortgages, and unpaid taxes. These are things, as a new owner you may not be privy to, but they will affect your ownership. A deed in such circumstances offers no legal protection, thus, title insurance is recommended and usually required.
- Home appraisal. In order to insure that the house you are buying is worth the amount the lender is loaning you, they will hire the services of an appraiser. They might also require a location survey to verify that the property is within the boundaries of the lot. The costs of both of these reports are built into your loan costs.
- Homeowner’s insurance. No title deed will be transferred to you if you do not possess homeowner’s insurance. Homeowner’s insurance will protect you against certain types of disasters as well as any theft or damage to your property.
- Escrow and closing. The final step to purchasing your home is known as the settlement or closing. A title insurance company generally has an escrow agent to handle this process. The escrow agent will check that the title concerned is “clean,” meaning that all transaction costs are paid and monies are exchanged, and that the seller’s mortgage has been paid off. The closing statement prepared by the agent will clearly indicate who is paying what and where the funds are going. However no money will be exchanged unless the checklist of items is all taken care of.
What Types of Loans/Assistance Are Available?
In terms of housing, the loan that the bank or lender grants you is your mortgage (or note). The monthly amount you pay the bank/lender is your mortgage payment and the rate of interest is your interest rate or mortgage rate. If you don’t make regular payments or default on payments to the bank, the lender is fully within its rights to repossess your home. The term of your loan indicates the number of years you will take to pay back the entire amount (with interest). It is normally either 15 or 30 years in the US. A 30-year term is easier to qualify for, with lower monthly payments, allowing you to have more liquid cash and possibly purchase a more expensive house. But it obviously takes much longer to pay off this loan. A 15-year loan, on the other hand, saves you a lot on the interest and can help you pay off your loan in a shorter time. You have to choose between the flexibility of the 30-year loan versus the short duration of a 15-year loan. This will obviously depend upon your financial status and future commitments.
It is ultimately your lender’s job to find the most affordable loan for you depending on your requirements and qualifications. But, it is always wiser to be informed about the terminology and “legalese” associated with the different types of loans available. Following are the different types of loans and assistance available.
- Conventional mortgages: This type of mortgage offers a fixed rate for terms of 10-, 15- or 30-years. With conventional mortgages, you may pay less than the normal 20 percent down payment required. However, if you do this, you will be asked to pay Private Mortgage Insurance (PMI) as well.
- Adjustable Rate Mortgages: Unlike a fixed rate mortgage where the interest rate stays constant for the lifetime of the loan, Adjustable Rate Mortgage interest changes periodically depending on an index. As a result, the payments may rise or fall with the index. Initially, the interest rates with ARMs may be much lower, but you will have to weigh this against the risk of higher and increasing payments in the future. If you know you are going to stay in your new home for a short period of time, this type of mortgage may make sense. But, before choosing an ARM, also ask yourself if you will be able to make the higher payments if the rates increase or if there are any big ticket purchases that you plan to make in the future. There are also several different types of ARMs available. For example, Hybrid ARMs, Interest Only ARMs, and Payment Option ARMs. There are a number of technicalities involved in an ARM that will affect your monthly payments over the years. These include the initial rate and payment (usually between one to five years), the adjustment period (the period between rate changes), the index and the margin, which determine the interest rate, as well as payment and interest rate caps. It is therefore advisable to seek professional advice before deciding on an ARM.
- Bridge Loan: If you are selling an old home to buy your new one, you might need a bridge loan to tide you over until the old house is sold and your new primary mortgage is in place. But make sure you can afford this, as there will be a time when you will be paying off two loans simultaneously – your bridge loan and your current mortgage payments.
- FHA mortgages: There are several advantages of a Federal Housing Administration (FHA) loan. These include lower down payments (3% to 5%) and lower cash expenses during closing as you can add many closing expenses into the loan. These can be easier to qualify for, but the paperwork involved can be time-consuming.
- VA Mortgages: Veteran Affairs (VA) mortgages are offered for a pre-determined amount (not more than $200,000) and allow you to buy a home without any down payment. The primary guideline for this type of loan is that you are a Veteran or service-member on active duty or have a discharge from the armed services (not dishonorable).
- Assumable mortgages: These loans stay with the property you are buying and are transferred to the next owner. FHA loans granted before December 1, 1986 and VA loans taken prior to March 1, 1988, are considered “assumable.”
- Balloon mortgages: If you are planning to sell your home in the near future and hope to pay off or refinance your loan before then, a balloon mortgage might make sense. This type of loan has a fixed rate for a certain period of time (generally seven years) after which a lump sum or balloon payment of the pending balance has to be paid. The interest rates on this type of mortgage are also lower than other conventional loans.
- Department of Agriculture loans: The USDA offers a number of home loans to buyers in rural areas who fall within the low-to-moderate income bracket.
- State/county/city programs: Call or check the website of your state/county/city housing division, as they can inform you about programs that will assist home buyers – some that you may easily qualify for.
What To Determine When Choosing a Mortgage
- What is the down payment required?
- What is the interest rate and the Annual Percentage Rate (APR)?
- What are the closing costs (and any extra fees applicable)?
- Is there a possibility of your mortgage being resold on the secondary market?
What To Do If You Get Into Financial Trouble/Loss Mitigation
There are times in one’s life when unforeseen circumstances arise. Even if you work hard and make all your payments on time, situations such as illness, being laid off, marital problems, an increase in your household expenses, or emergency repairs can affect your ability to pay your debts. Even one of these situations can affect you making your home loan payments and if these missed payments continue for a while (generally longer than three months), you could be facing the prospect of losing your home. This is where loss mitigation comes in. It is a process where a representative of the holder of the loan or a third party agency tries to stop the foreclosure before it takes place. A third party agent is often best suited for this job because of the unbiased professional experience they offer.
It is through the joint efforts of the federal government and the mortgage industry that the process of loss mitigation evolved. When too many homeowners found themselves losing their properties due to default and delinquent payments, this program was created to work with both parties concerned (the homeowner and the lender) in order to reach an alternative solution.
The main goal of loss mitigation is to help the owner keep his or her home. Options such as loan modification plans, renewed repayment plans, partial payments, and an extension of the loan could be employed. If all this fails, then every attempt to get the best price possible for the house is made, before the loan foreclosure begins.
Here are some of the different types of loss mitigation options available:
- Loan modification – The mortgage is modified and new terms are drawn up between the lender and the owner. These could include a new lower interest rate, smaller principal balance, drawing out the term of the loan, waiving of late fees, and fixing adjustable rates.
- Short sale – If the owner’s mortgage is more than the property is worth, a short sale could be helpful. To assist the owner in selling the home at the actual market value, the lender might accept a payoff that is lower than the principal balance of the original mortgage amount.
- Short refinance – Reducing the principal balance of a mortgage can also allow the owner to refinance the loan with a new lender.
- Deed In Lieu – This will not apply if you can still meet your payments. However, if there is no other option, a Deed In Lieu of foreclosure (DIL) allows the owner to put up collateral property and, as an exchange, he or she is released from the standing obligations of the current mortgage.
Knowing your rights in matters of default payments and foreclosure is of extreme importance. At the end of the day, lenders want to keep you in your home and it is your responsibility to prove to them that you will live up to your part of the bargain. Loss mitigation helps to work out a mutually sustainable solution and prevent further losses and financial burden in case of foreclosure.
When you signed the agreement with the lender who loaned you the money to buy your home, you agreed to pay back the loan in a series of pre-determined monthly payments over a fixed period of time. If you miss these monthly payments (often for even as little as three months), this will be considered a delinquency. The bank or lender is fully within its legal rights to start the process of foreclosure on your home and take ownership of it. Your lender will start the proceedings by sending you a notice but there is no need to wait until that happens to start being pro-active and preventing the foreclosure. If you find yourself having trouble meeting your monthly mortgage payments, it’s time to take stock of the situation and avoid a financial crisis.
There could be a number of reasons that cause you to default on your payments. These could include losing your job, ill health or an injury, a divorce, the death of a spouse or even a change in your financial picture. What often happens is that you are so involved in dealing with this crisis in your life, the last thing you pay attention to is other responsibilities such as paying off your debts. That is why it pays to plan in advance. You could speak to a housing counseling agency or look for professional advice to help get your finances back on track before it’s too late.
- The most logical solution to preventing foreclosure is to save money and reduce expenses. Put away a certain amount every month in an emergency fund that can help you in times of crisis. Also, cut down unnecessary spending to the bare necessities, if required.
- If you still find yourself struggling to make ends meet, speak to a loss mitigation consultant as soon as possible to help you negotiate with your lender until you get back on your feet.
- Always be honest. Don’t ignore any notices in the hope that the problem will go away because it won’t. Discuss your situation openly and don’t hide any information from your lender or your counselor. If your lender feels that you are making every effort to pay back your loan, they might be more lenient in the way they decide on the consequences of your default. Communication is imperative.
- Make sure you know exactly what is owed and to whom. Give your mortgage the priority it deserves and act accordingly.
- Work with your housing counselor to draw out a workable household budget that you can stick to. Take stock of all your assets such as investments, insurance and jewelry. These could help you through the crunch if necessary.
- Remember that even if you are a month overdue on your payments, you will end up paying a late fee as well as interest. Keep this in mind when calculating what you owe your lender and budget accordingly.
- If there is no other option but to sell your home, look at your options to minimize losses in such a transaction. Sell before the foreclosure process starts to get the best price possible without legal intervention and having it showing up on your credit report.
The most important thing when facing foreclosure is to never lose hope. There are a number of alternatives and solutions out there that can help you as long as you are willing to make the necessary changes to improve your life. Keep in mind that your lender only wants its money back and they would rather avoid going through the complicated foreclosure process.
If you continue to be positive and look for ways to deal with the crisis, there is a chance that you might be given another opportunity to deliver on your promises and save your home as well. Be informed, understand the situation, take professional advice, stay honest, and think positively. It can be done!
In This Chapter, You Learned:
- When it’s better to rent and when to buy.
- How to review your financial status and determine whether you are ready to buy a home.
- The costs that go in to buying a home.
- The step-by-step process of buying a home.
- The different types of mortgages available that will help you close the deal.
- How a loss mitigation specialist can help you out in case of financial trouble.
- The preventive steps to take to avoid foreclosure.