Check this out… According to TransUnion, which is one of the big three credit bureaus, credit card delinquencies are currently at their lowest level in 17 years.

Surprised? I am. Given all the tight job market, stagnant wages, and increasing food prices (among other thing), I wouldn’t have expected it.

At the same time, however, more Americans are falling behind on their mortgages. According to Charlie Wise, TransUnion’s director of research and consulting, “Consumers are protecting their credit cards. It gives them financial flexibility.”

Back in 2008, 4.3% of consumers were current on their credit cards but behind on their mortgages. Fast forward to 2010, when that number climbed to 7.4%. On the flip side, the number of consumers that are delinquent on their credit cards but current on their mortgages dropped from 4.1% to 3.0%.

So the numbers here aren’t huge, but there’s a definite pattern — and the relative changes are quite large. But why? Historically, people in financial trouble have tended to pay stay current on their mortgages while letting their other obligations slide. So why the reversal?

Experts say it’s because the housing market is so bad that consumers are being forced to make tough choices. As it becomes clear that they’re going to lose their homes, more people are choosing to protect the few financial tools they have left.

Whatever the cause, it’s an interesting — and potentially troubling — change.

Source: AJC.com

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On Friday, I talked about using your 401(k) to pay off your mortgage. Then, over the weekend, a reader wrote in to ask about a different scenario – a family member lending you the money to pay off your mortgage. Robert asked:

Is a $100k personal loan from a family member to pay off a mortgage debt taxable?

The short answer is that personal loans are not themselves typically taxable — assuming that it’s truly a loan, and will be paid back. However, if there is no (or not enough) interest being charged, the IRS can figure what the interest on the loan should have been and treat it as though the borrower had incurred.

These calculations are based on the “Applicable Federal Rate” for a short, medium, or long-term loan. The AFR changes monthly. You can see the most recent values at IRS.gov – click here. You can learn more about “Below Market Loans” by reading IRS Publication 550.

Since the lender is required to report the interest as taxable income, this could create some tax issues. In most cases, however, this isn’t a big deal, as the unpaid interest can be treated as a tax-free gift from the lender to the borrower. This works without any complications as long as the total amount of unpaid interest is less than the current year’s gift-tax exclusion, which currently stands at $13k.

Now for some good news… With some exceptions, this rule does apply to loans under $10k. In addition, if the loan is for $100k or less, the interest that must be reported by the lender (or treated as a gift) is limited to the total of the borrower’s net investment income for the year. And if the borrower’s net investment income is $1k or less, the amount is treated as zero.

But what if you the lender ends up forgiving the loan and you never repay all or a portion of it? In that case, the amount forgiven will be treated as a gift, and will be subject to the annual and/or lifetime gift tax exclusions. If the lender is in no danger of exceeding their lifetime limit, the forgiveness can be done all at once.

If, on the other hand, the lender wants to preserve their lifetime exclusion, then they can forgive the principal (and ongoing interest) in chunks of up to $13k/year (per recipient) until the entire amount has been forgiven.

As always, I highly recommend that anyone facing complex tax situations like this seek out professional advice. It’s not terribly expensive to buy an hour or two of a tax pro’s time, and you could save yourself a significant chunk of money, not to mention a bunch of headaches.

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Earlier this week, I ran across an article about a new piece of legislation being promoted by two Georgia Congressmen who want to allow people to pull money out of their retirement accounts to pay down their mortgages.

Dubbed the Hardship Outlays to Protect Mortgage Equity (HOME) Act of 2011, the legislation would allow homeowners to withdraw up to $50k or half of the account value, whichever is smaller, without paying the usual 10% penalty. In short, you’d have to use the funds to make mortgage payments within 120 days of receiving the distribution.

You can read the text of the bill here: HOME Act of 2011

The sponsors, Sen. Johnny Isakson and Rep. Tom Graves, argue that people who are faced with losing their homes should not be forced to pay a penalty to access their own money. At the same time, many financial experts are skeptical. One big concern is that people would be pulling money out of 401(k) accounts that are protected from creditors and putting it into a home that could ultimately be taken from them.

Another justification that Isakson gave is that people could use the withdrawals to get their underwater mortgages back above water, thereby allowing them to refinance their mortgage to a more favorable rate. Of course, with the recently announced changes to the HARP program, those with underwater mortgages will now have an easier time refinancing, so it might not be necessary to raid their 401(k) to make this happen.

One concern I have is that, if passed into law, the new rules would effectively allow anyone with a mortgage to raid their retirement account, whether or not they really need the money to cover their payments. While I understand the desire to help people stay in their homes, the last thing we need to do is make it too easy for anyone and everyone to pull money out of retirement accounts.

What do you think? Is this a good policy move? Or are we just kicking the can down the road, essentially transforming the problem from unaffordable mortgages into unaffordable retirements?

As an aside, I know of at least one reader out there will likely be strongly in favor of this idea… Our good friend Carlos, who cashed out his 401(k), paid the 10% penalty (plus taxes), and used the proceeds to pay off his mortgage just three years after buying his house.

Source: AJC.com

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Everyone has seen how housing prices have taken a nosedive in most markets across America since the start of the 2008 recession. Almost $3 trillion worth of equity has disappeared, and homes are now worth significantly less than what their owners paid for them. This evaporation of equity has dealt a devastating blow to many elderly Americans who were originally planning on tapping into that equity to supplement their retirement through reverse mortgages.

The truth is that reverse mortgages shouldn’t be used as a last minute tool to fund your retirement. Unfortunately, the lack of homeowners’ equity and a host of other factors have made reverse mortgages a thing of the past as a retirement option.

What is a reverse mortgage?

A reverse mortgage is much like a standard mortgage for your home. It is called a reverse mortgage because the homeowner will receive a cash payment based on the amount of equity he or she has in their home. So, after you finally get your home mortgage paid off and you own your home free and clear, you can go back into debt again for the exact same house with a reverse mortgage.

In contrast to a conventional mortgage, however, there is no repayment requirement as long as the homeowner meets certain requirements, such as continuing to use the home as his or her primary residence. Once the borrower dies, the loan must be repaid.

Reverse mortgages require equity

One of the biggest realizations to come out of the current housing crisis is that reverse mortgages require homeowners to have equity in their homes. If you’ve been banking on a reverse mortgage to fund your retirement instead of investing for your financial goals that you should be been doing all long, you could be in for a rude awakening if the equity in your home has vanished.

This is exactly what happened during the recent (and ongoing) housing crisis, and many Baby Boomers and retirees have been left in a tough situation with little in the way of retirement savings and a hope of using home equity and a reverse mortgage to fund their retirement dreams. But, when the equity disappeared, so did their ability to borrow against their home for retirement. Traditionally, homeowners thought that home prices would rise forever, but that has proven not to be the case in recent years.

Reverse mortgages can hurt your heirs

When you borrow against your home equity to cover living expenses in retirement, you’re putting your heirs at risk of some serious estate planning consequences. When you die, your reverse mortgage must be repaid. Many estates do this either with insurance proceeds or by selling the primary home that was mortgaged. This can be devastating news to family members who may have been counting on those funds for one reason or another — e.g., daily living expenses, paying for a future college education, or paying off other debts of the deceased. Reverse mortgages also have the potential to forcing the sale of homes that have been in families for generations.

Reverse mortgages aren’t a substitute investing

When home prices in America were skyrocketing, many people skipped funding their retirement accounts in favor of buying a bigger home and paying down their mortgage. The trouble with this is that you really need to have a well-rounded financial plan that includes investing for retirement and other goals, saving, paying down debts, and protecting yourself and your family with insurance. Banking on the ability to borrow against the equity in your home during your retirement years is a very risky strategy that can blow up in your face.

Reverse mortgages are expensive

Historically, reverse mortgage are very expensive because of very high fees. These fees erode the value of what little equity you have built up in your home. Like all home loans, there is an origination fee, appraisal fees, closing costs, insurance, and a host of other fees that are tacked onto your reverse mortgage. Because of this plethora of fees, the cash payout that you receive in this depressed housing market will be even further reduced.

In the final analysis, there’s no better alternative to investing for retirement than a well-balanced portfolio of stocks, bonds, and/or mutual funds. Using your home as a way to fund your retirement dreams is fraught with potential drawbacks, and the expectation that you’ll have a ton of equity at retirement is based on the faulty assumption that your home will necessarily increase in value, or at least retain its current value.

Do you have any experience with reverse mortgages? Has your declining home value now made a reverse mortgage impossible? I’d love to hear your thoughts in the comments section.

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If you’ve been unable to refinance your mortgage because your loan is underwater, you’ll be happy to learn that the Obama administration has announced sweeping changes aimed at helping homeowners like you. More specifically, if your loan was sold to Fannie Mae or Freddie Mac on or before May 31, 2009 and your loan-to-value ratio is 80% or higher, you could benefit.

The biggest change here is that they’re removing the old ceiling of 125% LTV ratio from the Home Affordable Refinance Program, which unilaterally excluded even the best borrowers if they lived in an area where home values had plummeted. To qualify, you have to be current on your loan payments, have no late payments in the past six months, or not more than one late payment in the past twelve months, and you cannot have previously refinanced under the HARP program.

As far as the lenders go, they no longer need to warranty their loans, which required them to buy back loans from Fannie Mae or Freddie Mac if the borrowers defaulted. This change will reduce lender liabilities and should make them more willing to work with borrowers. The White House is hoping that increased ability to refinance to a lower mortgage rate will keep people in their homes and spur spending as monthly mortgage obligations decrease.

Specific details will be made available to lenders by November 15th, though certain aspects of the program won’t go into effect until next year.

Source: Chicago Tribune

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» Time to Refinance Your Mortgage?

Last week, I talked about refinancing your mortgage to improve cash flow, but without extending your time horizon. Today, I want to talk about something slightly different… Refinancing your mortgage to accelerate your mortgage payoff.

For now, we’ll set aside the debate over whether you should pay off your mortgage early or string it out and focus on investing. We’ve covered that topic extensively in the past so, for today, I’ll just assume that the decision has been made.

As before, I’d like to highlight the possibilities with a concrete example… Bob and Sue bought their home ten years ago using a standard $240k, 30-year fixed rate mortgage at 6.5%. Since then, they’ve consistently made their required payment of $1,517/month (principal + interest), and their balance has dropped to $201k.

If they just keep on keepin’ on, they’ll be mortgage free in 20 years – at which time they’ll have paid a total of $278k in interest. Yikes! Once they see that they’ll pay more in interest than the original balance of their mortgage, they decide to get out of debt as quickly as possible. Unfortunately, their budget won’t support extra mortgage payments, so they’ll have to think creatively.

After shopping around, they find a 15-year fixed rate mortgage for 3.5% APR. Nice, right? Actually, that’s slightly above current mortgage rates, but it’s a nice round number, so let’s just go with it. And yes, I’m once again ignoring the costs associated with refinancing. Given that we’re using an above-market rate, let’s just say that they found a no-cost refinance deal.

Running the numbers

Despite cutting the amortization time in half, their monthly payment will drop to $1,437 thanks to that super low rate. And, of course, their mortgage will now be wiped out in 15 instead of 20 years. The cost? A little under $58k in interest on the new mortgage plus $134k in interest payments already made during the first ten years for a total of $192k in interest payments.

Wow! That’s $86k in savings, and they’ll be mortgage-free five years early. Not too shabby. But remember, they decided that they wanted to get out of that mortgage as quickly as possible, so why settle for a lower payment? Why not keep making the original payment, and apply the $80 monthly excess to their principal?

If Bob and Sue do this, they’ll save a little more than $4k over the straight 15-year scenario, bringing their total cost down to $187k in interest payments, for a total of $91k in savings. Plus, they’ll be mortgage-free about a year earlier, meaning that they’ve now shaved a total of six years of their mortgage.

All of this is possible simply because they refinanced to a lower rate (and a shorter term) while continuing to make their original payments. Of course, any additional money that they can scrape up and send with their payment will accelerate things even further, so it pays to look for corners to cut, or ways to earn extra money.

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Have you looked at mortgage rates lately? They are (once again) crazy low, with 30 year fixed rates averaging just a shade over 4%. I feel like I’ve been saying this over and over, but rates can’t get much lower than this, so if you’re looking to refinance refinancing your mortgage, now is a great time.

That being said, I wanted to shed some light on a possible downside of refinancing that many people overlook…

In the good old days of ever-appreciating property values, many people were treating their homes like piggy banks, and refinancing to pull out equity that they could spend on something else. Nowadays, the economic landscape has changed, and most people are refinancing to reduce their interest costs and improve their cash flow.

While a healthy chunk of the apparent cost savings associated with refinancing comes from getting a better rate, it’s also important to keep in mind that you may wind up resetting the mortgage clock when you decide to refinance.

Mortgage refinancing: an example

Consider the following…

Ten years ago, shortly after getting married, Bob and Sue took out a $240k, 30-year fixed at 6.5% APR. They’ve steadily made their required payment of $1,517/month (principal + interest), and their mortgage balance has shrunk to $201k (rounding off). If they now decide to refinance to a new 30-year fixed rate mortgage at 4.5%, their payment will shrink to $1033/month.

Wow! That’s great! They’re “saving” nearly $500/month. What’s not to love?

Well… The interest rate savings is only a part of what’s driving down their monthly payment. The balance is coming from the fact that they’ve reset the time horizon to 30 years from now. Instead of being mortgage free 20 years from now, it take them 30 more years — for a grand total of 40 years!

Let’s take a look at the underlying math… Consider that, had they kept the original mortgage, they would have made $278k in total interest payments. Even with the mortgage interest tax deduction, that’s a huge chunk of money.

With the refinance, they paid nearly $134k in interest during the first ten years, and with the new mortgage, they’ll pay an additional $166k of the next 30 years, for a grand total of $300k in interest payments. Yikes! Even though the refinance greatly reduced their monthly payments, it wound up costing them $22k in additional interest payments.

Now consider what would have happened if they had used their heads, and shortened the term of their new mortgage. Given that shorter term mortgage typically have lower rates, let’s say that they manage to find a 20-year fixed rate mortgage for 4.25% (i.e., 0.25% less than the 30-year mortgage).

In this case, their payment would drop to $1,245/month, a savings of $272/month over their original loan. Not as good as with the 30-year option, but still quite good. And we’re not done yet…

In this scenario, they’d still be on the hook for $134k in interest payments during the first 10 years. But during the next 20 years (the life of their new mortgage) they’d paid just $98k in interest. That’s a grand total of $232k in interest payment — a $68k savings over their original mortgage scenario!

The point here is to not get wowed by the monthly payment. Run the numbers and figure out both your monthly payment and the total cost to own your home. It’s possible to reduce both. But if you’re not careful, you’ll wind up reducing your monthly payment while simultaneously increasing your costs.

Note: Yes, I totally ignored the cost to refinance, the payback period on these costs, etc. Those points are generally well understood, and I didn’t want to muddle the current issue with unnecessary details.

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Interest payments on home mortgages have long been tax deductible in the United States. In fact, prior to the Tax Reform Act of 1986, interest on all personal loans was tax deductible. The deductibility of loan interest dates back to the introduction of the income tax system in 1913 when, according to an article in the NY Times, it was difficult to distinguish between personal interest and business interest in a nation full of small proprietors.

Regardless of Congress’ initial intentions, the home mortgage interest deduction eventually became a stepping stone to home ownership. The reason for this is that it effectively decreases the cost of borrowing to buy a home. There are, however, some limitations that reduce the value of this deduction.

For starters, you must elect to itemize your deductions, and the mortgage interest (and other deductions) only reduce your tax bill to the extent that your itemized deductions exceed the standard deduction. Another limitation, but one which does not impact the majority of Americans, is that interest is only deductible on the first $1M of mortgage debt. A similar limit of $100k applies to home equity loans regardless of their purpose.

Another important thing to keep in mind is that an income tax deduction is very different from an income tax credit. Whereas the former reduces the amount of your income tax that is subject to taxes, the latter directly reduces your tax bill.

Take, for example, an individual in the 25% federal income tax bracket. For every $1000 in mortgage interest that they pay in excess of the standard deduction, their tax bill will be reduced by $250 (plus whatever state income tax benefits they might enjoy). In contrast, a $1000 tax credit would reduce their total tax bill by $1000.

While the home mortgage interest tax deduction is undoubtedly beneficial to those with mortgages, many people use it as an excuse to keep their mortgage when perhaps they shouldn’t. We could debate all day long whether or not you should pay off your mortgage early – with the alternative being to keep your mortgage in favor of putting extra money into your investments. In my opinion, the mortgage interest deduction should be just a small part of this decision.

Let’s consider a simple example…

The standard deduction for 2011 is $11,600 for married couples filing jointly. Let’s assume that a married couple buys a $300k house on January 1st with 20% down, resulting in a $240k fixed rate mortgage at 5%. Over the course of the first year, they will pay a total of $11,919.58 in mortgage interest. Let’s further assume that they donate $3k to charity and pay $3k in property taxes.

Taken together, these mortgage interest and charitable contributions add up to $17,919.58 in deductible expenses. Sounds great, right? Assuming that they’re in the 25% tax bracket, this works out to a tax savings of $4,479.90 — or does it?

The reality is that they would’ve been able to take the standard deduction regardless, so we really need to subtract that out to find out the marginal gain from itemizing. The standard deduction would have reduced their tax bill by $2,900 ($11,600 x 0.25) so they’re really only gaining $1,579.90 in additional tax savings.

That’s $1,579.90 tax savings in return for paying an extra $11,919.58 in interest — a 13% tax savings. While this 13% savings is far better than nothing, it’s nowhere near as good as one might expect based on their tax bracket. And if they hadn’t made that charitable contribution, the benefit would have been less.

As with anything, you’ll need to run the numbers and decide what’s best for you. Just be aware that when someone warns you not to pay off your mortgage because you’ll be giving up that huge tax deduction, the numbers aren’t nearly as good as you might think.

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Earlier this week, a long-time commenter named Carlos (aka CharlieBoy) mentioned that he paid off his mortgage early. Having done the same thing myself, I was intrigued, so I sent him a note asking for details.

Within a few hours, Carlos sent a lengthy reply with tons of details. Today, I’ll be summarizing his story.

“My wife and I purchased our house in the fall of 2008 for $300,000. I believe the interest rate was 6%. We used the equity from our old house to pay off three small auto loans and to make a 35% down payment on our new house. The big down payment made it easy for us to refinance it two times since 2008 because we were never under water.

We didn’t want to buy a huge house with a huge mortgage. We decided not to let the bank or agent tell us how much house we could afford. WE did the math, WE knew our budget; therefore, WE decided how much we were comfortable paying each month. We found a house that works well for us within our budget.

Sure, it doesn’t have the desirable three-car garage that we wish we had, but a bigger garage comes with even a bigger mortgage, so we decided we could live with a smaller garage but with the smaller mortgage. [...] Back in 2008 the bank would have let us borrow two times the amount that we borrowed. Ouch!”

That’s quite impressive… They paid paid off a $195k (= $300k – 35% down payment) mortgage in about three years. But how? Well, a big part of it was the decision to downsize so they could pay off those three auto loans and put up a big, fat 35% down payment. But there’s more…

“Just a few weeks after we bought the house in 2008, we refinanced our mortgage into a 5%, 15-year loan. To make up for the larger monthly payment of a 15-year mortgage, we had to make some budget cuts. It wasn’t too hard because we no longer had car payments. We don’t go to regular restaurants, and we rarely go to movie theaters.

Last December, we refinanced it again at 3.75%. That was our Christmas gift to ourselves. That lowered our monthly payment once again, but the thought of spending the next 15 years slaving away for a mortgage company continued to bother me every day, we started saving even more to pay it down faster.

By living below our means, we started sending every extra penny we saved to pay down our mortgage principal after we saved a little for emergencies.”

Okay, they refinanced to more agreeable terms, scraped up additional money for extra mortgage payments, etc. But still, how so fast?

“The extra payments towards the principal were making a huge difference, but then something else happened. In April, I changed jobs, which meant I had to decide what I wanted to do with my 401(k). I kept going back and fourth between cashing it out to pay off my mortgage or just rolling it over to an IRA.

I know very well that cashing out your 401(k) to invest in a 3.75% mortgage is not considered wise when you look at the stock market’s historic returns of 7% to 8%. I don’t even recommend it to anybody.”

Yikes. Cashing out a retirement account early results in a hefty tax bill plus 10% early distribution penalty. Ouch. So why did he do it?

Well, he went on to argue that, due to our country’s massive deficits and the political mess that has developed over the past few years, the investment outlook in this country just isn’t that good, and he’s not expecting anywhere near historic returns for the foreseeable future. Given an expectation of low returns, he could justify taking the hit to get out from under his mortgage.

This is a pretty extreme view, and Carlos is well aware of that. After all, he explicitly states that he doesn’t necessarily recommend this course of action to others. But it was the right decision for him.

Looking forward:

“By not having a mortgage, I can now focus more aggressively on my retirement. Who knows, I might save enough money to invest in a small business. Not having a mortgage will create more opportunities for me. Getting rid of my biggest financial responsibility makes sense in every way to me.”

Having paid off a mortgage myself, I can say with certainty that it does free up a lot of cash and provide a lot of flexibility. That being said, trading your 401(k) for a mortgage-free life isn’t a decision to be made lightly. Given that contributions to retirement accounts are capped on an annual basis, Carlos will have to work extra hard to rebuild his retirement nest egg.

Sure, he’ll be able to pour money into a tax-efficient (but taxable) portfolio to complement the money he’s able to stash in retirement accounts, but he’s lost a bunch of tax-advantaged space (not to mention the 10% penalty) that he can’t easily re-gain.

So… What do you think? Is Carlos crazy for cashing out his 401(k)? Or crazy like a fox? As much as I disagree with the decision to liquidate his 401(k), I have a feeling that Carlos is going to be just fine in the long run.

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If you’re in a position to refinance your mortgage and haven’t done so already, now’s a great time to lock in a very low rate. And even if you have refinanced, it might make sense to refinance again.

You’ve likely heard about the “historically low” mortgage rates over the past few years, but 15-year fixed rate mortgages dipped to an all-time low of 3.50% last week. And for their part, 30-year fixed rate mortgages averaged 4.32% last week, which is nearly an all-time low, and the lowest rate in the past nine months.

With rates this low, there’s a pretty good chance that you could score a “no-cost” refinance – wherein you accept a slightly higher than market rate in return for the lender covering your closing costs – and still come out way ahead.

In fact, these rates are so low that I almost wish we had a mortgage to refinance. Almost.

Source: USA Today

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About a year and a half ago, we paid off our mortgage. The issue of whether you should pay off your mortgage early or invest has always been a hot topic in financial circles, but I can tell you this much:

We haven’t regretted our decision to pay off our mortgage. Not even once.

Of course, just because we’ve paid off our mortgage doesn’t mean that we’re living for free. We still face a number of expenses, including property taxes, routine maintenance, homeowners insurance, etc. So just how much do these things really cost?

Let’s start with property taxes. Property taxes vary widely based on location, but around here they average about 1% of a home’s assessed value per year. Unfortunately, the only real way to combat this bill – aside from moving to a less expensive home – is to appeal your assessment. The good news is that this can be done. In fact, I’ve successfully appealed our assessment on more than one occasion.

Next up, insurance. Once again, rates vary based on a number of factors. While you could technically drop your homeowners policy once your mortgage is paid off, you’d be a fool to do so. You can, however, save on homeowners insurance by shopping around, increasing your deductible, etc. In our case, homeowners insurance runs roughly 0.2% of the value of our home per year.

Another big issue is maintenance. I’m talking here about things like painting, pest control, replacing your carpet and appliances, etc. The general rule of thumb is that you should budget roughly 1-2% of the value of your home per year for ongoing maintenance. Some years will be less, and others will be more – possibly much more.

In the six years we’ve lived in our house, the biggest maintenance issue we’ve dealt with has been replacing our water heater. Looking ahead, however, I’m expecting to have to replace the roof sometime in the next ten or so years.

There are, of course, other expenses that I haven’t factored in here such as lawn maintenance – either paying someone to cut your grass, or buying and maintaining a mower and associated equipment so you can do it yourself – utilities, HOA fees, etc. These things vary so widely based on your circumstances, however, that it’s hard to come up with a general rule of thumb.

Combining just the property taxes, homeowners insurance, and general home maintenance, we arrive at a rough estimate of 2.2%-3.2% of our home’s value per year. Given that our house is worth somewhere in the neighborhood of $325k, that means we’re facing roughly $7k-$10k in annual housing costs even in the absence of a mortgage payment, and that’s without considering utilities or lawn care.

I mainly bring this up to combat the overly-simplistic view that once you pay off your mortgage, you’ll be essentially living for free. The reality is that even without a mortgage payment, you’re still likely to face significant housing-related expenses.

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I recently ran across an interesting story on CNBC about “serial refinancing” – the practice of refinancing your mortgage time after time as rates improve. On the surface, this makes perfect sense. If you can drive down your rate without incurring additional costs, why not?

And yes, you can refinance without paying any closing costs. To do this, you effectively sell points – i.e., you accept a higher than market rate on your mortgage in return for cash to cover the closing costs. As long as this rate is lower than your current rate, you can come out ahead.

This renewed interest in refinancing has been driven by a recent drop in mortgage rates to within 0.25% of last summer’s 50 year lows. Of course, you can only refinance if you currently owe less than your home is worth, and nearly 11M homeowners are currently underwater.

With that as a backdrop, here’s a link to the video. I tried embedding it here, but the embed code doesn’t seem to work – sorry. Also note that it’s a Flash video, so it may not work on certain mobile devices.

In case you’re in a hurry, here are some of the more salient points:

For starters, they interviewed an older couple that has refinanced their mortgage four times in the past four years, ultimately cutting their interest rate “nearly in half.” Of course, it was later acknowledged that their most recent round of refinancing involved switching from a fixed rate loan to an adjustable rate mortgage (ARM), so this is a bit of an apples-and-oranges comparison.

Speaking of ARMs… They also interviewed Keith Gumbinger of HSH.com, who argued that ARMs are a good choice for many homeowners because they come with a significantly lower interest rates, such that you can save a ton of money before the rate starts adjusting.

While I agree that ARMs can be a reasonable choice in certain circumstances, you also have to keep in mind the downside risks. When taking out an ARM, you’re essentially betting that interest rates will stay low (such that you can refinance again in the future) or that you’ll move before your rate starts adjusting.

Yes, it’s true that the average homeowner owns their home for just eight years, and that the spread between ARM and fixed rates is the highest that it’s been in eight years, but… You also have to look at recent history and realize that the market might move against you such that you’ll be unable to sell or refinance when you need to.

Another risk of ARMs is that they allow people to buy more house than they can truly afford. In fact, it was just this sort of “creative” financing that got us into our current mess, so be very careful. If you can save enough money to make it worth the risk, then go for an ARM. But if you’re just using that lower payment to justify borrowing more than you can afford, then think twice.

Finally, I found the statistics on the percentage of homeowners using ARMs to quite interesting. Back in 2007, when our ARMs made up 18% of the mortgage market. In 2009, when credit markets were at their tightest, ARMs made up just 1.5% of the mortgage market. Since then, ARMs have made a bit of a comeback, and currently account for 6.5% of the mortgage market.

Should you refinance?

So… Should you refinance? And if so, which type of mortgage should you get? As I noted above, refinancing your mortgage can be a great way to save money, but you also need to keep in mind that you effectively “reset the clock” when you refinance.

For example, let’s say that you’re currently 5 years into a 30 year, fixed rate mortgage. If you refinance into another 30 year mortgage, you’re now 30 years away from paying off your mortgage instead of just 25 years. In that case, you can (and should) consider making larger than required payments to pay off your mortgage ahead of schedule.

Another possibility would be to refinance into a shorter term, dropping from (say) 30 years to 15 years. Yes, your payment will go up due to the shorter amortization period, but the lower rate (both due to current market conditions and to the shorter term) will help to minimize the impact.

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This is a guest post from Lisa White.

For senior homeowners needing some extra cash, it’s sometimes better to look backwards instead of forwards – with their mortgage, that is.

Reverse mortgages are not easily understood, and many who could benefit from them shy away, afraid of making a mistake. Journalists who have only a cursory understanding of the product may contribute to this. This post lays out the pros and cons of reverse mortgages, and when you’re finished reading, you should be able to confidently determine if they are right for you or someone you care about.

What exactly is a reverse mortgage?

A reverse mortgage is exactly what it sounds like. With a forward (i.e., regular) mortgage, you start with a principal balance and make payments until the loan is paid off and you own your home outright. With a reverse mortgage, the lender makes payments to you. Repayment on a reverse mortgage is not required until the home is no longer your primary residence. Because you don’t make payments, lenders don’t care about your credit score or your income when you apply for a reverse mortgage.

Types of reverse mortgages

The most common reverse mortgage is the Home Equity Conversion Mortgage, or HECM. The program is administered by HUD, and its fees are regulated. HUD requires seniors to attend sessions with HUD-approved reverse mortgage counselors before they can take out one of these loans. About 90 percent of reverse mortgages are HECMs.

For very low income seniors, Single Purpose reverse mortgages are a low- to no-cost option that can provide funds for home maintenance or property taxes. They are available from local governments and charitable groups.

Proprietary reverse mortgages are funded by private lenders, and these companies make their own rules. You may be able to borrow a lot more money with these loans, but costs are much less regulated. Counseling is not required, but it’s probably a good idea – see below for more details.

How much can you borrow?

The more equity in your home, the more you can borrow. However, this amount also depends on your age (older people can borrow more), your home equity (if you have a mortgage, it must be small enough that the reverse mortgage can pay it off), interest rates and, for Home Equity Conversion Mortgages (HECMs), HUD’s loan limits.

How should you take your proceeds?

You can customize the way you receive your proceeds, depending on your use for the money. Your reverse mortgage counselor can help you with this.

• Lump sum payment: This is ideal for thing like paying for catastrophic medical expenses or consolidating debt. An unspent lump sum, however, can jeopardize your eligibility for government benefits tied to assets, like SSI and Medicaid. Reverse mortgage proceeds are not countable as income because they are loans. However, Medicaid and SSI eligibility requires applicants to have no more than $2,000 ($3,000 for a couple) in countable assets each day out of the month. So if you took a lump sum distribution and parked it in something like a high interest savings account, even just for a day or two, you’d be ineligible for these benefits.
• Monthly payments: Modified tenure gets you payments for a specified period of time, for example, five or ten years. Traditional tenure gets you payments for life. Although your payments will be considerably smaller, this is a good option for ongoing supplemental income.
• Line of credit: This lets you tap your home’s equity only when you need to. It can be the best choice, like credit cards which charge no interest until you use them.

Combinations of the above options are also available, allowing you to customize your distribution; for example, a lump sum to pay off debt and a line of credit for emergencies.

How much does a reverse mortgage cost?

Like all financing, reverse mortgages come with costs. There is mortgage insurance, which is paid upfront and costs one-hundredth of 1 percent (0.0001) of the property value for HECM Saver (which has lower borrowing limits) or 2 percent for HECM Standard. On a $300,000 home, that’s $30 for the Saver and $6,000 for the Standard. Then there are other charges and of course interest. Lenders have to give you a disclosure called the Total Annual Loan Cost (TALC) which lets you compare reverse mortgage costs.

Because the upfront costs can be substantial, reverse mortgages may not be appropriate for those who can qualify for less-costly home equity loans instead. You should also think twice if you are in poor health or are contemplating a move within the next few years.

Don’t skip counseling

If you have decided a reverse mortgage is your best bet, talk to a reverse mortgage counselor so that you can be an informed shopper. Along with local HUD-approved counseling agencies, there are a number of national counseling agencies that can assist you. While HECM loans are regulated, proprietary loans are not, and even HECM lenders do price differently. Whether counseling is required or not, it’s smart to compare reverse loans and be fully informed before committing to a product.

About the Author:

Lisa White is a writer, editor and marketing professional with more than 25 years of experience. She has worked for a number of corporations, business and consumer publications and associations in a variety of industries, including food/foodservice, retail, distribution, venues/entertainment, finance, health care and insurance. White’s background includes serving as editor for four magazines and assisting in the start up of three publications. She has been an independent writer since 2001 and is based out of the Chicago area.

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For background, I should note that Bob and Sue were part-time homebuilders for the better part of the past decade. While Bob worked full time and Sue stayed home with the kids, they also built houses on the side. Every couple of years, they’d start building a new house. When it neared completion, they would put it along with their current house on the market, and then live in whichever one didn’t sell.

Raising the stakes

This worked so well for them for several rounds that they eventually decided to start building more expensive homes – homes that they couldn’t actually afford to live in themselves if they didn’t sell. Unfortunately for them, they made this decision right around 2007. I’m sure by now you can see where this is headed…

As their the mega-house they were building neared completion, the bottom dropped out of the housing market (and the economy in general). Real estate stopped selling almost overnight, and they were stuck with two houses. They put the new one on the market for awhile, but there were no potential buyers.

Eventually, they put their current house on the market in hopes of salvaging the situation. Their plan was still to sell the mega-house if they could. But if they couldn’t, they would buy time by selling their regular home and using the proceeds to keep themselves afloat. Since they couldn’t afford the mega-house in the long run, they’d move into it, but leave it on the market and move again went it (hopefully!) sold.

Hitting rock bottom

After a few stressful months, they sold their regular home and moved to the mega-house. Sue also went back to work to help makes ends meet, and it seemed like they’d be able to stay afloat, at least for awhile. Unfortunately, “awhile” recently ran out. They fell behind on their payments, and the bank ultimately foreclosed on them. They’ve lost nearly everything.

In retrospect, it’s easy to say that they should’ve just let the mega-house go when the market tanked. Sure, that would’ve ruined their credit, but they were already in a house that they loved, so why not dump the mega-house and move forward? Now they have no house, no credit, and presumably little to nothing in the way of savings.

Well, for starters, Bob and Sue were intent on “doing the right thing.” They got themselves into this mess, and they were intent on getting themselves out of it. I respect them for that even though they’re now paying a huge price. At the same time, I don’t think they wanted to admit to themselves just how big a hole they’d dug for themselves.

Lessons learned

With the story above as a backdrop, I wanted to share some financial lessons that can be learned from Bob and Sue’s plight. It’s too late for them to change course, but it’s not too late for others to learn from their mistakes.

Don’t be greedy

As much as it pains me to say it, Bob and Sue are victims of their own greed. Things were going so well for them that they decided to up the ante and start building huge homes that they couldn’t afford to keep. Sure, the profits would be bigger with their new strategy, but the risks were astronomically higher. In the end, they reached for the brass ring and wound up losing everything.

Respect risk

This is related to the point above, but it’s important enough to split out on its own… Risk is a funny thing. If you’ve ever read a financial book, you’re aware that “with risk comes reward.” But what many people often fail to realized is that investment risks are very real, and they’ll often rear their ugly head at the worst possible time.

It’s easy to be blinded by the potential upside, and to simply declare that they’re sufficiently risk tolerant to reach for higher returns. In Bob and Sue’s case, they let their risk/reward ratio got out of whack.

Let’s say they would’ve made $50-$100k by building and selling a “regular” house, and that the mega-house would generate $100-$200k in profits. In this case, they would’ve doubled their potential gain, but at what cost? Their downside risk went from being a manageable setback to complete financial disaster.

Leave a margin for error

And finally… Bob and Sue’s prospects apparently took a turn for the worse when he was laid off from his job. While they would have been able to pull this deal off if everything had gone perfectly, they didn’t have any wiggle room. And things didn’t go perfectly – the house didn’t sell, their income took a hit, and so on.

Unfortunately, even with Sue going back to work, they didn’t have enough cash reserves to carry them through the lean times. They took on such an extreme financial burden that they simply couldn’t make their plan work unless everything worked out perfectly – they had no margin for error.

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Have you ever thought about buying mortgage protection insurance? Do you even know what it is? My husband and I first heard about mortgage protection life insurance from our mortgage company. They’ve been sending out little sales pitches along with our mortgage statements.

I’m usually skeptical about programs and accounts advertised by banks, but on the surface having mortgage protection sounded like a good idea, so I decided to look into it and find out what it’s all about.

What is mortgage protection insurance?

As the name implies, mortgage protection insurance protects your mortgage in case of hardship. A typical policy will cover mortgage payments in the event of job loss or disability, and will pay off the mortgage balance in the event of death.

In short, you agree to pay your carrier predetermined regular payments in exchange for the peace of mind of having your mortgage taken care of for your loved ones. Many of the policies I’ve looked at pay the mortgage lender directly.

Types of mortgage protection policies

The first concern I had was the return on the policy. As you continue making payments on the policy, your mortgage balance is (hopefully)decreasing. What benefit is there for you? Based on general trends, I see this as being very profitable for insurance companies and not a great deal for homeowners who pay off their mortgage.

I found out that you can adjust your insurance policy to make it more worth your while.

Level benefit term policy

This sounds pretty much like a term life insurance policy. You can set it for a specific time period (such as 20-30 years) and pay a locked-in premium. This typically doesn’t give you the flexibility of a regular life insurance policy, though, as any benefits are intended to go specifically toward your mortgage.

Return of premium term policy

If you are still alive when your mortgage is paid off, this type of policy will return all premiums that you’ve paid. You won’t get any of the accrued interest, but that’s still a nice chunk of money to have once your biggest debt is paid off. The other downside is that you can be disqualified if you miss any payments.

Who Benefits the Most?

As with everything in the financial realm, you really have to look at the numbers and your circumstances to determine if mortgage protection insurance is right for you. Every family can come up with something different, so I’ll just share some information for you to look at on your own time.

Some borrowers find mortgage protection to be an easier policy to get than your typical life insurance, as a physical exam may not be required.

Rates, though, can be significantly higher than a term life insurance policy. Andy Albright of the National Agents Alliance estimated the average costs of mortgage protection:

The national average for a mortgage balance is $120,000. For such a mortgage, you would pay roughly $50/month for a bare minimum policy. If you want to add riders (such as “return of premium” or living benefits), you could end up paying as much as $150 a month.

That comes out to $600-$1,800 a year out of the policyholder’s pocket. Not surprisingly, only about 2% of American homeowners have mortgage insurance, Albright says.

For term life insurance a a 40-year-old non-smoker with a $500,000 term policy will pay somewhere between $352-$641 a year. That’s a significant savings for much higher coverage.

I honestly think that you should seriously consider getting term life insurance rather than a mortgage protection policy. It’s cheaper, and you can use the money saved to pay down your mortgage faster if you want.

If you’re concerned about disability, you can back up your standard life insurance policy with a long term disability insurance policy, which may be a good idea to have whether or not you have a mortgage.

Thoughts on mortgage protection insurance

I know many people have strong opinions on getting the right types and amount of insurance to protect their family. I’d like to get your take on it to make sure I’m weighing the pros and cons correctly.

How many of you have mortgage protection insurance? How hard or easy was it for you to obtain? What are the premiums like for you? Do you think it’s a good or a bad deal?

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While the focus of the study was rather narrow (micro-entrepreneurs in the Dominican Republic), the results were quite interesting. In short, they found that “standard” financial training had no impact on business practices and outcomes, but that simplified, rule-of-thumb based training produced “significant and economically meaningful improvements.”

While it’s probably a stretch to take lessons from micro-entrepreneurs in the Dominican Republic and apply them to your family’s budget, I’d be willing to be that there’s some truth to the idea that it pays to keep things simple.

For example, instead of teaching people how to calculate their needs income needs in retirement and how to project their exactly what it will take to get there, simply telling them to save and invest 10% (or 15% or 20%, whatever) for the future.

Likewise, instead of teaching people about modern portfolio theory and the importance of asset allocation, maybe we should just tell them that their percentage stock allocation should be 100 minus their age.

Of course, rules such as these aren’t failsafe, nor should we expect them to be. After all, a rule of thumb is defined as:

…a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.

Source: Wikipedia

Beyond the inherent limitations of a one-size-fits-all rule, it’s also important to recognize that these rules can change over time. While sometimes these changes are warranted, other times they may not be. For example…

The old “100 minus your age” advice, mentioned above, eventually morphed into “120 minus your age” when modern pundits got their hands on it during the high-flying markets of a decade ago. To be fair, this change was also likely influenced by longer life expectancies, but still… How does that change look in the context of the past three years?

Similarly, the age old advice of spending no more than 28% of your monthly income on your mortgage payment gradually swelled to 30%, then 33%, and finally 36% as housing prices spiraled out of control. Once again, how does that change look in the context of the recent history of the housing market?

But in the end… If preaching rules of thumb spurs people to action – as opposed to overwhelming them into inaction – then maybe that’s where our focus should be.

What are your favorite financial rules?

Hat tip: Barbara Kiviat for linking the original study

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I recently ran across an interesting article that provided details about Ramsey’s new mansion just south of Nashville (pictured below). Based on what they had to say, it seems that Dave has a taste for the finer things in life…

According to tax records, Dave’s house spans more than 13,307 square feet – not including the 1,454 square foot garage – and sits on a parcel of land that Dave bought or $1.5M back in 2008. Though the market value of the land has reportedly dropped to $750k, the total assessed value of his home is $4,909,200.

Curious what it look like on the inside?

From what we hear Dave’s home office, including the sliding library wall ladder, is made of solid mahogany. The shower in the master bathroom is rumored to have 18 shower heads and is larger than the jacuzzi tub. Cathedral ceilings throughout. The local who we spoke with felt the basement was by far the most impressive. Full bar with whiskey barrels built into the walls, media room and several bedrooms make up the broad lower basement level you see from the distance, wrapping around the tip of the mountain.

Oh, and if you’re wondering… There’s no record of a mortgage on the property.

If you’re interested in moving into the area, you can make an offer on Lee Ann Rimes’ house right next door. While the $6,499,900 price tag might seem a bit shocking, that’s a bargain compared to the original listing price of $6,950,000. Beyond that, she’s apparently never lived there, so it should be in great shape.

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This issue has been brought into sharper focus by recent developments in the ongoing foreclosure crisis. In fact, a number of major lenders have frozen their foreclosure proceedings due to concerns over the validity of their claims.

So… What would happen if a bank foreclosed on a home and ultimately sold it to someone else, only to later have a judge overturn their decision? What if you were the new owner, and the original owner came back to claim their home?

These are the questions that Ron Lieber tackled in his recent NY Times column. The short answer is that you’d be in trouble if you didn’t have title insurance. And such troubles aren’t limited to botched foreclosures.

What if the long-lost heirs of the original owner showed up on your doorstep stating that they never agreed to the sale of the property? Or maybe a contractor field a lien against the original owner, and now wants to make a claim against your house. While title insurance will protect your interest, there are a couple of potential gotchas.

• For starters, you need to be sure that your title insurance policy covers both the lender and you. If you take out a mortgage, you’ll be required to carry a policy to protect the lender, but not necessarily yourself.
• Second, title insurance policies typically only cover the purchase price of the home. Thus, if you buy a home on the cheap and spend a bunch of money fixing it up, you could wind up taking a hefty loss.

Ultimately, title insurance is a necessary evil. And guess what? If you refinance, you’ll need to buy a new policy. The good news is that you should be able to get your new policy for a reduced “re-issue” rate. If the title company doesn’t offer it to you at a reduced rate, ask them to do so.

Foreclosure moratorium?

While I was writing this, a story popped up on the local news talking about the possibility of a national moratorium on foreclosures. This talk is coming on the heels of reports of bank officials signing stacks of foreclosure documents without even reading them.

What do you think? Should lawmakers step in and halt foreclosures until we get things sorted out? Or should they just butt out and let the process run its course?

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One option for consolidating your debt is rolling it into a HELOC. But first… You might have some questions.

What is a HELOC? Is consolidating debt with a HELOC a financially sound decision? What problems might arise if you use your HELOC to reduce your debt?

What is a HELOC?

The term HELOC is shorthand for “home equity line of credit.” Home equity is defined as the difference between what your house is worth and what you owe on the mortgage. This home equity line of credit essentially let you borrow money using the equity in your house as collateral.

Lenders typically calculate the line of credit based on a percentage of your home’s appraised value. For example, if you have a house that is appraised at $200,000 and your principle is $135,000, he lender may calculate your home equity line as:

$200,000 * .80 (it varies among lenders) = $160,000
$160,000 – $135,000 = $25,000 HELOC limit

The percentage of your home’s appraised value depends on the lender, but it’s generally 75-80%. With houses appraising for much less than they used to in some areas, many homeowners have had their HELOC reduced or closed.

Why you should use a HELOC

The big plus with using your home equity line of credit to consolidate your debt is that you’ll almost certainly reduce the amount of interest that you’re paying. Since it’s a secured loan, your HELOC will typically will have a much lower interest rate than your credit cards.

If you’d like to play around with just how much you can save, I highly recommend the online calculator over at Dinky Town.

Another good reason to use a HELOC is that, assuming you itemize you tax deductions, the interest on your HELOC is tax deductible. Thus, you’re not only paying much less in interest, but you’re also catching a tax break, thereby reducing the cost further.

Why you shouldn’t use a HELOC

The other side of the coin when using a HELOC to consolidate debt is that you’re taking unsecured debt (credit cards) and tying them to your home. This can be a risky bet – what happens if you lose your job and can’t pay your HELOC? You risk losing your house, that’s what.

Also, getting a HELOC isn’t necessarily cheap. There are several possible fees associated with it that add to the total cost. Some of the fees you might face include:

• Appraisal fee
• Application fee
• Annual fees (some, not all lenders charge this)

Ultimately, you’ll have to weigh the costs of opening an account against simply using a debt snowball, or similar approach, to get out of debt.

It’s also worth noting that lenders have gotten much more strict when it comes to approving loans, so if you’re looking at getting one, be sure that you can qualify.

Another minor downside is that when you apply for a HELOC, they’ll do a hard credit inquiry which can hurt your credit score. It’s not much of a hit, but it’s worth keeping in mind.

Thoughts on using a HELOC for debt reduction

In my opinion, if you can get yourself out of debt in two years or less, I wouldn’t bother with a home equity line of credit. If you’re struggling with high interest rates, try negotiating with the credit card companies or look into doing a balance transfer to a card with lower interest.

Personally, I’m not a fan of converting unsecured debt (credits cards) to secured debt (HELOC). Yes, you can save money, but… With people getting laid off and paychecks being cut, your plans could fall through and you could lose your home.

There are other options besides using a HELOC if you’re looking to consolidate your debt. For example, you could try to get a personal loan through your bank or credit union, or you could consolidate your debt with a loan from Lending Club.

Your take

Have you ever used a HELOC to consolidate your debts? How did it work out for you? Would you do it again? Why or why not?

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But what then? Once you’ve defaulted, you won’t be able to get a new mortgage for a long, long time. Well… According to a recent Bloomberg article, some homeowners are starting to “buy and bail.” In other words, they’ll acquire a new house before they walk away from the old one.

While “buy and bail” constitutes fraud if the borrower lies on their loan application, this strategy is most often employed by those with a big paycheck and relatively little debt, as they’re more likely to legitimately qualify for financing on a second home. Lenders are then left holding the bag.

What do you think?

Are there any circumstances under which you’d consider a strategic default?

Source: Bloomberg via Consumerist

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If so, then check out this graph…

This is a graph of historical mortgage rates going back to 1986. As you can see, rates on 15- and 30-year fixed rate mortgages are currently really low.

Back when we bought our first house in 2002, we were paying something like 6.5% on a 30-year fixed rate mortgage. Not long thereafter, we refinanced to 5.75% — once again for 30 years.

When we sold that house and bought our current one in 2006, our rate bounced back up 6.375% for 30 years. We later refinanced into a 15-year fixed rate mortgage at 4.875%, and have since paid it off.

As things currently stand, you could get a 30-year fixed rate of 5% or less. Amazing. Almost makes me want to have a mortgage again. Almost.

Source: HSH.com via MyMoneyBlog

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» Mortgage Refinance Rates Continue to Fall

Interestingly, even with these historically low rates, there hasn’t been much action. Home values are down and many homeowners are upside down, and thus unable to refinance. Others can’t qualify given the higher underwriting standards. Still others have already refinanced in the past few months and doing so again doesn’t make financial sense.

What about you? Have you recently refinanced? If not, are you thinking about doing it now? If we hadn’t paid off our mortgage, I’d be thinking very seriously about refinancing. As things stand, however, I’m not interested in re-mortgaging even at these rates.

Source: Associated Press

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While this legislation seeks to put restrictions into place to prevent another financial meltdown, there are also a number of consumer protections included in the legislation, or proposed as amendments. For example…

The new legislation seeks to establish an independent “Consumer Financial Protection Bureau” within the Federal Reserve — the House calls for a standalone entity. This new bureau will oversee lenders (except possibly car dealers) and protect consumers against predatory and/or deceptive lending practices.

Other consumer-related changes include:

• Free access to your credit score. Thanks to prior legislation, you’ve had free access to your credit report for several years. You may soon gain similar access to your credit score — once per year from each agency.
• Making the FDIC insurance increase permanent. As most of you are aware, FDIC insurance limits were increased from $100k to $250k, but this increase is set to expire at the end of 2013.
• No credit checks for employment. As I’ve noted in the past, employers often check your credit before offering you a job. Under an amendment to the reform bill, this would no longer be allowed (with exception for jobs related to national security, etc.).
• Mortgage prepayment penalties. Believe it or not, some lenders still levy penalties if you pay off your mortgage early. The proposed legislation could restrict such penalties, and make them go away entirely in many cases.
• Mortgage compensation. Mortgage brokers won’t be allowed to accept compensation that varies depending on the loan type. This is intended to discourage brokers from putting borrowers in fee-laden products with disadvantageous terms.
• Debit card fees. A late addition to the legislation limits debit card fees that merchants pay, meaning that banks might wind up adding other fees to make up for the lost revenue. For their part, retailers argue that they’ll be able to afford more workers, and also pass savings along to consumers.
• Minimum transaction amounts. It’s fairly well known that stores aren’t allowed to set a minimum transaction amount for credit card purchases (see: Visa guidelines, MasterCard guidelines). Under the proposed law, such minimums would be allowed as long as they’re applied across the board.
• Credit card discounts. Stores would also be allowed to provide discounts based on what type of credit card you’re using. For example, they could offer a discount for using Visa or MasterCard instead of American Express. Cash and debit card discounts would also be allowed.
• Brokers and “best interests.” The House version of the bill requires investment brokers to act in their clients’ best interests. The Senate version requires only that they recommend “suitable investments,” with no “best interests” requirement.

Which of the above changes will make it into the final legislation remains to be seen, but there certainly seem to be a number of consumer-friendly measures under consideration. What do you think?

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Some fraction of these people will (like us) be looking to pay down their mortgage loan with their tax refund. Instead of simply paying extra principal toward their mortgage, however, there’s another option to consider… They could recast, or re-amortize, their mortgage loan.

Each approach has pros and cons, and different people will arrive at different decisions depending on their goals and circumstances.

Shortening your mortgage term

I mentioned before that you can shorten your mortgage length paying extra principle on it every month. We’ve also covered some strategies for paying off your mortgage early. Making the extra payments can cut years off your mortgage and save you tens of thousand of dollars in interest, depending on your loan terms.

For example, with most 30 year fixed rate mortgages, you pay a huge amount of interest for the first seven years or so of your mortgage. As you get closer to the end of the life of the mortgage, more of your payments go towards principal.

The primary advantage with paying off your mortgage early (aside from peace of mind) is the big improvement in cash flow. Once your mortgage payment is gone, you’ll have hundreds (maybe a thousand or two) in extra cash each month that could be used for your other financial goals.

What is mortgage re-amortization/recasting?

Mortgage re-amortization is basically a loan modification that changes your monthly payments. Amortization refers to the paying off of a debt in installments over a set period of time. Instead of simply paying extra money towards principal, you may be able to use that money to reduce you balance due and re-calculate your monthly payments.

The advantage of re-amortization is thus that you can get lower monthly payments and have a slight, ongoing improvement in your household’s cash flow. It won’t be as big of a change as if you paid off the mortgage early, but you’ll get an immediate benefit.

You could then use the difference in the monthly payments to build your savings, pay down other debt, or build a retirement nest egg. Not all lenders offer this option, however, so check with your lender to see if you can recast your loan.

You should also check on what sort of fees are involved with, and what restrictions might be in place. Some lenders will allow you to do this multiple times, while others offer this as a one time deal.

Recasting vs. shortening your mortgage

You really have to know your plan for your mortgage and run the numbers to figure out the best option for you. If you plan on consistently over-paying your mortgage, then recasting won’t provide much of a benefit. If, however, you plan on just making a big payment once, and would rather reduce your monthly mortgage expenses instead of shortening the overall timeframe, then re-amortization may be something to consider.

Shortening your mortgage can have bigger costs up front as you’re putting more money in now, but your pay off will be on the huge decrease in your monthly expenses when it’s finished. You will also have saved tens of thousands of dollars in interest payments. Only you and your family have all the information needed to run the numbers properly and decide which option will put you ahead.

Sticking with paying off the mortgage early

When I looked at the numbers, recasting our mortgage wouldn’t make much of an impact on our cash flow. It would reduce our monthly housing expenses by only $50 or so. We think it would be better to just focus on going ahead and paying off our mortgage early. By focusing on getting a conservative mortgage amount, we’ve already created a little bit of a buffer between income and expenses.

Your thoughts

I’d love to hear your thoughts on this. If you had (say) $10,000 to pay down your mortgage, what would you do? Would you recast and go for lower monthly payments or would you shorten your mortgage? Why?

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While looking at the breakdown of our most recent payment, I noticed that about 20% went towards our escrow account. Having never had a mortgage before, I was curious to find our more about escrow accounts and decided to check out the Housing and Urban Development website to get more information.

Our lender had us pre-pay the first year’s premiums for our homeowner’s insurance policy. Going forward, our payment also includes an allocation for our future insurance premiums as well as our property taxes. This money is deposited into an escrow account.

What is an escrow account?

When you purchase a home with a mortgage, lenders typically add certain stipulations to protect their investment. One of the main things that they’ll do is require you to pay into an account that is used to cover the insurance premium and property taxes. That way they can be 100% sure these things get taken care of.

The amount that a lender can require a homeowner to put into the escrow accounts is limited by the Real Estate Settlement Procedures Act (RESPA). More specifically, they can only maintain a cushion of 1/6 of your annual escrow payment. After making annual payments out of the escrow account, any surplus over $50 has to be returned to you within 30 days.

Estimating escrow payments

If you’re a numbers type person, you can get an idea of what your escrow payments should be by following HUD’s formula:

1. List all your annual obligations that will be paid out of your escrow account
2. Don’t forget to include flood insurance (if applicable), which may only be due every 3 years
3. Divide the sum total by 12 to arrive at your monthly obligation
4. Add in two month’s of escrow payments to allow for the RESPA cushion limit

This should give you a good feel for your maximum required escrow total. If you feel that your lender is taking too much for escrow payments, contact them to receive an explanation on the difference.

Advantage of escrow accounts

Aside from providing your lender with a measure of protection, escrow accounts can be a very convenient way of taking care of, and budgeting for, your tax and insurance obligations. Having a large property tax bill show up unannounced can ruin your budget, and having an escrow account relieves you of this possibility.

It’s also worth noting that, even if there is an error with a payment from your escrow account, you have some protection. If your county sends a letter to you because your property tax was paid late, for example, you should forward a copy of that to your lender because they’re responsible for the penalty.

Downside of escrow accounts

While having your property tax and home insurance premiums handled automatically can be convenient, there can be a downside. For the financially savvy, escrow accounts can have a big opportunity cost, as could be stashing away that money yourself in a high interest savings account. In theory, you could tuck away 1/12th of your insurance and tax bills every month and then pay them yourself.

After all, most of use handle our life insurance and car insurance premiums on our own. Why should homeowner’s insurance be any different? In this day and age of online bill pay, escrow accounts can seem redundant from the consumer’s perspective. Not only are you losing money in the form of unearned interest, but you’re also ceding control.

Closing thoughts

In the final analysis, I think that an escrow account is a handy tool — and if you have a mortgage, you probably don’t have a choice in the matter. What do you think? Either way, we can’t wait to pay off our mortgage, and we’re focusing on that goal.

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Only student loan and mortgage debt left

Remember the Jeep that I totaled and had in the shop for 8 months last year? Well, I didn’t technically own it until three days ago. Last August, I consolidated the amounts owed on my Jeep and the debt still owed on the credit cards that I shredded with a Lending Club loan of $11,000. It took less than seven months to settle those debts once we got focused.

Now the only affiliation I have with Lending Club is that of an investor extraordinaire, and I’m setting my sights on the next debt in line – I’m just not sure exactly which one to pick. Here’s a list of our remaining debts we have left:

• First mortgage = $118,950 at 5.5% fixed with 20 years remaining (recently refinanced)
• Second mortgage = $39,700 at 8.8% fixed with 27 years remaining
• My student loan = $31,850 at 6% fixed
• Her student loan = $34,200 at 4% fixed

Unless something unexpected happens, we should have at least $1,500 in extra cash to put toward our debts each month. This is above and beyond our regularly scheduled payments, so we should really be able to accelerate our debt reduction.

I was planning to shift our debt snowball to our secpnd mortgage until it dawned on me… What if the housing market rebounds?

Repay student loan first?

Should I repay my student loan before my second mortgage? Here are some of the factors that are influencing my thinking:

• The housing market might rebound. We plan to sell our home as soon as we can get what we owe on it. If we focus on the student loan and the market rebounds, then I can repay my mortgages with the proceeds from the house sale, and my student loan will have been greatly reduced.
• The mortgage interest deduction. If I repay my student loan first, I’ll still have a much larger interest deduction to claim come tax time 2010 and 2011.
• Student loan debt is not dischargeable. Not that I would ever file bankruptcy, but the simple fact that student loan debt is not dischargeable in bankruptcy makes me question if it would be wise to make this a priority over a second mortgage.
• The psychological factor. I’m the type of person who would rather focus on paying off a higher interest loan to realize the savings (i.e., our second mortgage), rather than paying off a smaller loan for a psychological boost.

Repay second mortgage first?

I’m already leaning toward paying off our second mortgage first, chiefly because the rate is 2.8% higher than my student loan rate, and 4.8% higher than my wife’s. So… If you think it’s better to pay off my student loan off first, you’ll need to convince me.

• Higher interest rate. As I mentioned above, our second mortgage interest rate is considerably higher than the rate on my student loan, so I stand to save more on interest paid by attacking this debt first.
• The housing market probably won’t rebound quickly. I’m not a real estate agent or an economist, but I believe that both would agree that the housing market will not rebound to 2007 values anytime soon.
• We want to sell ASAP. To be honest, I would like to sell my home tomorrow… And I certainly do not want to wait 5 – 10 years or possibly longer for the market to get our heads above water. By paying down this debt, we’ll be able to sell sooner.

Value of my home vs. amount owed

Lastly, I wanted to throw out some more numbers to help you understand the decision we’re facing. It’s important to keep in mind that I live in Michigan, and that our housing market is worse than most. My home was originally appraised at $170,000 in April of 2007, and our purchase price was $165,000. When we refinanced our first mortgage last week, the lender estimated the current value of the home at $120,000 though I’ve seen online estimates as low as $107,000.

Which should we pay off first?

If you were in my shoes, would you focus your debt sledgehammer on the second mortgage, thereby enabling us to sell our home and downsize ASAP? Or are we better off knocking attacking our student loan debt? Whichever you think is better, I’m very interested in hearing your reasoning.

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Oh well, our plan moving forward is to pay off our mortgage early and stay put until prices trend upward.

As an aside, if you want more information on buying a home vs. renting you can check out Laura’s view of the buy vs. rent dilemma, as well as my opinion on the same thing.

Mistake #1 – Zero down mortgage

So many new homeowners made the mistake of entering into a zero down mortgage. If you cannot afford a down payment of at least 20%, lenders typically require either a 2nd mortgage or carrying private mortgage insurance (PMI).

One positive result of the housing crisis has been a huge scaling back of the zero and low down payment mortgages, which has been a large contributing factor of plummeting home sales. Nowadays people who don’t have any money cannot buy houses. Go figure, right?

2nd mortgages and Private Mortgage Insurance (PMI):

Private mortgage insurance (PMI) is insurance payable to a lender or trustee for a pool of securities that may be required when taking out a mortgage loan. It is insurance to offset losses in the case where a mortgagor is unable to repay the loan and the lender is not able to recover its costs after foreclosure and sale of the mortgaged property. Typical rates are $55/mo. per $100,000 financed, or as high as $1,500/yr. for a typical $200,000 loan. (source)

A second mortgage (commonly used as an alternative to PMI) is a secured loan that is subordinate to another loan (your 1st mortgage) against the same property. The 2nd mortgage typically carries a significantly higher interest rate and is typically used as part or all of the 20% down payment. The higher rate is a reflection of increased risk to the lender, and results in much higher interest costs to the borrower over time.

We fell into this trap like so many others. We wanted to get into our new home now, and were ready to employ any creative financing necessary to make it happen… And so we entered into a 2nd mortgage for 25% of the purchase price (75/25 loan.)

To avoid a costly 2nd mortgages or PMI, save at least 20% of the purchase price of the home.

Mistake #2 – Buying high and selling low

Whether you’re trying to time the stock market or time real estate transactions, buying low and selling high should always be the goal. In a bad market the temptation to do the opposite can be powerful.

Take my housing situation, for example. I hate the fact that we have debt at all, and am very tempted to sell, despite the fact that we would have to take a loss! I’m tempted to sell our house for a loss and then rent for much less than our current mortgage payments and pay off our remaining debt while renting.

Though getting out from under the mortgages is tempting, I decided against it for mathematical reasons. If we were to sell now, we would not only lose money on the transaction, but we’d have to pay cash to our lender. If I could wind up even money, I would sell tomorrow. Instead, we are doing the next best thing… Making our 2nd mortgage the next victim of our debt snowball.

The faster we can reduce our amount owed, the sooner we can sell without any out-of-pocket costs. Our hope is that the housing market will bounce back in the mean time, affording us the option to sell for gain.

To avoid selling your home for less than you owe, increase mortgage principal payments and wait for the market to rebound.

It is worth mentioning that we cannot control market conditions, so we should spend our energy focusing on the factors that we can control:

1. Once you have high interest consumer debts under control, focus your debt snowball on reducing your mortgage – and look into refinancing your mortgage to see if rates are attractive as you may be able lock in a lower rate. If you have a 2nd mortgage, pay it off ASAP. Those of you with PMI should also focus on reducing your mortgage principal to speed your ability to drop the PMI once your principal is reduced below 80% of the home value.
2. Make property upgrades that raise the value more than the amount they cost to implement. DIY projects can cost very little, yet yield superb ROI.

In closing…

Most who fall victim to either of these housing and mortgage blunders end up paying dearly. I hope this article will help future homebuyers avoid the same mistakes. For our next home purchase, my wife and I intend to save 100% of our payment before buying… But that is a post for another day!

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Mortgage payments

For example, our first mortgage payment is due in March. Along with our mortgage payment, we’re also putting money into an escrow account to cover our property tax bill and home insurance premiums. While we budgeted for it and anticipated paying these costs, it still feels odd to have our housing bills mapped out for the next 30 years.

The mortgage payment itself (considering principle and interest) is much lower than the rent we were paying for our two bedroom apartments. The discrepancy between the cost to own and rent in our city is one of the big reasons we considered buying a house. If it was much cheaper to rent, we would’ve continue renting, either saving for a huge down payment (making the mortgage much smaller) or investing the difference for other goals.

Our goal is to pay an extra $150/month starting with our first payment for 2010 payments to help pay off our mortgage early and greatly reduce the amount of interest we pay over the life of the loan. If and when we can afford more, we’ll add to this amount accordingly, but we want to make sure we build up our emergency fund first.

Homeowners’ association fees

This is a new bill that I’m not too crazy about, but membership is mandatory with in our development. Our HOA fees covers water and sewage, pool and clubhouse access, lawn maintenance, and condo area upkeep. When we were looking at some older homes in the area, we found that the HOA dues were often higher and sometimes came with fewer amenities.

After reading some horror stories on HOAs, we asked some friends who live in a development by the same builder and with the same company running the HOA for their opinion. It turns out that they’ve been happy with their experience thus far, and the fees have remained consistent so far.

Property taxes

As I noted above, we’re paying into an escrow account every month to cover our property taxes (as well as our homeowner’s insurance). Property taxes are an unavoidable expense of being a home owner.

My best advice is to look at your city or county’s tax records online to get an idea of what you might expect to pay in taxes before you buy. While we were shopping around, I looked at different neighborhoods and researched the property taxes. As a result of this additional information, we actually ended up reducing the amount we were willing to spend on a new home just so we could stay within our budget.

Once you’ve bought your home, don’t let your guard down. Keep an eye on your property tax assessment, and don’t be afraid to appeal your home’s assessed value.

Your take

I’m curious to hear how you guys made the transition when you went from being renters to owners. What was the biggest financial adjustment you had to make as a home owner? If renting is a better option for you, I’d like to hear about that, too.

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Are you at all concerned about where mortgage rates are headed as we roll into 2010? If so, it’s understandable since many analysts have predicted rates to rise as the year goes on.

While there’s still some uncertainty surrounding the future direction of mortgage rates, it’s safe to assume that rates will rise in the absence of the Fed’s mortgage-backed securities (MBS) purchase program. As evidenced by the statement from the very latest Federal Open Market Committee Meeting (FOMC), the Federal Reserve maintains that their purchase program will expire at the end of the first quarter.

A quick history lesson

As a strategy to lower conforming fixed rate mortgages and to promote stability in the housing market, the Fed announced a program on November 25, 2008 that was designed to purchase $500 billion in Fannie Mae and Freddie Mac MBS. By early 2009, the Federal Reserve decided to purchase an additional $750 billion in MBS in order to keep mortgage rates low.

The Fed’s influence on rates

By March 31, 2010, the Fed will have spent $1.25 trillion to keep conforming rates at or near historic lows. By our reckoning, the Fed’s involvement in the mortgage market brought conforming fixed-rates down perhaps 0.75% below where they would be absent the program. This means that we expect interest rates to rise somewhat when the program concludes.

By how much rates will actually rise will depend on whether or not private investors will be in a position to buy these investments. How strong that private demand will be is still uncertain at this time. It’s best to plan for at least some increases in interest rates as the end of the Fed’s program approaches, and for some period after the March 31 deadline.

While some analysts expect an immediate increase of up to a full percentage point in rates when the Fed decides to stop buying agency MBS, we’re not among them. We think that any rise in rates would be accompanied by a reduced demand for mortgages, which in turn would serve to somewhat temper any upward rise in rates.

Here’s why: The Fed’s purchases are serving to help keep rates low by absorbing MBS supply that the private market cannot or will not buy. When the Fed exits, the additional supply might overwhelm remaining demand, causing a rise in interest rates. That rise in rates would strongly curtail refinancing (and possibly some homebuying) activity, limiting the amount of new MBS supply the private market will need to absorb. This falloff in new MBS supply means that rates might not rise as much as some fear, since the private market may be able to more easily digest it.

Back to “Normal”

During 2010, the mortgage market will transition from almost-fully-government-supported to one once again driven by the private market to a much greater degree. As markets return to “normal,” so too will mortgage rates, which, for the early portion of 2010, should still remain among the best seen during the past 50 years. However, barring a double dip to the recession, borrowers should have no expectations that rates will remain at multi-generation lows throughout the year.

Broadly, we expect 30-year fixed-rate mortgages to hang around the 5% mark during the first quarter of 2010, as support programs (MBS purchases and the homebuyer tax credit) remain fully in force. After that we’ll start the transitional period described above and, for planning purposes, borrowers should expect rates to rise one-half to even a full percentage point higher than where they are now.

Rates for the rest of the year are likely to be more economy- and inflation-dependent. With continued economic healing expected, pressure will build for the Fed to raise their Federal Funds rate and remove certain supports like the TALF and the TSLF. Absent any resumption of these programs, rates will nudge closer to 6% than 5% for the final two quarters of 2010.

Will yesterday’s failed loans continue to distort the market? Will Fannie Mae and Freddie Mac’s evolution cause rates to rise or fall? Will lending standards ever ease? You can get the answers to these questions and more by consulting HSH.com’s “2010 Outlook for Mortgage Rates and the Mortgage Market.”

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In the end, we did manage to get a better deal, and I wanted to share the process from start to finish.

Last minute delay

We were less than 48 hours away from our closing date and had just came out of the walk through of the condo. It looked great overall, and we wrote down a few things that needed to be fixed before closing. We were nervous and excited about the place as we headed towards Lowe’s to get some painting supplies for the big move. We received a call from the building company and were told that our closing date was delayed.

Since we were getting an FHA loan and it was a condominium, the builder was supposed to notify HUD when it was complete, and then HUD had to have some paperwork approved before the bank would be willing to the loan us the money. Unfortunately, HUD was backed up, and the earliest we could close would be sometime in the New Year.

Working with the builder

Our main worry was about our housing situation until we could get the financing worked out. We were supposed to close Wednesday and be out of our apartment the following Monday. To make matters worse, it was a holiday week so we needed come up with somethings ASAP. The builder acknowledged the hardship they caused us and said they’d help us out.

We called the leasing office at the apartment to extend our month-to-month lease until we could get this sorted out. They said they’d be happy to help us, but we’d have to pay $300/month more than market price! We were already paying an extra $150 since our lease expired, and $300 was too much.

We then contacted our real estate agent to negotiate something with the builder, and gave them several options hoping to get an answer right away.

Switching lenders – worth the incentive?

Unfortunately we had to wait to hear from the builder. Their first offer was a little more than $500 off at closing, but in order to talk further we’d have to call a lender they recommended so they could get the paperwork in sooner. We were skeptical about talking to another lender, but we called just to see what they had to offer.

The guy who answered explained that they could give us a better rate (by about 1/4%) than what our current lender was offering. In addition, they could close in about two weeks instead of another month or so. I asked how could they close quicker than big bank we were dealing with. He responded that they were a “correspondent lender” (i.e., they lend money and then immediately sell off the loan) and wouldn’t have to wait for the sign off on the condominium before proceeding.

Since they were sort of a mix between a mortgage broker and lender they had some leeway with things. The catch was we had to completely re-do our paperwork (which they claimed they could expedite) to get the house through them. He was pushing how some other buyers were switching to their company from other lenders because of the better rate, and he insisted we’d have a great deal. I told him we needed to think about it before we’d commit to anything.

I had a bad feeling about this last minute change in lenders, so I started to gather more information. Since I had some friends that used this particular lender, I called them to see what they thought. As it turns out, they didn’t like the lender at all. In fact, when they called to lock their interest rate, the lender had already locked it without their permission which at a rate that was 1/2% higher. They worked it out, but it was a pain to get the paperwork changed.

I told our real estate agent that we didn’t want to go with the correspondent lender, and to instead see if the builder could offer something more suitable. If not, we wanted to just end the deal. Meanwhile I went to check with the Department of Housing and Urban Development.

Calling HUD for information

Since we’re first-time home buyers, we wanted to get more information about how this process worked. I went to HUD’s website and found the HUD office in our state. From there, I was directed to an office in my city and was connected to the finance help department.

I explained our situation to the rep and asked if this was a typical occurrence. The woman said things weren’t typically that messy, and that it was wise we didn’t jump to a different lender. We ultimately received a lawyer referral hotline number and contacted a real estate attorney. Under the program, you can get a 30 minute legal consultation for $30. We came away with more information of what to expect, and what would be reasonable to request.

More Closing Costs Covered

Through emails and phone calls, we relayed the information we were given and told them we had contacted HUD and a local lawyer to get everything squared away. It helped that we kept all of our documentation and organized our notes to be clear and concise.

We finally heard back from the builder that they would increase their offer. By being persistent and informed, we were about to save an additional $1,400. That worked for us, as we found a cheaper housing solution in the mean time.

While we would’ve preferred to avoid this trouble altogether, I’m glad we took some time to negotiate and get ourselves a better deal. We were able to get a good mortgage rate, the lender we wanted, and a better deal on our closing costs. We’re now in the process of painting, moving, and unpacking from our apartment to the house.

Your take

How did your home buying process go? Did you ever hit any speed bumps? And were you able to get any additional concessions from the builder/seller to make up for the trouble?

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While we could’ve (arguably) saved some money by opting for adjustable rate mortgages, we already have enough unknowns in our life. Thus, we quickly narrowed our options to fixed rate products. While there are some 20 (and even 40!) year fixed rate mortgages out there, 15 and 30 year mortgages are far more common.

So… Which to choose?

Advantages of a 15 year mortgage

Aside from being amortized over half the total time (15 vs. 30 years), mortgage rates are usually significantly lower for 15 vs. 30 year terms. This combination of a shorter term and lower interest rate means that, while your monthly payments will be higher, you’ll pay far less interest over the life of the loan.

Advantages of a 30 year mortgage

The primary advantage of a 30 year fixed rate mortgage is that it will have a lower monthly payments. As noted above, 15 year mortgages typically have significantly lower rates, but 30 year mortgages have much lower monthly payments. Thus, many people opt for them, as they make home ownership more afforfable on a month-to-month basis.

A subtle difference here is that a far greater proportion of your monthly payment (especially at first) will go toward mortgage interest with a 30 year mortgage. Thus, you’ll have more mortgage interest to deduct with a 30 year vs. 15 year mortgage. Of course, that also means you’ll be paying far more in interest over the life of the loan, so be careful.

15 vs. 30 year mortgages by the numbers

Consider the following scenario… You’re in the market for a $200k mortgage, and you learn that you can get a 15 year fixed rate mortgage at 5% or a 30 year fixed rate mortgage at 5.5%. Which should you choose?

Running the numbers

For a $200k, 15 year mortgage at 5%…

Your monthly payment will be: $1581.55 (principal + interest)
Your total cost over the life of the mortgage will be: $284,685
Your total interest paid will be: $84,865

For a $200k, 30 year mortgage at 5.5%…

Your monthly payment will be: $1135.58 (principal + interest)
Your total cost over the life of the mortgage will be: $408,807
Your total interest paid will be: $208,807

As you can see, the 30 year mortgage is significantly more costly, but it frees up an additional $446/month that can be used for other things (living expenses, investing, additional principal payments, and so on).

The best of both worlds

What if you’ve decided that you want to be mortgage free as soon as possible? A 15 year mortgage is a no-brainer, right? Maybe, but maybe not.

Depending on a number of factors, such as your income, job stability, and level of self-discipline, you might be better off taking out a 30 year mortgage and then simply over-paying it every month.

The advantage of this approach is that you you get the best of both worlds… You can pay your mortgage of in 15 years (give or take) while still having the flexibility to fall back to the lower payment level if you ever run into financial problems.

Another look at the numbers

Let’s say you went ahead and took out the 30 year mortgage detailed above with one exception… You dedicded to send an extra principal payment of $446/month, making your monthly payment equal to the 15 year mortgage.

If you did that, you’d end up paying off your mortgage in 15 years and 10 months at a total cost of $299,698. That’s an extra 10 months and $15,013 as compare to the 15 year mortgage, but it’s a savings of roughly $109k vs. following the 30 schedule, and it also comes with significantly more flexibility than a 15 year mortgage.

If you wanted to achieve the same 15 year payoff period with the 30 year mortgage, you’d need to send roughly $500/month in additional principal payments ($1635/month), making your monthly obligation $54 higher than with the 15 year mortgage.

Once again, however, you’d have the freedom to fall back to that $1135.58 base payment if you really needed to. Of course, this flexibility is a double-edged sword. It could be a blessing to those who wind up needing it, or a curse to those who lack the self-discipline to send extra principal payments.

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Well… I now have my “before” and “after” credit score, and guess what? It went down! At the time we paid off our mortgage, I had a FICO credit score of 781. Fast forward a few weeks and I got a ScoreWatch e-mail alert. Bingo. Just what I had been waiting for.

When I logged in, I saw the following…

Which was followed by this little gem…

Just to be sure that the mortgage was to blame, I poked around a bit more. And… Boom goes the dynamite:

The only change they were showing was our lump sum mortgage payoff off which resulted in a zero balance. Interestingly, when I read on about how this change might impact my credit score, I learned that:

“Generally, less debt is better for your FICO score.”

(in case you can’t read it, that’s the bit underlined in red)

Hmmm. It’s generally better, but clearly not always.

I’m no FICO credit score expert, but my understanding is that the decrease occurred because I no longer have any installment loans. Apparently their algorithms aren’t smart enough to distinguish between people who’ve never had an installment loan and people who’ve had one, never made a late payment, and paid it off within the past month.

Anyway, I’m not sweating it, but I thought it would be worth tracking to see what would happen. I also thought some of you might be interested in the outcome. Thoughts?

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No more escrow

As most anyone with a mortgage is aware, your mortgage is made up of four primary components: principal, interest, taxes, and insurance. The principal and interest payments are kept by the lender, whereas the taxes and insurance typically go into an escrow account that the lender maintains on your behalf.

The reason that it works this way is that your lender wants to be 100% sure that your property taxes and insurance premium get paid. Once you pay of your mortgage, however, you’re on your own. Thus, you’ll need to contact your insurer and ask them to begin billing you directly for your insurance, and you’ll also need to stay on top of your property tax bills.

Increased cash flow

Several readers have asked what we intend to do with the increased cash flow that accompanies a paid off mortgage. In the short run, we’ll likely focus on investing what we would’ve otherwise been sending to our mortgage lender. In the long run, the lack of a mortgage payment provides us with significant flexibility when it comes to lifestyle decisions.

Of course, as noted above, we’ll no longer be paying into an escrow account. Thus, it will be important to consistently set a bit aside to cover our homeowners insurance and property tax bills.

Tax planning

Of the tax advantages associated with home ownership, the mortgage tax deduction ranks near the top. For those that are unaware, you get to reduce your taxable income (with some limitations) to the extent that your mortgage interest and other deductions exceed the standard deduction.

Beyond effectively reducing the interest rate on your mortgage, the mortgage interest rate deduction helps you get over the standard deduction hump, which has an impact on the tax treatment of other financial decisions — such as charitable contributions.

In fact, the loss of the mortgage tax deduction is the main reason that I recently started investigating donor-advised funds. Instead of donating a set amount each year, we may begin donating twice that amount in alternate years.

This strategy will maximize the tax benefits of our charitable donations, and the use of a DAF will remove the urgency associated with making those donations.

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Yes, we’re well aware of the mathematical advantages of keeping your mortgage and investing our extra cash, but we decided to pay off the mortgage for a variety of non-mathematical reasons.

Our mortgage story – in the beginning

We got our first mortgage back in June of 2002. Actually, we got two mortgages back in June of 2002. We didn’t have enough cash on hand to put 20% down, and we wanted to avoid PMI, so we went with an 80/10/10 when we bought our first house.

Our primary mortgage was a 30 year fixed rate around 6.5%, whereas our second had a rate around 8% and was amortized over 30 years, but there was a balloon payment due after 10 years if we still had it.

Anyway, not long after closing on our house, we ended up killing off the second mortgage in favor of a HELOC with a significantly lower rate. Over time, we rebuilt our savings and eventually plugged it into our HELOC to kill of the balance.

Nowadays, I probably wouldn’t recommend this strategy… We essentially rolled our emergency fund into the HELOC to save on interest. It worked well, but the credit markets are now much dicier than they used to be, and there’s always the risk that your HELOC might get shut down.

Anyway, we ultimately rebuilt our savings without ever having to tap the HELOC, and thus all that was left was our primary mortgage. Throughout this time, we were also consistently paying at least a little extra toward principal.

At the same time, mortgage rates had been falling and we decided to refinance to a lower rate. Once again, we opted for a 30 year loan, but our rate dropped into the mid 5% range. The breakeven period was about a year, so it seemed like a no-brainer at the time. We ended up keeping that mortgage for around two years, so we ultimately came out ahead.

Our mortgage story – movin’ on up

In 2006, we ended up moving to another state. We made a tidy profit on our first house when we sold and… Though we ended up moving to a larger, more expensive home, we were able to put down 50% this time around. Unfortunately, rates had drifted back up at this point, so we wound up with a rate a bit over 6%.

As before, we continued making extra principal payments every month, so the balance was spiraling downward. About 18 months later, rates dropped dramatically and we decided to refinance once again. This time, however, we went with a 15 year fixed rate mortgage at a bit under 5%.

This time around, we had minimal closing costs. Thus, even though we ended up paying the whole thing off about 18 months later, we still came out ahead.

Our mortgage story – paying it off

Okay, as I noted above, we’d been consistently making extra principal payments. Over time, these prepayments got more and more aggressive, so our balance was dropping fast. At the same time, we had also been saving and investing aggressively, fueled not only by my day job, but also by my online endeavors.

Fast forward to this past December. After giving it a lot of thought, my wife and I decided to request a payoff statement from our lender and to make a lump sum payment to payoff our mortgage early. After transferring some money around, I headed over to the bank to wire the funds to our lender.

And that’s all she wrote… The funds arrived later in the day, and our mortgage account was updated the next day to reflect our zero balance. From start to finish, this entire process took just about 7.5 years. This isn’t to say that you should pay off your mortgage early, but rather to provide evidence that it can be done if you decide that it’s the right course of action for you.

P.S. Hey Matt, our debt-to-income ratio is zero.

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What is your debt-to-income ratio?

Commonly referred to as your “DTI,” your debt-to-income ratio is a personal finance benchmark that relates your monthly debt payments to your monthly gross income.

As an example… Let’s say that your gross monthly salary is $5,000 and you are spending $2,800 of it toward monthly debt payments. In that case, your DTI would be an unhealthy 56%.

This version of your DTI is sometimes referred to as your “back-end” DTI. This is often broken down further to give a front-end debt-to-income ratio, which is a component of your back-end DTI.

How to calculate your front-end DTI

Your front-end DTI is calculated by dividing your monthly housing costs by your monthly gross income. Front-end DTI for renters is simply the amount paid in rent, whereas for homeowners it is the sum of mortgage principal, interest, property taxes, and home insurance (i.e., your PITI) divided by gross monthly income.

From above, if that $2,800 in debt payments is attributable to $1,500 in housing costs and $1,300 in non-housing costs, then your front-end DTI is $1,500/$5,000 = 30% (and your back-end ratio is still 56%, as calculated above).

How lenders use your DTI

Mortgage lenders typically use DTI (along with other variables) to determine whether or not you qualify for a loan, and to help determine your mortgage rate. A high front-end DTI raises red flags with lenders because it is commonly associated with borrower default. In fact, reducing front-end DTI to reduce the risk of homeowner default was one of the main objectives of the loan modification programs introduced by the government in 2009.

There are specific limits for DTI that are used as cut-off points when evaluating borrowers. Current DTI limits for conventional conforming mortgage loans are typically 28% on the front end and 36% on the back end, though these limits are slightly higher for government subsidized FHA loans.

While there are certainly other factors to consider when determining our eligibility for financing (e.g., credit score, etc.), your DTI is an important determinant that you should be aware of. By working to improve it, you can make yourself a better credit risk, and thus get more favorable treatment from lenders.

Two obvious ways to improve DTI are to increase your income and/or decrease your debt. Both are solid goals.

What is your DTI?

I just figured our current household DTI. Our front-end ratio is 15%, and our back-end ratio is 24%. What is yours?

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“If bank A offers me a certain APR with roughly $3,000 in closing costs, while bank B offers me a lower APR with roughly $3,000 in closing costs, but bank B is a no name bank, which do I pick? In the end, a contract is a contract, right? If I sign with ‘Joe Blow Bank’ and they loan me X dollars at the lower APR, should I go with them? Or should I remember what my mom told me? If it sounds too good to be true, then it probably is.”

Personally, the only factors that I really pay attention to are the mortgage interest rate, lender’s fees, and closing costs. We’ve generally worked through a mortgage broker, and haven’t ever thought about who would ultimately wind up underwriting our loan.

In fact, it’s very common for mortgages to change hands within a few months of origination. As such, it’s not like you really get to choose who will end up servicing your loan, anyway.

Just be 100% sure that you’re comparing apples with apples… For example, adjustable rate mortgages (ARMs) typically have low initial rates that will move upward after three, five, or seven years. In the case of fixed rate mortgages, shorter term loans typically have lower rates than longer term loans (e.g., 15 year rates = 30 year rates).

Assuming that you’re being offered truly equivalent products, I’d focus on the financial details rather than sweating the name of the bank. Of course, you’ll want to be sure that your prospective lenders are legitimate outfits, so go ahead an check them out with the Better Business Bureau, but… Don’t let name recognition (or lack thereof) push you into a more costly mortgage.

If you have anything to add, please share your thoughts in the comments.

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Aside from learning that I currently have a 781 FICO credit score, I ran across some interesting numbers about the effect of your credit score on interest rates. What follows is a breakdown of the numbers for three different loan types.

30 year fixed rate mortgage

These are the numbers for a 30 year fixed rate mortgage. As you can see, the numbers increase by about an eighth of a point at each level while you’re still in “prime” territory.

If you want the best mortgage rates, you’ll need a credit score of more than 760. The other thing you’ll notice is that the rates skyrocket once you drop below 660, which pushes you into subprime territory.

15 year home equity loan

If you’re already in a house and are looking to borrow against your equity for home improvements, you might be interested in home equity loan rates. In this case, there’s a big jump once you dip below 720, and it only gets worse from there.

48 month auto loan

Finally, we have the 48 month auto loan. While I wouldn’t generally recommend borrowing money to buy a car, many people do this, so I thought it would be worth covering. In the case of car loans, the uptick in rates is significantly more pronounced as your credit score drops.

Keep in mind that the above rates are just a snapshot from one point in time. While the overall rates will change, the numbers above will give you an idea of things will vary across.

It’s also worth noting that the credit score ranges differ for the three different types of loans. For example, the top range for a 30 year mortgage is 760-850 whereas the top range for a 15 home equity loan is 740-850. This is how the data were presented, so that’s how I’m giving them to you.

If you’re curious about where you stand in terms of you credit score, you might consider signing up for the MyFICO 30 day trial. Just be sure to cancel before your thirty days are up if you’re not interested in continuing (and paying for) the service.

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I have been making an extra regular mortgage payment in the middle of every month. Currently, my next mortgage payment is not due until May 1, 2010. Is this the best way to put extra money toward my mortgage, or should I be specifying the extra money to go toward principal only?

The short answer is that this is not the best way to prepay your mortgage. In fact, all that’s happening here is that the bank is treating these like ‘regular’ payments that got sent in early. Instead of applying the overage to the mortgage principal, they’re holding the money (and pocketing the interest) until the monthly payments are due.

If it were me, I’d call the bank and politely (but firmly) insist that they go back and apply the payments properly. If they refuse, then I’d stop sending in the ‘regular’ monthly payments until they are due (May 2010), and instead focus on principal-only payments along with a note specifying how these funds are to be applied.

As an aside, I’ve never had a problem with a mortgage lender properly applying over-payments to the mortgage principal. In fact, I’ve never even enclosed a note asking them to do so. I’ve just written a larger then necessary check and they’ve taken care of things on their end.

Note that Merry has been “making an extra regular mortgage payment” every month. It’s thus possible that, when the bank received a standalone payment that exactly matched the expected monthly amount, they inadvertently applied it as a regular payment. Either way, it’s definitely worth calling to get it straightened out.

If you are interested in prepaying your mortgage, you can tinker with a mortgage prepayment calculator to determine the impact extra payments would have on your loan and loan term. You can also compare mortgage rates to determine if you can save money over the course of your loan by refinancing to a lower rate – 30 year fixed mortgage rates are averaging 5.11% this week, according to MoneyRates.

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According to a recent report from VantageScore Solutions, which is a credit scoring company created by the “big three” (Equifax, Experian, and TransUnion), here’s what you can expect:

• Short sale = 120-130 points
• Foreclosure = 140-150 points
• Bankruptcy = 355-365 points

Apparently loan modifications, where late payments and penalties are rolled into the mortgage balance, can actually have a small beneficial impact on your credit score.

Note that your VantageScore isn’t the same as your FICO credit score. VantageScores range from 501 (subprime) to 950 (superprime), whereas FICO scores range from 300-850.

Despite these differences, the numbers above can give you an idea of the relative impact of the different scenarios. Moreover, your VantageScore is being used by an increased number of lenders, particularly large mortgage lenders.

If you’re curious about your “real” FICO credit score, you can take a free peek at it by signing up for a free trial with MyFICO.

Source: Baltimore Sun via Clark Howard

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Is the homebuyer tax credit retroactive… or not?

From everything that I’ve heard, the answer is that it will not be made retroactive. While this might not seem fair, the undelrying logic makes sense… Since the goal is to stimulate sales going forward, it makes no sense to hand out credits to people who have already bought. The likely effective date of the new credit will be December 1, 2009.

The bigger question is whether not the $6500 tax credit will be enough to push existing homeowners into the market for homes and mortgages. Even if it does, I’m not convinced that it will have much of an impact for anyone other than realtors. After all, for every homeowner that goes looking for a house, there will be one more house on the market.

Can you use the $6500 credit to buy a second home?

The only exception to this one-for-one swap will be if people want to use the credit to buy a second home. The primary limitation here is that the new home has to serve as your primary residence. I’m not sure how they’ll enforce this, but it seems like you could buy and move into a new home while keeping your old one as a rental property.

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To be honest, I’ve been anxiously watching our lender’s site and counting the days until our closing date. I was worried that mortgage rates would go up before we locked. Fortunately they didn’t, so we have one less thing to stress over about.

What is an interest rate lock?

A rate lock is an agreement with your lender to fix your interest for a limited time period. Locking in your rate keeps the terms of your agreement consistent prior to close. Your lender won’t increase your interest rate for a limited period of time, though they also won’t decrease it if rates fall.

While I’ve read that some lenders charge a fee locking your rate, we found that pretty much everyone offered to lock our rate for free. If your lender tries to charge a fee, ask if they’ll waive it. And, as always, the terms of your should get the terms of your agreement in writing.

Why lock your interest rate?

Interest rates change constantly, so it’s possible that the rate you were first quoted will rise (or fall) between prior to closing. If rates increase and you haven’t locked, you’re mortgage payment will increase — perhaps to the point where you can no longer afford the payments.

On the flip side, you may have to settle for the locked rate even if the interest rates go down. Be aware, though, that some lenders offer the option to “float down” your rate if it drops significantly. In our case, our lender will split the difference if the interest rate drops to 4.5% or lower prior to closing.

When should you lock your interest rate?

There’s no concrete answer to this question. If you think that interest rates will rise in the near future, you should lock your rate. In our case, the interest rate was 5.25% when we first applied for our mortgage. It then went up a bit in the summer, but it’s now down to 5% for our FHA loan.

In 2008, the average rate was 6.1% for a 30-year fixed rate mortgage. Since no one can predict the future, you’ll have to weigh your options carefully before you decide. You can compare current mortgage rates here.

In case you’re curious about mortgage rate trends, ShopRate has a widget that track weekly average mortgages rates. You can also check prevailing mortgage rates at Money Rates. Since rates are pretty low right now, we went ahead and locked.

Closing thoughts

Personally, I can’t wait for this whole process to be over. I’ve never read so many forms and studied so many educational guides before. Did you feel like this as you were going through the home buying process? Do you have a rate-locking stories to share?

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For background, we’re getting a 30-year fixed rate FHA mortgage for our town house. This means that our interest rate will remain the same through over the life of the mortgage. Since it’s an FHA loan, however, there are some differences vs. conventional loans.

FHA loans and the Mortgage Insurance Premium

With a conventional loan, if you make a downpayment of less than 20% of the purchase price, you either have to pay for Private Mortgage Insurance (PMI), or take out a piggyback loan to make up the difference. With an FHA loan, if your downpayment is less than 20%, you have to pay a Mortgage Insurance Premium (MIP).

For loans with terms longer than 15 years, the law currently requires your MIP to remain in place for at least 5 years, whether or not your loan-to-value (LTV) ratio drops below 78%. With a conventional loan, most lenders will allow you to drop your PMI, though you might have to make a special request.

Keeping that MIP in place — at a cost of roughly $50/month for 5 years — will take up money that we could use for other things. We had hoped to use my extra earnings to pay for it in advance and keep it from getting rolled into the mortgage, but…

I called the Housing and Urban Development (HUD) hotline for the FHA’s resource center (1-800-CALL-FHA) to asked about doing this and was told that we can’t. While that was a bit disappointing, we’ve decided to change our game plan a bit.

Our new plan for my windfall income

We’ve always been careful to avoid putting ourselves in a financially vulnerable position, so we’ve decided to continue down that road by putting using my extra income to increase our emergency fund.

We’re also going to put some toward a refrigerator for the townhouse (which doesn’t come with one). We were going to buy a friend’s fridge which still was under warranty, but it was too big to fit. So now we’re in the market for a new one. If you have any suggestions, they’d be greatly appreciated. Hopefully, this new appliance rebate program can work out for us.

Closing thoughts

The home-buying process has been very crazy so far. Hopefully, it’ll turn out alright when all is said and done. Have you ever had an FHA loan? If so, how was your experience? And do you have any tips to share?

Note: The good news is that MIP payments are, in many cases, partially refundable. If you have an FHA loan and are wondering if you’re due a refund, go to the HUD refund site and enter your loan details.

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Applying for a mortgage involves a thorough check into your finances to see if you really qualify for a mortgage loan. This process takes time, and waiting to the last minute could cost you the tax credit.

Before you apply for a loan, you should be familiar with some numbers that the lender will be examining closely. The better you look to them, the better your chances of getting a solid deal on your mortgage.

Credit score

One of the first things that a lender will look at is your credit score. Not only does your credit score influence whether or not you’ll get approved, but it can also influence your mortgage rate. Be sure to check your credit report well in advance of any loan application, and fix any errors that you see.

Buyer’s income

Lender have to verify your income, so be prepared to provide W-2s, pay stubs, tax returns, and bank statements. If you’ve recently landed a new job, you might also be asked for a letter from your employer verifying your new salary. In our case, we were asked for two years of tax returns and recent financial statements.

Lenders are also looking to see if the savings you have is a gift or if you have saved up for it. Receiving a gift from a relative isn’t necessarily a bad thing, but you’ll need a mortgage gift letter to prove that it’s not a loan that has to be repaid. Prospective lenders just want to know the full extent of your obligations.

Debt-to-income ratio

Your debt-to-income ratio is a number that lenders use to evaluate the amount of debt that you’re carrying. It’s calculated by taking your debt monthly debt obligations and dividing that total by your monthly income.

Lenders are looking for lower numbers, as you’ll be more likely to be in a position to pay your mortgage. Lenders used to want your total debt obligation (including your housing expenses) to be no more than 28% of your income, though this number drifted up as high as 36% or even 40% during the housing boom.

Improving your debt-to-income ratio

There are two basic ways to improve your debt-to-income ratio:

Decrease your debt: Before you apply for a mortgage, reduce your long-term debt such as your car loan or student loan debts. You should also pay down your credit cards and negotiate lower interest rates, starting with any that are behind. If you are having a hard time now with debt, adding a mortgage will be a disaster. Reduce your monthly expenses and put that money towards reducing your debt.

Increase your income: Building additional income streams can help you immensely in the long run, and not just with getting a mortgage. If you have a review coming up at work, prepare diligently, and include concrete examples of your worth to the company. If they don’t want to give you a raise per se, see if you can negotiate a bonus if you reach a performance goal.

Loan-to-value ratio

This is another number for lenders to asses the risk of loaning you the mortgage loan. The loan-to-value (LTV) ratio is the mortgage loan amount divided by the appraised value of the property (expressed as a percentage). An independent appraiser usually determines the property’s value. If the buyer has a high loan to value ratio, they can expect to pay private mortgage insurance.

Private mortgage insurance (PMI) can add to your monthly payments so having a larger down payment or piggybacking your mortgage loan can lower your payments.

Cash Reserves

I read about this one in a few books covering mortgages, but I personally haven’t noticed this from our lender. Some lenders examine how much cash you have on hand to see if you’ll be able to weather any emergencies that arise. The cash reserves that we have are for the down payment as well as some for our emergency fund.

Closing thoughts

While it’s gotten harder to get a mortgage over the past year or so, that’s a good thing. It means that lenders are checking to make sure that borrowers can handle their mortgages. As much as I hate paperwork and filling out form after form (after form!), I also understand what’s at stake, and why the bank is being careful.

Have you noticed a change in mortgage standards?

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We were in a horrible car accident last year and our car insurance just now paid the car towing company. This company turned our bill over to collection agency which listed this on our credit report. Now… Who does what? The towing company tells collection agency to delete record on our credit report? Or do we need to do something?

We actually experienced something similar when a local medical clinic sent to collections a bill that we had already paid. Based on our experience, I would suggest starting by reading up on the Fair Debt Collection Practices Act (FDCPA).

Once you’ve done that, I would then request validation of the debt from the collection agency. A quick Google search turns up numerous sample letters that you can adapt for you own purposes. As part of your request, it wouldn’t hurt to note that you have proof of payment.

Be sure to send this letter via certified mail within 30 days of the collection agency’s initial contact. The collection agency will then have 30 days to respond. If they can’t validate the debt, they’re not allowed to:

(1) attempt to collect it,
(2) contact you about it, or
(3) report it to the credit bureaus

If they don’t respond, send a followup noting (politely!) their failure to comply with the FDCPA. Further state that they will be in violation of the act if they attempt to collect and/or report you to the credit bureaus (or fail to remove the listing if they’ve already reported you).

In our case, this is as far as it went. We sent the request for validation and didn’t hear anything. I then sent a followup noting their failure to validate the debt, and further stating that we consider the matter to be resolved. We haven’t heard anything since.

In Mary’s case, it would also be worth following up with both the insurance company and the towing company and asking for their help. It’s important to be polite but firm, and to not give up until you get a resolution. Take good notes of every conversation, and provide documentation wherever possible/necessary.

What did I miss?

Have any of you successfully navigated this sort of situation, or otherwise dealt with a collection agency? If so, do you have anything to add?

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The housing market has been down for two years or more in much of the country, but many home buyers are continuing with the practice of buying a new home before selling the old one. While this was a common practice a few years ago in a stronger market, it makes little sense now.

Selling a house in this market is substantially more difficult than buying a new one.

If you insist on delaying the sale of your current home until you put a contract on a new one, then you’ll face the very real possibility of carrying house payments on two mortgaged properties at the same time. This is a situation that should be avoided at all costs in this market.

The downside of the real estate double deal

Below are some common entanglements you might face by not selling your house before buying a new one.

Qualifying for a new mortgage. A mortgage approval is much harder to obtain when the potential exists for carrying mortgages on two houses. Your lender will be aware of the situation, and may be less flexible in your terms. Either that, or they might not approve your loan at all. Since most buyers purchase at the upper range of affordability, the possibility of carrying two properties may be viewed as an unacceptable risk.

Sale of prior residence clause. If the lender wants you to sell your current home before closing on the new one, they will add this condition to your approval. Real estate agents don’t like it, and sellers like it even less. It makes the closing on your new home contingent on the sale of your old one —- a deal dependent on another deal. If your lender requires the sale of your current home, your offer on a new home may not be accepted.

The Simultaneous Close. This is typically the most desired outcome. You close on the old and new homes on the same day. This is the perfect world outcome, but much more difficult to pull off than most people think. It’s very stressful on all parties, and can be sabotaged by a laundry list of potential issues with EITHER transaction. This is the classic, “it ain’t over until it’s over” trap, that may cause sleepless nights and significant delays in closing.

Wiping out your liquid assets. There are numerous expenses that accompany the purchase of a new home that don’t show up on a closing statement. Costs of the move, new furniture, minor repairs to the new home and the “whoops, we didn’t know we would need to buy (or fix) that!” Now add an extra monthly mortgage payment to the mix, and how long do you think your liquid assets will hold out?

A forced rental situation. Renting out your old house to cancel the payment on it might make sense short term, but having tenants will make it much harder to eventually sell your house. Your tenant might not be open to real estate agents showing the house, and also might not keep it in salable condition.

Foreclosure. Carrying two mortgaged properties simultaneously is a major cause of foreclosure. Even if nothing goes wrong, the double payments might prove to be too much for you to handle.

Common reasons for not selling first

Over my many years in the mortgage industry, I’ve heard the following offered as reasons for buying the new house before selling the old one.

“My house is in (pick one) top condition/a top neighborhood/a top school district, so it’ll sell fast.” Most home sellers aren’t objective when assessing the salability of their homes, and tend to be overly optimistic. Note: seller optimism is not a factor in the marketability of your house.

“I don’t want to make a double move.” A double move is a temporary problem, and one you have some control over. It’s not uncommon to go a year or more carrying two house payments! That’s serious money.

“We might not be able to find another house quickly if we sell ours first.” For all the same reasons it’s difficult to sell a house in today’s market, it’s much easier to buy one.

“What if we sell our house, then can’t get a mortgage for one that we want to buy?’ You can and should obtain a mortgage pre-approval before entering into any home buying situation, so the risk here is remote at best.

The unspoken fear of being homeless. Okay, I’ve never actually heard this one, but I suspect that (perhaps in the dark of the night) people might have a pang of fear that selling their house before buying a new one could leave them out on the street. Given that you’ll have a loan pre-approval before doing anything anyway, this isn’t something to be feared — especially not in this market!

The alternatives

Simply getting a contract offer on your house isn’t always sufficient. Contracts can fall through for more reasons than you can imagine, as can the buyer’s mortgage approval. The cleanest way to enter the purchase of a new home is to fully dispose of the old one first. Below are some suggestions on how to accomplish this.

Before using any of these suggestions, it is strongly recommended that you first consult a qualified real estate attorney in your area as laws and practices vary by jurisdiction.

Sell your house with a delayed closing date. You can accept a contract on your current home and set the closing date 30, 45 or 60 days from receipt of a contingency-free mortgage approval from your buyer. At that point, you’ll have a solid buyer as well as time to find your new home, and you may be able to pull off the coveted simultaneous close.

Add a short-term rental provision to the contract on your current home. Add a clause to the sale of your old home that permits you to stay in the house as a rent-paying tenant for 30-60 days following the close. Use this time to secure your next home. You’ll avoid a double move, have the cash from closing in hand, and can make a clean offer on a new property.

Move into an extended stay hotel and put your furniture in storage. This requires a double move, but also eliminates the uncertainty pf being able to sell the old home. It also makes your a more attractive buyer. Yes, it will cost more, but it’s a solid defensive strategy that guarantees you won’t be stuck with two mortgages.

Sell your house, and take a lease purchase on a new home. This strategy also enables you to sell your old home and enter the market as an unencumbered buyer. You get a chance to “test drive” the new house and neighborhood, and you avoid the double move. There are now more lease purchases available than there have been in recent memory, and one might imagine that any property that’s been listed for sale for more than a few months might be a candidate for such an offer even if it’s not being presented as such by the sellers.

No doubt any of the above will create some problems, but you’ll be accepting smaller, short-term problems rather than risking larger, more costly problems later.

Do you know of anyone who’s been trapped with two homes for more than a couple of months? Are you in this position now?

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As we get closer to closing, we’ll also receive a HUD-1 Settlement Statement, which is a form used in the United States for disclosure of fees that the lender or broker is charging. The purpose of the HUD-1 statement is to help borrowers understand the total costs of buying their home. These documents are a great resource to give you an idea of upcoming expenses and costs.

Always ask questions

I’ve heard from my friends and read from others that they wished they ad asked more questions when buying their home. Unfortunately, they usually come to this realization after they realize that they could’ve gotten a better loan. Instead of relying on what a lender tells you, check out these resources:

• HUD’s Site on Buying a Home and Closing Costs
• Consumer’s Guide to Mortgage Lock-Ins
• Consumer’s Guide to Mortgage Settlement Costs
• Five Tips for Shopping for a Mortgage
• Looking for the Best Mortgage: Shop, Compare, Negotiate

Remember, no broker or lender has to give you the best deal. They are trying to make a profit, and that might involve higher rates and/or fees than you would otherwise have to pay. Be sure to ask questions, and don’t be afraid to comparison shop. It’s your name on that loan, and you’ll be the one responsible for it.

Is your interest rate adjustable or fixed?

It’s in your best interest to understand the term of your loan, your interest rate, whether it is fixed or adjustable, and whether or not you will have any balloon payments in your future — you should generally avoid loans that require balloon payments.

Fixed-rate loans generally have repayment terms of 15, 20, or 30 years.

Adjustable-rate loans, also known as variable-rate loans, usually offer a lower initial interest rate than fixed-rate loans. The interest rate fluctuates over the life of the loan based on market conditions, but the loan agreement generally sets maximum and minimum rates.

Source: Federal Reserve

Run all your numbers before agreeing settling on a lender and loan. Ask them to walk you through and show you how much your monthly payments could be a year from now, five years from now, and so forth. In the case of a fixed-rate loan, the principal and interest payments won’t change over the life of the loan.

How much are your settlement costs?

Besides your down payment, there are a number of costs associated with closing on your new house. Becoming familiar with the typical costs and fees will put you in a better position.

Loan origination fees: Borrowers might be asked to pay this fee in return for the brokers/lenders handling your loan. It typically ranges from 1- 1.5% of the house’s cost, though some lenders offer lower flat rates.

Hazard/homeowners insurance premiums: Lenders expect you to pay your first year’s premiums in advance. Going forward, they will also (most likely) collect a portion of your annual premium along with your monthly mortgage payment and place it in your escrow account.

Title insurance: The title insurance come into play if there’s ever a dispute of who really owns the property. While you have to find a company that meets your lender’s requirements, you can search to find a good deal on your title insurance premiums.

Just make sure the coverage you get is adequate. Some cheaper policies may have exclusions that can hurt you — e.g., they might only protect the lender’s interests.

Pest inspection: Depending on where you live, your new home might need to be inspected prior to closing for termites and other pests that might damage your house.

Credit report: Lenders will pull your credit report to make sure you’re a financially worthy candidate. The cost for doing this is typically passed on to the borrower.

Other settlement costs: You also have to consider processing fee, underwriting fee, document review (I’m not kidding!), tax service fee, commitment fee, wire transfer fees, overnight shipping fees, and a few more. There are a lot of fees involved, so review your Good Faith Estimate carefully to see what you should expect.

Closing thoughts

If you’re thinking of purchasing a new home, keep the settlement costs in mind when formulating an offer. Remember, you’ll have to bring enough cash to the closing table for both your down payment and your settlement costs.

Your settlement statement will also give you a pretty good idea of your complete cost of home ownership. Of course, this doesn’t include incidentals like new furniture and your monthly utility bills, but it gives you a pretty good baseline.

And remember… If you have any questions about fees, ask before you sign anything. Don’t be afraid to negotiate a better deal — if something doesn’t make sense to you, try to get it reduced or removed. Being an informed buyer is the best course of action.

If you’ve bought a home, what surprised you about the settlement costs and/or the closing process? Do you have any tips or tricks? Anything that we should be sure to do/avoid? Please share your thoughts in the comments.

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Is it better to pay money monthly that is applied to your escrow or your principal? I would like to pay the equivalent of one extra mortgage payment a year, but I’m not sure where to apply it.

The short answer is that you want the extra payments to apply to your mortgage principal — that’s the amount that you still owe the lender. In most cases, your lender will automatically apply any overage to your mortgage principal. That’s not always the case, however, so it’s best to check with them to be sure.

The longer answer is that your monthly mortgage payment likely consists of four parts: principal, interest, taxes, and insurance. This is where the acronym PITI comes from. The reason that your lender collects taxes and insurance is that they want to protect their investment (your home) from both disaster and tax complications by making 100% sure that both bills get paid.

What the heck is escrow?

So where does escrow come in? Well… The term escrow refers to a legal arrangement in which a third-party takes possession of money or property until certain obligations have been met. In the real estate world, the “extra” funds that your lender collects are placed in an escrow account until your tax and/or insurance bills come due. At that point, the funds are disbursed to cover your obligations.

More generally, escrow services are often used to reduce risk in business deals when the two parties don’t fully trust each other. For example, if a particularly valuable asset is being sold, the buyer will often transfer their money to an escrow agent instead of paying the seller directly. The escrow agent will then hold the funds until the asset has been transferred, at which point the seller will get paid.

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I don’t have any firsthand knowledge of ING Direct mortgages, but I was curious enough to go take a look. For starters, it doesn’t look like ING Direct offers traditional, fixed-rate mortgages. Instead, they offer a so-called “Easy Orange” mortgage as well as standard 5/1 and 7/1 adjustable rate mortgages (ARMs).

Inside the “Easy Orange” mortgage

The “Easy Orange” mortgage is a five year, fixed rate loan with monthly payments based on a 30 year payback period. Instead of making monthly payments, however, you make biweekly payments corresponding to half the monthly amount. This accelerates the repayment schedule, and helps you pay off your mortgage early.

At the end of five years, you can re-lock at the then-current rate for another five years. The downside here is that re-locking appears to cost the equivalent of two biweekly payments. The upfront lender costs are all wrapped up into $395 processing fee when you sign your original loan documents.

Inside the “Orange Mortgage”

The “Orange Mortgage” is an ARM that comes in two flavors — 5/1 or 7/1. In other words, the rates are initially fixed for five or seven years, after which time they adjust annually. As above, these loans are amortized over 30 years, and the total lender costs are wrapped up into a $395 processing fee.

Thoughts on ING Direct mortgages

Personally, I’m not crazy about ARMs. Instead, we’ve always used 15 or 30 year fixed-rate mortgages. While I’m aware of the arguments in favor of ARMs, I don’t like the uncertainty associated with them. This is especially true when rates are as low as they have been in recent years.

Speaking of rates, the Easy Orange loan had a 4.25% rate and the 5/1 and 7/1 ARMs were at 4.5% and 4.75%, respectively*. I just checked around, and these rates appear to be fairly competitive. Note, however, that these rates require a 75% loan-to-value (LTV) ratio or less. Thus, you’ll need to come up with a 25% down payment (or have at least 25% equity in the case of a refinance).

As I said above, I don’t have any firsthand experience with mortgages from ING Direct. This is where you come in… If you’ve ever borrowed from ING Direct, please weigh in. Likewise, if you’ve considered using them in the past, but decided against it, I’d like to hear why.

*Note: Rates as of 8/10/09.

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Credit scores are becoming increasingly important each and every day. While some people check them compulsively, almost as frequently as they check their investment portfolio, others check them infrequently, like the oil in their car. Regardless of where you stand, that three digit credit score plays a big role in your life, so it’s important to make sure that you have a good one.

So what’s a good credit score?

Good is relative. If you’re not planning on getting a loan, you probably shouldn’t be too worried about your score. As long as you have an average credit score or above, you’re in good shape. In such cases, good enough is good enough.

But let’s say that you want to buy a house, and you’re looking for a 30 year, fixed rate mortgage. What do the rates look like relative to credit scores?

Here’s what MyFICO says:

 
In that case, anything above 760 is “good,” though anything about 700 r†ange are pretty darn good. The point that I’m trying to make is that the definition of good depends on your needs. If you don’t need to borrow, then a 620 is as good as a 850. After all, you can’t walk into the grocery store with your 850 and expect to get anything with that alone, right?

So, the next time you’re fretting about how good your score is, think about what you’re trying to achieve first. Once you have context, it’s worth spending time finding out if your score is good, or at least good enough.

There are several ways you can see your FICO credit score for free, but all of them require that you sign up for a trial membership for some sort of paid service (e.g., FreeCreditReport.com requires a seven day free trial of their credit monitoring service). If you don’t want the hassle, you can always try a site like Credit Karma.

Credit Karma is absolutely free, but it’s not a true FICO score. Rather, it’s an approximation based on your TransUnion credit report. If you’re planning on getting a loan, you’ll want your real FICO score. If you’re just curious or want to see how it changes, the TransUnion-based score is good enough.

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The source for these thoughts is a recent book called “The Frugal Millionaires,” which profiles 70 anonymous millionaires and their thoughts about money. Interestingly, just like with our prior discussion here on FCN, there are ‘frugal millionaires’ on both sides of the fence. Here’s a taste of what they had to say…

Thoughts in favor of keeping your mortgage…

“When it comes to residences, mortgages can be a way for someone to save cash for investing and therefore possibly allow them to earn a higher rate of investment return than one is paying in mortgage interest.”

“If you can have money at a cheap rate then a mortgage is a great decision…”

“If the money is cheap, it can be smart to arbitrage the cost of the mortgage vs. the benefits of a tax deduction and market gains…”

“The US government tax system is set up to reward those who have mortgages…”

“If the government is going to pay you to own a home, why turn them down…”

Thoughts in favor of paying off your mortgage…

“If you want absolute peace of mind, don’t have any debt…”

“For many people the advantage of the ‘interest deduction’ is a myth perpetuated by by real estate agents, mortgage brokers, and even your friends…”

“Mortgages lose their interest rate deduction efficiency as they get older. This [is because] you are paying more principal towards the end of the loan…”

“Take opportunities to pay off a little of the capital on your mortgage whenever you can — even if it seems like an insignificant amount.”

“I prefer not to have one and say get rid of them as fast as you can. Debt will kill you.”

“There’s a great feeling in living in a home you own outright.”

What say you?

While I know that I number of you have weighed in on this already, I still thought it would be worth asking… As I’ve noted previously, we’re doing a bit of both. We’re paying down our mortgage ahead of schedule, but we’re not committing every last penny to the effort. Instead, we’re directing a sizable chunk of our ‘discretionary’ funds to our investment portfolio.

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