Home Finances

You and your spouse are tired of paying rent, but you fear you'll never be able to save up enough to buy a house. Or you may already own a home but think it's time to move up (or down) in size. Still others of you may live in a home that is perfect and affordable but are contemplating a move to a new area and don't know what that may mean for you financially.

Whatever your living arrangements are, certainly some important questions regarding the purchase of a home have entered your marital discourse a time or two. And the topic of buying a house is often a hot-button for couples: the mix of the financial and emotional elements too often lead to a conversation catastrophe.

Even for seasoned homeowners, such basic questions such as "How much house can we afford?" or "Where can we get the best deal on a mortgage?" or even "Should we pay off our mortgage early?" can bring confusion and frustration to your lives if you don't know where to find the answers. A house is the largest purchase most people make during their marriage, so it is worth doing your homework to make the best possible decisions and avoid any potential conflict.

Why Buy

The financial benefits of owning your residence versus renting are so extensive that I almost always recommend the purchase of a home be one of a couple's top investment priorities.

First, there are tax advantages to owning your home. If you are like most people, you will borrow most of the money needed to buy your home and will make monthly mortgage payments to the lender over a period of either fifteen or thirty years. Each mortgage payment consists of interest plus some principle. Since the interest amount is based on the balance of your loan, and each payment reduces your loan balance, the interest portion of each successive payment decreases slightly while the principle portion grows.

The interest portion of your loan payments is generally tax-deductible, meaning that after tax savings are considered, you can afford a substantially larger mortgage payment than rent payment. For instance, if you are in a 30 percent federal tax bracket, a $1,000 mortgage payment will cost about the same after taxes as a $700 rent payment. Conversely, a mortgage payment will cost you less on an after-tax basis than a rent payment of an identical amount.

Second, owning your residence increases your net worth. The gap between your home's value and your loan balance is called equity. This gap grows and your equity builds as your home appreciates in value and as your loan balance declines with each monthly payment.

Third, your mortgage payments remain stable for the term of the loan, while rent payments increase each year. Let me illustrate this with a personal story. Shortly after graduating from college and living on starvation wages, I rented a tiny one-bedroom apartment for $315 per month. At the same time, my parents, living in a house they had purchased fifteen years earlier, paid only $187 per month for a two-thousand square foot house that sat on a one-acre lot. Somehow, this disparity did not seem fair but such is the advantage of investing in a home.

Lenders

So, where do you go to obtain the best deal on a mortgage? Mary Donaldson, Branch Manager of Sunshine Mortgage Corporation in Smyrna, Georgia, shed some light on this area for me.

Three main types of lenders vie for your loan business—banks, mortgage bankers, and mortgage brokers. In the old days, banks generally made mortgage loans and held the paper, meaning they loaned money from their own portfolio, collected the payments, and profited from the interest earned on the loans. That is no longer the case, as most banks now act as mortgage bankers.

Mortgage bankers close the loan in their own names, but instead of keeping the paper, they sell the loan to a purchaser for a lump sum. The purchaser is normally a government agency, such as Ginnie Mae (GNMA) or Freddie Mac (FMAC), or an individual investor. The buyer pays the mortgage banker a fee to service the loan, meaning they collect the payments and keep all the records, but the buyer actually receives the money.

Mortgage brokers are essentially marketing organizations that match lenders with borrowers. The lenders close the loans in their names and either hold the paper or sell the loans. Mortgage brokers make money from the fees they collect when the loan is closed and may also make a premium if the interest rate on the loan is higher than is generally available in the market.

From which of these three entities can you generally get the best overall deal? Unfortunately, there is no set answer, which is why you should compare offers from each when shopping for a mortgage.

Fees

There are several fees involved with a mortgage in addition to the monthly payments. Almost all lenders charge an origination fee, usually about 1 percent of the loan amount, to compensate them for their efforts in processing the loan application and closing the loan. This fee is considered part of the closing costs and, especially for larger loans, may be negotiable.

Other costs involved in the process of closing the loan include the attorney's fees, a title search (to confirm that the seller holds legitimate title to the property), an appraisal of the property's value, and other miscellaneous costs. All the closing costs, including the origination fee, typically average slightly over 3 percent of the loan amount, though this figure may be lower for larger loans. When shopping for a mortgage, consider all the fees the lender charges as well as the interest rate.

Types of Mortgages

There are three standard types of mortgages available: Conventional, FHA (Federal Housing Administration), and VA (Veteran's Administration—available only to veterans of the armed services). The requirements for a loan are similar among the three, but they differ in their specific terms.

Conventional loans require a minimum 5 percent down payment, though some lenders will allow you to put less down in exchange for a higher interest rate on the loan. If your down payment is less than 20 percent of the loan amount, the lender will tack on a fee for private mortgage insurance (PMI), which protects them in the event that you default on your loan. If you default, the lender will foreclose on your loan and sell your property to recoup their money. If your loan amount is less than 80 percent of the value of your home, they should have no problem recovering the full balance. Therefore, they are willing to drop the PMI requirement if your loan-to-value ratio (LTV) is less than 80 percent.

The premium for PMI varies based on the size of your down payment. With the minimum 5 percent down, the monthly PMI premium currently equals (.78 percent x loan amount)/12. For example, on a $100,000 mortgage, PMI would cost you $65 per month, or $780 per year. Obviously, if you can avoid this extra cost by putting 20 percent down, you are well-advised to do so.

If you cannot pay 20 percent down, you can still avoid PMI with a 10 percent down payment using a little-publicized technique. You obtain a first mortgage for 80 percent of the home's purchase price and then take out a second mortgage, called a piggyback loan, for 10 percent of the purchase price. The second mortgage carries a slightly higher interest rate, but this combination allows you to avoid the PMI requirement and saves you money on your total payment. Recently, some lenders have even begun offering piggyback loans of 15 percent, allowing you to avoid PMI premiums with only a 5 percent down payment. However, there are higher costs associated with this arrangement.

The good news is that if you can only afford 5 percent down and you pay PMI premiums, this cost goes away as the equity in your home grows. When the loan balance drops to 78 percent of the value of your home, based on the lower of the purchase price or the appraisal at the time of purchase, the lender is required by law to drop the PMI. If your house has appreciated significantly since you purchased it, you may order an appraisal and drop the PMI if your LTV has dropped to 80 percent or lower.

The standard down payment for a FHA loan is only 3 percent. The premium for FHA mortgage insurance, FHA's version of PMI, currently consists of two pieces—an up-front fee of one-and-a-half points (one point equals 1 percent of the loan amount), which may be rolled into the loan, plus a monthly premium of (.5 percent x mortgage amount)/12. The monthly premium ceases once the LTV drops to 78 percent. FHA does not give you the option of obtaining an appraisal and making an early request to drop the PMI.

VA loans actually provide 100 percent financing for a home. The VA funding fee is their equivalent of PMI, but it is significantly cheaper.

How Big of a Loan Can I Afford?

Very early in the process of deciding what size house to buy, you must determine the largest mortgage you can afford. Generally, for conventional loans, lenders require that your total house payment be no greater than 28 percent of your gross (pre-tax) monthly income (GMI). Your total monthly obligations, including car payments and credit card minimum monthly payments, must not exceed 36 percent of your GMI. FHA allows your house payment to be as high as 29 percent of your GMI, and your total monthly obligations can reach as high as 41 percent.

However, you may not want to assume the largest loan for which you can qualify. If you squeak by the lender's requirements, your budget will be tight. Are the subsequent sacrifices worth owning the largest house you can afford? Maybe, and maybe not. If your income is relatively secure and rising steadily, it may be worth stretching initially and growing into your mortgage, especially for your first home. If you are a commission salesperson and your income vacillates significantly, I do not recommend buying the biggest house for which you can qualify after a couple of exceptionally productive years.

Paying Your Mortgage Off Early

Many financial advisors teach that you should pay your mortgage off as early as possible by making an extra principle payment each month. The justification is that you save a tremendous amount of interest by doing so. While this is true, there is a second side to this issue. Extra money used to pay your principle down becomes illiquid and cannot be used for other investment endeavors that may offer a higher return, such as investing in stock mutual funds. This opportunity cost must be considered.

If you decide to pay off your mortgage early, I suggest you do not make extra monthly principle payments. While this does reduce your balance, it does not reduce your monthly payment. If you experience financially difficult times, the lender will not allow you to skip a few payments just because you have accelerated the reduction of your mortgage. In fact, if the lender forecloses on your loan, accelerating the payment of your mortgage simply reduces the price at which the lender must sell your house to recover their money. Had you kept those extra principle payments liquid, they would be available to make your mortgage payments during lean times.

Therefore, make extra principle payments into a liquid investment, such as a mutual fund. Pay off your mortgage when the balance of this liquid account equals the balance of your mortgage. By keeping the extra principle payments liquid, you increase your financial security, not the lender's.

The benefits of home ownership extend well beyond the numbers. The extra responsibilities of a home tend to mature us. Owning a home gives one a sense of pride that renting does not yield. Do your homework, and your home-buying experience can be a richly rewarding experience, both personally and financially.

Scott Kays, CFP, is president and founder of Kays Financial Advisory Corp., which manages approximately $80 million in assets. He is the author of Achieving Your Financial Potential (Doubleday). Visit him at www.scottkays.com.

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