When it comes to pursuing the American Dream, it would appear that owning a home is the cornerstone of this dream. However, if not properly addressed this dream of home ownership can turn into a nightmare and a nemesis for those not prepared.
We have prepared this short guide to help you understand a few of the issues involved in home ownership. It would serve you well to educate yourself before embarking on owning one of the more expensive investments of your lifetime.
Fair Market Value
Before you make an offer on any home, you need to fully understand what the fair market value is of single family homes or condos or duplexes. We are assuming that you have done your homework regarding where you want to live, and the approximate size house you can afford.
Simply stated the fair market value is what a willing buyer is willing to pay and what a willing seller is willing to accept. That seems simple on the surface but let’s dig a little deeper.
When we say comparable we mean apples to apples. Here is the standard that we have used when we were looking for investment houses and even our own home.
- Same number of bedrooms
- Same number of bathrooms
- Approximate same number of living square feet, not including the garage or basement if it does not have an outside entrance/exit
- Comparable sales not more than one mile from your house
- Comparable sales not more than 6 months’ old
The reason you keep this within a mile is because you actually may end up in a different caliber of neighborhood more than a mile out. Prices of homes vary considerably over time so looking at sales more than the previous 6 months would not be a good comparison.
So let’s say that you had three homes that fit the above criteria. You simply add up the gross sale price of all three then take the average of the three. You would do the same with the total square feet of the three homes and take the average.
Once you have the average of the total price and the total square feet, you simply divide the average square feet into the average price of the three homes. You then have an average price per square foot.
You take this average price per square foot and multiply it by the square feet of your target house you wish to purchase and you will get a good starting price for the house you want to purchase.
It would look like this on a spreadsheet:
|House Address of the comparable||Sale Price||Total Square Feet||Price per Square Feet|
So now if the house you want to buy has 1900 square feet, you take 1900 times average price per square feet which is $115.55 and you get $219,545. This would most likely be the top dollar you would be willing to purchase the home for. It gives you a basis for the true value of the home at the current fair market values.
This is a true comparable analysis. The appraisal may come in higher or lower, but it is a good measure on whether you can agree with the appraisal or not. Just remember that home values can rapidly increase or decrease based on false criteria being pushed into the market by government legislation and overzealous mortgage lenders and appraisers. This is exactly what we saw from 2000 to 2008.
For most Americans, paying cash in full for a home is not possible or even advisable. This is where the mortgage loans come to be of great assistance or could be a huge problem if not addressed properly. Just to be clear, when you purchase a home with a mortgage note, you are the owner; they only have a lien against the house based on the remaining balance of the note at any given time.
That is what if a home goes into foreclosure. Even the mortgage lender has to go to the sheriff’s sale to get title to the property from you after foreclosure. However, that is a whole other discussion.
We will discuss a few issues concerning Mortgage Loans that you need to be aware of. We will discuss in general as these loans and offering vary from lender to lender and interest rates change.
The interest rate you get is based on many factors, including your down payment, your credit history, and a few other issues. Here are a few of the types of loans out there.
- Thirty years fixed interest rate
- Fifteen-year fixed interest rate
- Adjustable interest rate
These are the main types with lenders getting creative with other types of products. The bottom line is can you afford the monthly payment year over year. With the fixed rate mortgage, your payment will stay fixed for the term of the note until it is paid off. With an adjustable rate mortgage, the interest rate can change if interest rates are changed by the Federal Reserve.
With our current low-interest rate environment, you can rest assured that your adjustable rate mortgage will go up meaning you may not be able to afford the payment. This could be disastrous for you remaining in your home.
There is another issue and that is what is known as Private Mortgage Insurance (PMI). This is where the lender kind of forces you to buy insurance to cover their loan to you unless you have at least 20% of the equity in the home. They are required by law to drop it once you have reached 22% of the equity in your home.
So to eliminate the PMI payment, you can simply come up with a 20% down payment to purchase the home, leaving an 80% loan against the primary mortgage. Another way to do this is to take out a second loan to cover the 20%. Many lenders did this practice but in our opinion, it is not advisable.
Here is why! When the economy has systemic problems, then people lose overtime, get downsized and so forth. It was this second loan that they could not cover, even though they could cover the primary loan. The result was still foreclosure.
So a here are a few points to keep in mind:
- Qualify to purchase the home with your base pay, not your overtime
- Come up with as large a down payment as you can without fully depleting your six months savings reserve
- Do not take out a second loan to cover the PMI.
We think these three points will help you qualify and stay in your home, even if you decide to sell your house to move elsewhere in 5 to 10 years. You will need to understand that most of the interest is paid during the first 10 years of a loan, which means that the reduction in your principal balance does not occur until after this time frame.
As an example you could go to Mortgage Calculator and you will see your overall costs. If the home was valued at $300,000 and you had a 30 year fixed loan for $250,000 at 4% this means that you put a $50,000 down payment. Over thirty years you would have paid a total of $574,882. Is this what you are willing to pay for a home whose current fair market value is $300,000? Will the neighborhood go up in value or down in value in thirty years? One never knows.
The last thing to remember is to make sure that when you do get your mortgage that there is now pre-payment penalty attached to it. This is important if you accelerate the repayment or refinance.
So now we have to broach the subject of equity in your home. Home Equity is the difference between what you owe on the house and the house’s fair market value. As discussed above we know that this can change either up or down, and can change quickly upwards under a housing bubble and quickly downwards during a housing bubble burst.
So the key is to never allow yourself to be upside down in the equity in your personal residence. A good way to do this is to never have less than 15 to 20 percent equity in your house. You can do a comparable analysis of your house every year as discussed above. Or about every three years have an appraisal done.
Now I want to discuss what an “asset” really is when it comes to wealth creation. I learned this from Robert Kiyosaki in his book “Rich Dad Poor Dad”. An asset is anything that creates cash flow, like a dividend or interest-bearing stock or investment property or private placement into a business.
Under that definition, your house is not an asset, even if the bank thinks it is. It is the place where you live and you call home. It is only a realized asset when you sell it and make the gain against the entire principle you put into it over the years. So the key here is to never allow your home to become an unwanted burden, but a true blessing.
So now the issue of a Home Equity Line of Credit (HELOC) will come into the discussion. This is a credit against the equity in your home. It is not a bad idea to actually have the line of credit because it is always better to obtain credit and not use it when you do not need it. It can be reserved for any month that you need to fill in the gap as long as you can pay it back within a month or two.
So consider an HELOC as a tool to help you. It is only a second lien against your house up to the amount of any unpaid balance. The best approach would be to take whatever the line of credit is and add that to the total loan amount outstanding.
For example, let’s say your house is fair market valued at $200,000 and you have a $150,000 first mortgage against your house. If you get an HELOC for $10,000, just consider that you have $160,000 total lien against your house. This will keep you still at a 20% equity position with $40,000 of equity outstanding, even if you only used $2,000 of your HELOC.
After a few years in the house, most homeowners will either consider or be marketed with the idea of refinancing. The basic rule of thumb is that you should actually be in a better position after you refinance than before.
So what are a few of the scenarios that refinancing may be of some help? We would say to go from a 30 year fixed to a 15 year fixed might make sense. Keep in mind your monthly payment may go up, however, it will allow you to pay your house off earlier.
Going on a 15 year fixed to a 30 year fixed would make sense if you need to manage a smaller monthly payment. Lastly, going from an adjustable rate mortgage to a fixed rate mortgage would be in most cases a smart move because interest rates are so low now they have nowhere to go but up.
Keep in mind that if the unemployment rates start to decrease (meaning more people employed with disposable income) that interest rates will tend to go up. It is simple logic that people will demand more credit because they think they can manage the debt. The Federal Government will use that as one of the indicators to increase the interest rates.
We think that there is one reason that people refinance that will get them into trouble and that is for debt reconciliation of their consumer credit cards. This is an insane move and we will explain why.
First of all, consumer credit is a non-collateralized loan that the worst that can happen is a court judgment and or garnishment if you cannot pay it after several years. If you move this non-collateralized debt against the equity on your home, you just gave the lender more leverage against your house.
Secondly, if you do not correct and fix the habit that allowed you to get into high retail consumer debt in the first place, you will most likely have more retail consumer debt with a higher lien against your house in about 6 months to a year. This puts you into a worse situation than before.
We know that there is a better and more systematic way to pay off your debts in an accelerated fashion, but debt consolidation against your home, putting your equity at risk is not one of them.
Remodeling and Maintaining
The true cost of your home is everything you pay into it over the years. It includes interest, taxes, maintenance, and remodeling. Since it is not producing income it is not an asset as we describe it but a cost until you sell it and realize any gain.
Since there are several home improvement retailers, with plenty of ideas for home improvement, remodeling and maintenance it would do well to educate yourself on making sure you can at least do the simpler things. These stores have books on home maintenance and improvement you can buy to educate yourself.
Regarding remodeling, it should be done while you live there as a quality of life enjoyment and not necessarily as an equity enhancer. Many times, these remodel do not actually increase the equity position. A remodeled kitchen is for your benefit and a new concrete swimming pool is also for your benefit.
So consider remodeling as a way to improve your surroundings and ambiance, not to make money because that is unrealized until you sell.
Your Home Ownership Partner
The last issue that you need to understand about home ownership is your partners. These are entities that have a vested interest in your property.
They are as follows:
- You the home owner
- The first lien mortgage company
- Any second lien lenders on the property
- Your home insurance carrier
- Your local government through property tax
Now you can eliminate over time by paying the principal and interest back and having the liens removed as the mortgage lenders are no longer involved in your house.
The insurance carrier will always be your partner to protect the house,however, they have no legal claim on your house. You can work with them to make sure your premiums are as low as possible for the coverage you need. Simple things like fire extinguishers and smoke or fire alarms all help to reduce insurance costs.
The last partner is the local government that puts a property tax against your house every year. We think this is technically an unconstitutional attack on private property rights. The reason is even if you own your house free and clear, just try not paying your property tax for a few years and you will know who truly owns your home.
Until the people of this country and politicians have the will to redress this issue to their governments, this will continue to be the case. We bring this up to just help you understand that in America you will always have the local government as your property partner!
Owning a house as a personal residence is a serious commitment and not to be taken lightly as it represents a huge amount of your future earnings. Make sure you go into this with eyes and understanding wide open. We trust that this guide has helped you in gaining more understanding in becoming a homeowner.