Section 1031 of the IRS Code has to to with tax treatment on the exchange of one parcel of real estate for another. It’s similar to Section 1035 which covers most non real estate exchanges. Car for a car. Boat for a boat. Business for a business. But section 1031 allows indirect exchanges so long as you follow certain guidelines. After all, how often do folks want to trade two parcels directly? It happens, but not very often. Usually, if A is buying B’s parcel, then even if B wants to replace it with another piece of real estate, it probably isn’t owned by A.
Why would you want to do this? Taxes. No other reason but taxes. If the taxpayer makes the exchange according to the provisions, they defer the gain. But we’re talking capital gains, not ordinary income, so keep in mind it’s not worth going gonzo over. The maximum long term capital gains tax rate for most folks is 15 percent. Still, getting to keep 100 percent of your gains instead of 85 can be worthwhile, and when we’re talking sometimes about multiple hundreds of thousands of dollars, that’s quite a bit of motivation. It’s nice to be able to invest and use those (potentially) tens of thousands of dollars, rather than basically forking them directly to the tax man.
Your primary residence is not eligible for 1031. Second homes are severely limited in eligibility (general rule: You can’t occupy it more than 10 percent of total occupancy, although you get up to fourteen days per year. Check with your accountant for details. Matter of fact, check everything with your accountant. This is just a basic overview, and the devil is in the details). Section 1031 is for investment property, of whatever nature.
Section 1031 is not for “flipping”. I am not aware of any explicit minimum general holding time, but the IRS looks hard when the held period is less than a year. 1031 Questions are good jumping off points for general audits. Be careful. If the properties are being sold between related parties, there is a two year minimum holding rule, and nobody can end up with cash. For this reason, 1031s with a related party transaction are tough. If it’s a property you bought as investment that you later made into a personal residence (or vice versa) the minimum holding time is five years.
There are some significant complexities in duplexes where one unit is for personal use, or personal use dwellings where there’s a home office. I’ve just gotten to the point where I don’t understand the attractiveness or value of a home office deduction for many people, but they keep insisting upon trying for them.
Basically, there are three requirements for a standard “forward” 1031 Exchange. You can not have constructive receipt of the funds. You must designate replacement properties within 45 calendar days of the sale of the relinquished property, and you must consummate the sale within 180 days or before you file your tax return, whichever comes first.
Constructive receipt is a fancy way the IRS has of saying control of the funds. If escrow sends you the check, or if the check is in your name, you have constructive receipt of the funds and the 1031 will be disallowed. So what happens is that you need to pay an accomodator (most title companies have one) to act as trustee for the money, and the actual transaction is done in the name of the accomodator. If you see something about cooperating with a 1031 exchange at no cost to you as part of a sale or purchase, this is what it’s about. Makes no difference to the other party in the transaction, but the Grant Deed has to be made out to (or by) the accomodator entity, not the people who are actually taking part in the transaction.
There are three rules I’m aware of to use in identifying replacement property. The 3 property, the 200 percent, and the 95 percent. Keep in mind that this is investment property, often commercial in nature, and that even within major metropolitan areas it can be difficult to replace the property with something similar within the time frame. This is one situation where the law is a lot more flexible than most of the people. As long as it’s real estate within the United States not held for personal use, the law doesn’t care what the use of the property you replace it with is, but lots of folks are trying to find something as specific to their purposes as possible. Also, in hot markets, there may be difficulties created with finding a property you can afford and that the seller will agree to sell to you in that time frame.
Keep in mind always that we’re not necessarily talking a straight one property for one property exchange here. It can be multiple relinquished properties for one replacement (in which case the sale of the first relinquished property starts the clocks), it can be one relinquished for several replacement properties, or any mix of A properties now and B properties later, where A and B are nonzero, whole, and positive. Counting numbers, to use the technical mathematical name. For every additional property in the exchange, you can expect to spend more in fees to the accomodater, exclusive of all other costs to the transaction.
The first method of designating replacement properties is what’s called the 3 property rule. You may designate up to three properties of any value, and as long as you actually acquire one or more that fits the parameters within 180 days, you’re good to go. The second rule is any number of properties but no more than 200 percent of value. The final rule, 95 percent, is basically worthless and a good way to get in trouble, because unless you only designate one replacement property, you’re not going to be able to acquire 95 percent of the total value of the designated properties. Identification of these properties must be precise and unambiguous. “Land at the corner of First and Main” won’t work. You need something like a legal description or an Assessor’s Parcel Number (APN).
Finally, you need to acquire the replacement property within 180 days of selling the property (or before filing your tax return for the year – this can require you to be forced to extend your taxes)
Where the person making the exchange wants to buy the replacement property before selling the relinquished property, that’s called a “reverse” 1031 exchange. It’s basically the same concept switched around. You have 45 days to designate which property will be sold (usually not difficult), and 180 days to actually sell it, which may be a problem in slow markets. Reverse exchanges are also more expensive, as they require accomodaters to take title to an actual piece of land, and they are not, in general, for the weak of wallet. Any financing must be non-recourse financing, because the accomodater is in title and they’re not going to agree to be on the hook for the value of the loan if you can’t sell the property. This can also cause a requirement for larger down payments.
There are also “partial” 1031 exchanges, where you end up with a replacement property but something else you didn’t have before. In general, the replacement property must cost at least as much as the relinquished was sold for, the equity in the replacement property must be at least as large as the equity in the relinquished was, and the loan must be at least as large as the previous loan. If any of these three conditions is not satisfied, you’ve probably ended up with what the IRS code calls “The part of a like kind exchange transaction which is not like-kind exchange” but most accountants and other people in the real world call “boot,” as in “you’ve got this, and that to boot.” Boot is taxable, so if there’s a lot of boot, it may defeat the purpose of a 1031 exchange.
There are a lot of pitfalls, and with typically large amounts under consideration, the IRS is notorious for being hard nosed about all the particulars of 1031 exchanges, whether they are forward or reverse. Don’t try this without the aid of a tax professional, and for real estate purposes, an agent who has a good understanding can save your bacon. But if you do fulfill the requirements, it can be a good way of keeping money in your hands that you can continue to have invested in your new property, reducing your mortgage on that property, further saving you money, where otherwise nobody would be happy but the tax collectors.
Caveat Emptor
Joint Loans
First off, let me say that your site has been very informative and helpful. I stumbled across your blog looking for information on ARM vs. 30 year fixed loans and ended up reading every article.
One issue I have never really seen addressed is joint loans. When a couple, married in this case, gets a loan, which FICO score do they use?
Right now, my wife is a nursing student, when she graduates in August we want to buy a new home that is significantly more expensive than our current home. Our combined salaries at that point should be somewhere around 120K. I have been told by a mortgage professional in our first phone conversation that being a student counts for “years in
line of work”, but we would have to wait until she receives her first paycheck from her new job before we could count her income. We just accepted an offer on our current home last week, and will have enough cash to put down 10% in the price range we are looking at (200-300 K). If we want to buy before she is employed, but has an offer so we know
her salary, what are our options? It seems to me that we would be in a situation where we are doing a Stated Income type loan.
The answer to this is that whoever make more money is the primary borrower. This works with a couple as well as other arrangements. It’s a very simple answer, but you’d be amazed how often I have to repeat it for trainee loan officers. Of course we all want to use whichever score is better, but it’s the person who makes more money whom the lender will consider to be the primary borrower.
Now as far as A paper goes, it’s kind of academic. If you want to use both incomes for the loan, you both have to qualify. This can be an issue when one spouse forgets to pay bills and the other is as a-retentive as I am about it. Over time, spouses credit reports tend to track one another more and more closely, as they switch from single credit accounts to joint accounts. If it’s a joint account, doesn’t matter who forgot to pay the bill – you both take the hit. On the other hand, even long-married spouses don’t tend to have exactly the same score, and in many cases they have intentionally segregated the credit accounts for precisely this reason, that one spouse is better about paying bills. So one spouse has a 760, and the other spouse has a 560. Ouch.
It is to be noted that the superior solution is to have the responsible spouse pay all of the bills, which results in two high credit scores. Why is this important? If one of you has a 760, they may qualify A paper. If the other has a 560, you have a choice: go subprime, or have the high scoring spouse be the only person on the loan. In other words, when you’re talking about A paper, you both have to meet the credit score minimums, or you don’t qualify as a couple.
This has implications. Suppose you have a 760 score spouse who makes $3000 per month, and a 560 score spouse who makes $5000 per month, you have a choice: Qualify based upon $3000 per month, go stated income, or drop to subprime.
$3000 per month doesn’t qualify for a lot of house most places. So if you’re thinking 3 bedroom house, you can be stuck with small one bedroom condo – if you want the best rates.
The second alternative is going stated income. This only works if the necessary income for the loan is believable for someone in that occupation. Somebody who makes $3000 per month is not likely to be in a profession where $8000 per month is a believable income, and most people tend to overbuy a house rather than underbuy, regardless of the fact that underbuying is a lot more intelligent in most cases.
The third solution is to go subprime, where you’ll qualify, but get a higher rate. A single borrower with a 760 credit score gets a better loan, with less of a down payment, than the couple in this case – the primary borrower has a 560 score, remember – but they just won’t qualify for as large of a loan because they can’t afford the payments.
You might also go NINA, which is a “here I am – gotta love me!” approach where income is not verified, nor employment history. The loan you get is based totally upon your credit score and equity picture (how much of a down payment you make, in the case of a purchase). The rate is higher than stated income and the restrictions on equity is greater, but you’ll get a better loan at a better interest rate in most cases for a NINA A paper loan than even a full documentation loan for a 560 score.
Now, as to what you were told, student does not, in general, count as time in line of work. As a question to make why this is obvious: How are you going to compute her average income over the last two years? That is the way full documentation loans are justified. Some subprime lenders will accept it (not the better ones), or the person who told you this could just be planning to substitute a stated income loan based upon your income. The fact is, that unless you’re talking ugly subprime, they’re not going to accept your wife’s income until there’s some time actually working it. Many people graduate school and never work in the field. They don’t pass licensing, or they decide soon after they start that it’s not for them.
In this case, you are talking stated income unless you go subprime. It’s just the way things are computed. Sorry.
As I keep telling folks, there are a lot of shysters out there in my profession. The easiest way to get people to sign up is to promise the moon, and until you get the final loan paperwork you have no way of knowing whether they intend to deliver what they said.
Caveat Emptor
Company Stock in Retirement Accounts
Most of what you read on financial planning in the media is garbage, but here is one of those occasionally useful pieces: IRA Rollovers Could Have Tax Implications.
Here’s the idea: You keep company stock in your qualified plan aside from any rollover you may do. Leave it with the company. Convert it to non-qualified money, which means you take the hit for ordinary income at whatever you paid for the stock, or its value at time of acquisition(consult a tax professional. There used to be some circumstances where you could substitute other assets of equal value, and avoid the ordinary income hit altogether). Hold them for one year or more after conversion.
Now, if you sell them, you’re talking about long term capital gains, rather than ordinary income tax, a much lower rate, and subject to your control as to when you realize it.
Because it’s no longer part of your IRA, you are not paying ordinary income tax rates on the whole amount as you take it out of the account. Nor is it subject to Required Minimum Distribution (RMD) rules that the IRS has. You pay only capital gains tax when and where you redeem them, as you redeem them. Capital gains is a much lower tax than ordinary income, provided you hold for at least one year.
This is not for every qualified account. Since Roth 401s are after tax accounts, the whole thing is rather self defeating if the assets should be held in one of those, or in a Roth IRA for that matter. Why would you want to do this to conserve taxes if there are no taxes due if you just do nothing?
Now, by and large, I recommend moving your money to an IRA of equivalent nature when you leave a company. Traditional 401k to Traditional IRA, Roth 401k to Roth IRA. But as you can see from this, there are exceptions to that general rule.
Caveat Emptor
(Postscript: My wife is the IRA clerk for a fairly large local institution. You would be amazed how often people get bad advice from generic tax farms, and how often theoretically competent professionals do the rollover forms wrong. This highlights the fact that just because they work for Famous Well Known Corporation, doesn’t mean they know what they’re talking about. Matter of fact, I’ve regularly seen people working for Famous Well Known Corporations give awful advice that cost clients money, and would lose the business permanently to anyone else. But people cut Famous Well Known Corporations way too much slack. It is a better strategy to consider the individuals who will be performing your services.)
“Banks Give Better Deals Than Brokers”
Better deals for the bank, that is.
Ken Harney has a recent article Study Shows Loan Brokers’ Better Side
But now a new, independent academic study has concluded the opposite: According to a team of researchers headed by Georgetown University’s Gregory Elliehausen, home mortgage applicants with less-than-perfect credit pay lower financing costs when they obtain their mortgages through brokers rather than from loan officers directly employed by lenders. The same pattern holds true for African American, Hispanic and low-income borrowers.
The study was limited to subprime borrowers, but the results are not surprising:
Overall, broker loans cost 1.13 points less for first mortgages, 1.98 less for second mortgages
For borrowers in predominantly black areas, the difference was 1 point and 1.9 points, respectively.
For borrowers in predominantly hispanic areas, the difference was 2 points and 2.4 points. The explanation as to why this gap is larger is probably as simple as the fact that many of these folks limit themselves to dealing with Spanish speakers.
Skolnik added, though, that the data overall could reflect that “brokers in general operate in a much lower-cost structure” compared with banks and retail mortgage companies that carry heavy overhead and employee costs. Moreover, he said, “brokers are far more agile and nimble than retail” lenders, when pushed to compete on pricing and terms.
That and any given lender may have anywhere from a dozen loan programs to fifty, all intended to hit specific niches and priced for given underwriting assumptions. A 3/1 is different from a 7/1 is different from a 30 year fixed, stated income is different from full doc is different from NINA. That’s nine programs right there, and this is A paper stuff. Subprime is even more varied. It doesn’t matter if you barely meet guidelines or soar through them. If you find a program with tougher underwriting guidelines that you still qualify for, than that lender will give you a better rate on the loan, because they will have fewer of them go sour, and therefore get a better rate on the secondary market. You can go around to all the lenders yourself – or you can go to a broker.
Furthermore, even if you’re one of those so slick that you fit into the top loan category of the toughest lender, brokers can typically get you a better price. Why? Two reasons. First, the lenders don’t have to pay broker’s overhead, making it more cost effective for the lender to do the same business through the broker. Second, and more importantly, when you walk into a lender’s office, they regard you as a “captive” client. Brokers know better. Brokers are not captive to anyone, and they know that you’re not captive to them. A good broker’s loan officer will price with at least a dozen lenders. I’ve shopped fifty or more for tough loans. Furthermore, there’s an efficiency factor at work. After a while, a good loan officer learns which lenders are likely to have good rates for a given type of client. Which do you, as a client, think is likely to be the best use of your time and resources? Going to all those lenders yourself, or going to a few brokers?
This article of mine is also highly relevant to this discussion.
Caveat Emptor
Passive Asset Allocation
A while ago I talked about Passive Asset Allocation as a way to beat market return as a strategy. So I’m going to write a bit about what it is, why it works, and how to do it.
Passive Asset Allocation is very simple at its heart. What you are doing is keeping the balance between asset classes that you have decided is best for your situation.
The way you do it is simple. The objective is to maintain a certain investment mix. You allocate your investment pool among the asset classes, and at strict intervals, rebalance to that allocation from whatever has happened over time. Typical period is once per year. You can do it either with individual stocks and bonds, or with mutual funds, variable subaccounts, or even a mix. For most folks, bonds especially are going to require mutual funds or variable subaccounts, as individual bonds tend to be high dollar values.
Here’s an example, based upon an established portfolio of $100,000. Average market growth is 10%, but it’s not evenly spread:
Large Cap growth $10000 @11%=$11100
Small cap growth $10000 @14%=$11400
Large cap value $10000 @14%=$11400
small cap value $10000 @20%=$12000
developing world $10000 @-5%= $9500
developed world $10000 @-2%= $9800
sector investment $10000 @24%=$12400
short bond $10000 @ 7%=$10700
intermediate bond $10000 @ 8%=$10800
long term bond $10000 @ 9%=$10900
The portfolio is now $110,000. Rebalancing (note that this is a taxable transaction unless it’s in a tax-sheltered account) to the original percentage allocation, we get these returns the next year:
Large Cap growth $11000 @18%=$12980
Small cap growth $11000 @ 4%=$11440
Large cap value $11000 @25%=$13750
small cap value $11000 @ 6%=$11660
developing world $11000 @20%=$13200
industrial foreign $11000 @14%=$12540
sector investment $11000 @-12%=$9680
short bond $11000 @ 6%=$11660
intermediate bond $11000 @ 8%=$11880
long term bond $11000 @11%=$12210
Total is $121000. Seems like right on 10% compounded, right? But look what would have happened if you didn’t rebalance:
Large Cap growth $11100 @18%=$13098
Small cap growth $11400 @ 4%=$11856
Large cap value $11400 @25%=$14250
small cap value $12000 @ 6%=$12720
developing world $9500 @20%=$11400
industrial foreign $9800 @14%=$11172
sector investment $12400 @-12%=$10912
short bond $10700 @ 6%=$11342
intermediate bond $10800 @ 8%=$11664
long term bond $10900 @11%=$12099
Total is $120,513. You’ve added $487 by moving money from where assets were relatively expensive, to where they were relatively cheap.
Let’s do it on more year:
Large Cap growth $12100 @-5%=$11495
Small cap growth $12100 @14%=$13794
Large cap value $12100 @-9%=$11011
small cap value $12100 @12%=$13552
developing world $12100 @18%=$14278
industrial foreign $12100 @20%=$14520
sector investment $12100 @24%=$15004
short bond $12100 @ 8%=$13068
intermediate bond $12100 @ 9%=$13189
long term bond $12100 @ 9%=$13189
Total is $133,100, If you rebalanced once per year. If you didn’t, here’s what you end up with:
Large Cap growth $13098 @-5%=$12443.10
Small cap growth $11856 @14%=$13515.84
Large cap value $14250 @-9%=$12967.50
small cap value $12720 @12%=$14246.40
developing world $11400 @18%=$13452.00
industrial foreign $11172 @20%=$13406.40
sector investment $10912 @24%=$13530.88
short bond $11342 @ 8%=$12249.36
intermediate bond $11664 @ 9%=$12713.76
long term bond $12099 @ 9%=$13187.91
For a total of 131713.15, a difference of 1386.85 you lost in just two years.
This works even better in real world circumstances. Here, I used a larger number of asset classes than most folks use, forced them to be exactly equal, and then forced the yearly returns to average exactly 10% in order to isolate the effects of rebalancing versus not rebalancing from all other concerns. The real market is not so neat. Some years you’ll be on top of the world because you gained 40 percent, some years you’ll be picking up pennies on street corners because you lost twenty (and it’s been better as well as worse than that within the last ten years).
The whole thing that makes this work is that you are moving money from where assets are relatively expensive to where they are relatively cheap at the moment. This is another real world example of the principle behind dollar cost averaging.
It would fall apart if one asset class outperformed all others, or underperformed all others, consistently over time. But this hasn’t happened yet. Even in the asset classes that do outperform others over time, the consistency is not there. These classes are volatile. They will do very well one year or two, then do very poorly. When I see or hear people talking about “letting their winners run” over a multi-year period, particularly if they’re talking mutual funds or the equivalent rather than a particular individual security, I know I shouldn’t trouble myself about their advice. If an individual security was bought as part of an asset class, that’s fine – as long as it still meets the definition of that asset class and you deal with it appropriately.
The one thing that kills this strategy is not sticking to it. “Google has doubled and is still going up!” (or Qualcomm, or Microsoft, or…). The idea is lock the gains in, buy where stuff is relatively cheap. The same asset classes do not do equally well from year to year. It is rare to find one year’s superior asset class among the next year’s superior performers. This can be hard with individual securities, so most folks who adopt this strategy use mutual funds or variable insurance instrument subaccounts.
What can sabotage you is a fund company or variable subaccount who will not sit on their fund managers and make certain they adhere to stated asset class. When a Large cap value allocation has forty percent of its stocks in common with a small cap growth allocation, you’ve got a problem, no matter how wonderful that forty percent performs. It’s likely buying apparent performance through demand, which only works short term. One mutual fund company got away with artificial inflation of this kind for about two and a half years back around the start of the decade before the market caught up with them. People are still holding their funds, though, confident that they’ll recover because they were doing so well for a while…
Speaking of which, I left financial planning a couple of years ago, but my former clients who did this had amazingly resilient accounts when the market went bust in 2000-2002. Nobody went much below peak account values, and they were all ahead of previous high account balances by the beginning of 2003 (even discounting the effects of contributions). One’s balance went from $44,000 to $86,000 over that period with about $10,000 in contributions. Why? Because they didn’t let greed rule them.
And before I close, I do need to say that past results are not guarantees of future returns, and this is not a panacea. Consult a currently qualified professional. If an asset class is getting obviously overbalanced or under-represented, it may be time to deal with the situation even though it’s only been six months, or one. If you’re holding security X, and you keep getting tips on how hot it is, it’s probably time to sell.
Caveat Emptor
Media a Privileged Class? I Don’t Think So!
Volokh Conspiracy has an excellent article on the state of the law vis-a-vis publicizing past felony convictions.
I ask, how can it be permitted for the media to do something that private citizens cannot? Does the media have more freedom of speech than a private citizen? I would submit that the first amendment was clearly intended to protect both equally.
Do we want privileged classes in the US? Admittedly, we have them de facto, but is this a practice we wish to discourage, or encourage, de jure?
As an additional note, at what point does it become media? Am I, with roughly 1300 visits and 2000 page views per day over the last week (making my articles more read than many small papers, newsletters, etcetera), a media publisher? Are the Volokhs, at roughly ten times that level? Michelle Malkin, at roughly ten times that level? Does it require incorporation? Financial Statements? What, precisely, is the factor or factors distinguishing media publication from non-media?
I mistrust, as a matter of principle, all lines dividing our nation into two or more parts as to legal rights, privileges, or obligations. The correct view to take, and definitely to start with, is that all citizens are equal before the law. If A is allowed to do something, what compelling societal reason do we have for forbidding B? If C is not allowed to do something else, what overriding concern allows it to be permissible for D? We may disagree on specific cases, but I believe that the reasoning is universal.
I submit that in this case, no valid distinction can be drawn between the rights of media and the rights on individuals.
As a final reductio ad absurdem, suppose it is permissible for something to be published by one media outlet or another. Can we visualize any scenario under which it should be illegal for one citizen to tell another what they saw in a news report? If this distinction is drawn, that is precisely the state of affairs we will find ourselves in.
Loan Qualification Standards – “Loanbusters”
This is definitely not a “Who you gonna call?”
I’ve done a couple articles in the recent past on the two ratios, debt to income and loan to value. Nonetheless, there exist a plethora of reasons why someone can be turned down for a loan even though they make it on the ratios.
The first of these is time in line of work. A paper looks for two years in the exact same line of work. One change that trips a lot of people is going from being employed by a company to being self employed in the same line of work. Believe it or not, a promotion can also sink a loan if your job title changed, for instance from salesperson to sales manager. If it was with the same company, it can sometimes be okay, but if you changed companies to get the promotion, that’s a really tough loan. Subprime loans will accept shorter time periods.
Making payments on time is probably the biggest deal buster for A paper. In general, you are allowed no more than one mortgage late, or no more than two other lates. The reason does not matter. It does not matter how justified you were in not paying. The fact remains that you are reported as being late. The only way to remove them is for the company to admit it was in error in reporting you late. Many people will not pay the charge as it gets marked later and later and later. This is self defeating. Pay it now, dispute it afterwards. Yes, it’s harder to get your money back – but the money it saves you on your home loan is typically much larger.
Store credit cards are one of the biggest headaches here. If you buy merchandise with a generic credit card, you’ve got the card company, who are neutral, looking at the transaction. Both you and the merchant are their customers, and the merchant needs to take credit cards. They’re not going to quit taking them. If you use your store credit card, the dispute department is going to take the view that you bought that merchandise at their store and therefore you owe the money. I run across five or six store card problems for every generic card problem I encounter.
Bankruptcy is another deal buster. People in Chapter 13, or just out of Chapter 7. Most banks won’t touch them. It’s not really rational, but you there you are.
Reserves can be a deal buster, particularly for stated income loans. A paper stated income requires six months PITI reserves somewhere that you can get to it. Subprime is less demanding, but if you don’t have the lender’s requirements, you won’t get the loan. Would you loan money to someone with absolutely no cash in the bank? Payment shock, where your monthly cost of housing is increasing, can increase the reserve requirements.
Related Party Transfers are another questionable point. All of the background for loans assumes that the transaction is between unrelated parties, who have no reason to cooperate in order to do the lender dirt. If you’re buying the house from your brother, that assumption goes out the window. Some lenders will do them with caveats, others won’t touch them at all. Some will but charge extra. Others will but have special requirements. Whatever they are, you have to meet them.
The appraisal coming in low is another. The lender evaluates the property on a “lower of cost or market” basis. The Appraisal is the “market” part of that, and the lender will only loan money based upon the lower of these two methods of evaluation. I have people tell me all the time that their new purchase is worth $20,000 more than the appraised value (or the purchase price). No it isn’t. By definition – it’s worth what a willing buyer and a willing seller agree upon. The bank’s evaluations are necessarily conservative, and they don’t want to take over the property. They’re not in that business. They want you to pay back the loan.
Late payments. Whatever you do, while the loan is in progress, keep making all your payments on time. Whether just indirectly due to the credit score dropping, or directly because now you’ve got a(nother) thirty day mortgage late, this can raise your rate or even break the loan.
Sourcing and seasoning of funds to close. Just because you’ve got $100,000 in the bank doesn’t mean the bank is happy. Nobody rational keeps that kind of money outside of investment accounts. At least nobody rational who needs a loan – Bill Gates might. Lots of folks hide loans that way. The bank is going to what to see that you’ve had it a while (seasoning) or prove where you got it from (sourcing). If you really just got $400,000 from the sale of a previous property, you’re going to have the escrow papers and HUD 1.
Final credit check: I have a set spiel I go through, “Until this loan is funded and recorded, don’t breathe different without getting my okay. Make the payments you’ve been making. Make them on time. Don’t take out any new credit. Don’t allow anyone (other than mortgage providers!) to run your credit. Just before the loan gets recorded, the lender will pull a final credit report. Woe be unto the person whose situation has deteriorated, and it means we’ll have to start all over again, if there even is a loan that makes sense.”
Failures of verification. Three biggies here: employment, rent or mortgage, and deposit. I do not know why people bother lying, but they do. Don’t you be one of them. World of hurt if the lender wants to prove a point.
Lines of credit/credit history/no credit score: Most lenders want to see at least 3 lines of credit with a 24 month history of making payments on time. Freezing your credit cards is a wonderful idea, but you need to use them to demonstrate a payment history. Once per month, I use mine for something small and stupid that I would otherwise pay cash for – just to show payment history (it also helps your credit score). Pay if off as soon as the bill gets there. Waivers for two lines of credit are fairly easy, but if a given bureau doesn’t know you have two open lines of credit, they may not score your credit profile. If you don’t have at least two credit scores among the big three – no loan.
Property is structurally unsound, is not certified for habitation, unsuitable or not zoned for intended use, etcetera. Wouldn’t you really find out about this before you have a very large debt to pay? Okay, this can cost you money, but it’s a “Thank (deity) I found out now!” moment.
So there you have them, most of the most common reasons why loans – and therefore real estate deals – fall through.
Caveat Emptor
Naming Beneficiaries – Do It, and Keep Them Current
what happen when 401K leave blank on beneficiary
Nothing unless you die, and it’s not covered in your will or other documents. Then the state’s intestate code takes effect. Each state has a law for how the estates of those who die intestate will be divvied up. These laws were typically made generations ago, and the societal assumptions that they make are no longer valid. Furthermore, by failing to name a beneficiary, you are passing up on the chance to avoid probate, the legal process by which your estate is gotten to your heirs. Everybody has a probate, and fees are levied on the basis of the value of the assets that are in probate. For many assets, such as bank accounts and investment accounts, avoiding probate is as easy as naming someone a beneficiary, and any accounts where you have named someone a beneficiary go to them immediately upon proof of your death, outside of probate.
This is important because your heirs do not have access to those assets until probate is settled. This is a minimum of nine months, and in large complex cases can be a couple of decades. Probate fees are about seven percent per year, and until probate is settled, they might get to live in the house you left – but they can’t sell the house if they need to move, or if, for instance, all of your assets are tied up in probate and they can’t make the payments on the loan.
Most people do not understand the naming of beneficiaries, and never give it a second thought. Many times this translates to the first spouse still being the beneficiary of a policy of life insurance, when you divorced without children fifteen years ago, and now your second spouse has two young children to bring up without you, and without your life insurance proceeds. Even if the first spouse is generous enough to disclaim the money, since you obviously did not name your second spouse as a beneficiary, the money now has to go through probate.
Contingent beneficiaries are also important. Primary beneficiaries sometimes predecease you, or perish in the same accident. One common (and often worthwhile) tactic is to name spouses as primary beneficiaries, children as contingent beneficiaries. Many accounts allow the naming of secondary contingent beneficiaries as well. One approach is to name them individually, another to name them as a class (“all natural and adopted children of John and Jane Smith”), and two ways of accounting for their as yet unknown numbers of people who may be born later, “per stirpes” which is by branch, and “per capita” which is by head.
Every time you have a major life event, such as marriage, divorce, birth of a child, or the death of someone who is one of your beneficiaries, you should make a habit of going through all of your accounts and making certain the beneficiary designations are up to date with the new developments. Of course, if you have trusts and the like, this is also an ongoing requirement for them, and trusts are even better for avoiding unnecessary estate complications.
Caveat Emptor
Mortgages and RAMs in Later Life
“Should People in their sixties take out a mortgage?”
The short answer is “Not if you don’t have to.” Now if I suddenly vanish, the explanation will be that the loan industry put a contract out on me.
Success in loans, and sales in general, is often attributable to selling people stuff they don’t need. If you don’t sell something, you don’t eat. Getting people to call or stop by is expensive. The traditional idea of sales is that you have to make a sale at every opportunity, whether it really makes sense for the client or not.
The various tricks of selling a mortgage to retired folks is a case in point. “It’s a cushion,” “It’s there in case you need it,” and all sorts of other stuff to that effect. Combine this with the “If you wait until you need it, you won’t qualify!” and most folks who don’t know any better will cave in and apply.
This is exacerbated by the fact that most people seem to want to stay in the same home they raised their family in. This is very understandable, emotionally, and often the worst thing you can do financially.
Let’s consider the typical three or four bedroom house with a yard, and the retired couple. It becomes more and more difficult, physically, for them to do the required routine cleaning, and even more difficult to do the maintenance and repairs that any home needs from time to time. Sometimes the kids are close enough and willing to help, sometimes they aren’t. If their finances are tight in the first place, they get tighter and tighter over time.
Into this environment comes the guy with a Reverse Annuity Mortgage (RAM) to sell. This is a special kind of mortgage, with a special protection for the homeowner (here in California, and in many other states as well) that they cannot foreclose in your lifetime. You cannot be forced out. Well, what if you’re sixty-five and live to 100, as a far larger proportion of today’s 65 year olds will? That’s thirty-five years they are locking this money up for, and there is always the possibility that by the time they consider the cost of selling, etcetera, there will be no equity.
Lending is a risk based business, and that kind of lending carries its own risks. Who pays for the risk to the lender? You do. Especially as opposed to the typical loan where half have refinanced in two years and ninety-five percent in five, this is a long term loan they are being exposed to. Yes, the recipient could get cancer and die in a few years, but they could well survive that. The lender has no way of knowing what the interest rate environment for the money will be in a few years. So either the rate the clients get is variable, or the clients pay a higher rate to have a fixed interest rate.
Once you start taking money out of the RAM, it starts earning interest. Since in the most common forms you are typically not making payments, it accrues interest. If you are making payments, it makes your cash flow even tighter, and you need to take more money. In either case, your balance is increasing, faster and faster with time, until you hit the limit, at which point you can no longer get additional money. This often happens surprisingly quickly, as you have the power of compound interest working against you. This all but guarantees that the family will have to sell the home, often for less than they could have gotten had they the luxury of a longer sale time. Furthermore, if keeping the home in the family is something you would like, a Reverse Annuity Mortgage is almost certain to torpedo the hope.
Contrast this with the swap down option. Suppose instead that adult children buy a small place suited to the parents needs such as a condominium, and the parents live there, while they live in the parents home. This minimizes cleaning, upkeep, and maintenance that the parents need done.
If this won’t work, another option is selling the home and buying something smaller. Remember, a RAM will almost certainly cause the family to lose the home anyway. You get more mileage out of cashing in the equity by selling, and investing the equity, than you will from borrowing against the equity. Instead of working against you, compound interest is on your side. Most states have laws preserving property tax basis if that’s something that is advantageous.
Let’s say that with a $500,000 home, moving down to a $200,000 condo. Net of costs, you net at least $250,000 to invest, and let’s say you do so at 7 percent, well below a well invested portfolio. This gets you $17500 per year, or about $1460 per month, indefinitely, and you keep both the condo and the $250,000. Contrast this with taking the $1460 per month out of your equity. Even if you can find a RAM at the same 7 percent, the entire equity is gone out of your home in a little over fifteen years, and that’s without including initial loan charges.
Nobody can make you do this, and there are many reasons why you might not want to. But looking at it from a strictly financial viewpoint, it’s hard to find the justification for a Reverse Annuity Mortgage.
As a resource, here’s the AARP page on reverse mortgages.
Caveat Emptor
What Drives Loan Rates?
Supply and Demand.
Now that I’ve given the short answer, it’s time to explain the macro factors behind interest rate variations. But I’m going to keep referring to those first three words. It is a tradeoff between the supply of money and demand for it.
The most obvious thing influencing loan rates is inflation. This is a general environmental factor. If the inflation rate is higher, then other factors being equal, there will be fewer people willing to lend at a given rate, and more people willing to borrow. Who wouldn’t want to borrow money if the money you have to pay back is actually worth less than they money you borrowed? All loans are priced such that a given inflation is part of the background assumptions of making it. If inflation is 4 percent, someone lending money at seven is making an effective 3 percent. If inflation is ten percent, they are losing that selfsame three percent. Which scenario would you prefer to loan money in? Which scenario would you prefer to borrow money in?
On the other hand, when inflation is high, loan rates usually rise to compensate. When the prime rate is twenty-one percent, that means that a business borrower has to make a minimum of twenty-one percent on the money just to break even. That’s if they’re a prime customer. Making twenty one percent is tough. The reason you borrowed (“rented”) the money was because you have a use for it to make money. There’s a lot fewer opportunities that make enough over twenty-one percent to make them worthwhile, than there are opportunities making enough over seven. This is one reason why inflation is a Bad Thing.
What alternatives exist is a major factor on the supply side, as well. If you absolutely must invest your money in US Government securities, that’s where you’re going to invest, and since you’re increasing the supply of money to the treasury, the price is less. Supply and Demand. This is one of the many reasons why Congress’ handling of the trust fund is a national disgrace. If they were private trustees, they would be help liable for not investing it where the best returns are. If, however, you think that stocks are looking more attractive now, that means that the supply of money for loans will shrink by whatever dollars you move out, and the rates will rise. The effect for any one person is small, but there are a lot of people in the market. In aggregate, it’s many trillions of dollars. Supply and demand.
Savings rates means a lot, also. When there is a lot of new money coming available in the borrowers market that money is going to be cheaper to borrow, in the form of lower interest rates. This is partially why rates went down throughout 2002, and stayed down into 2003, and 2004. People who had been burned in stocks wanted nice “safe” mortgage bonds. When there is comparatively little new money coming into the market, the only source becomes old loans being paid off. Negative savings or negative investments in the bond market means that what money is coming off older loans is at least partially being used to fund the withdrawals. Competition for money gets fierce, and price – by which I mean interest rate – rises. Supply and Demand.
Competition for money is also a part of the demand side. When the government needs to borrow a lot, for instance, that increases the competition. Even on the scale of our capital markets, whether the government is breaking even or needs to borrow the odd $100 billion has a real and noticeable effect When they need to borrow $400 billion, you can bet it’ll raise the cost of money. The government doesn’t care, and the bureaucrats running the treasury have been told to get this money. They will do their jobs and get the money, whether it costs 4 percent, 14, or 24. Every time competition from the government drives up rates, a certain number of borrowers whose profit margin on the loan was likely to be marginal will drop out of the auction. But government spending rarely grows the tax base. It’s those corporations and small businesses investing in future opportunities that grow the tax base, and they are the ones dropping out of the auctions as money gets more expensive. This is why government deficits are a Bad Thing. Supply and Demand.
The desirability of the alternatives is another factor on the demand side, as well. There’s more than one way to make money for most. If it become prohibitively expensive to borrow (bonds), sell part ownership instead (stock). There is a point at which even the most die-hard sole proprietor needs the money, and just can’t afford it as opposed to selling some stock to new investors. This can dilute earnings, and cause you to lose control of the company (there were multiple reasons why the high inflation period of the seventies and eighties was followed by the era of the corporate raider, but that’s one part), but better to dilute your share of the pool by ten percent while increasing the size of the pool by fifteen. That is a net win, while borrowing the money at twenty-something percent is likely not.
Now, let us consider the money supply here in this country, and thence the state of likely interest rates. We have increased government borrowing. We have the social security trust putting decreasing amounts of money into the government. We have a national savings rate that’s negative (and it is the overall rate, not just working adults that we’re concerned with, here). More and more people are becoming comfortable with foreign investment. And mortgage bonds are looking jittery right now, with foreclosures up. Supply and Demand, remember?
Therefore, in my judgement, we are likely to see continued raises in the interest rate for some time. If you’re on a short term loan that is likely to adjust in the next couple of years, the time to refinance is now, unless you’re planning to sell before it adjusts. And if you had asked me a year ago if I’d ever be recommending thirty year fixed rate loans, I would have said, “Not likely”. I’m recommending them now. When it’s the same rate or higher to get a 5/1 ARM, there is no reason not to choose a thirty year fixed rate loan instead.
(If, on the other hand, you have a long term fixed rate loan, stay put. Once you’ve actually got the loan funded, they can’t just draw the money back unless you do something like fraud or default. Even if you go upside down on your loan for a while, if you’re already in a fixed rate loan, that’s okay. The market price of the home only matters at loan time and at sales time. If you don’t need a loan and you don’t plan on selling, why should you care? Note to the young: home prices will rise again.)
Caveat Emptor