The Consequences of Not Shopping Multiple Lenders

Minorities get higher rates.

They add that the fact minorities are more likely to borrow from institutions specializing in high-priced loans could mean they are being steered to such lenders or that some lenders are unwilling or unable to serve minority neighborhoods.

What they describe is called redlining. It is illegal. HUD really gets their panties in a bunch over it, too. Mostly what actually happens is that the lenders simply aren’t chasing certain kinds of business. If any comes to them, they deal with it like anyone else. This is standard marketing procedure. Figure out who you’re trying hardest to serve, and really chase that segment. If anyone else wants to come to you, that’s wonderful and you serve them the same as any other customer, but they’re still not someone you’re going out of your way to attract.

One thing that the article explicitly said: This does not include/compensate for credit scores. Working with people in the flesh, I have experienced the fact that there is a difference between how various groups handle credit. Often, the urban poor have some difficulty in meeting the requirements for open and existing lines of credit. They are more likely to have failed to make the connection between credit reporting and future qualifications for credit, having at some point made a decision not to pay a creditor. Often, they are more pooly educated about their options or think they’re a tough loan when they’re not. This extends into the general population, although it’s less prevalent. I have a friend I went to high school with. He and his wife make over $160,000 per year between them in very secure jobs they have held for over a decade each. Their credit score is about 760. The loan officer they were originally working with told them they were a tough loan to try and scare them into not shopping with anyone else. The reality is that the only question is what loan is best for them because they easily qualify for anything reasonable. This is far more common than most people think. The current standard is that if you have two or three open lines of credit and your credit score is above 640 – sixty plus points below national average – I can get 100 percent financing, and the possibility doesn’t disappear completely until you go below 560 (whether it’s smart is a question for the individual situation, but I can get a loan done if it is). With increasing equity, I can usually get a loan done even for credit scores below 500 (two hundred points below national average!). Now, the better your situation, the better your loan (e.g. rate, terms, closing costs, etc.) will be, but the question is not usually “Can I do a loan for these folks?” but “Can I find them better terms than anyone else?” and “Should I do this loan or is it really putting them in a worse situation than they’re in?”

Quite often, the loan provider that urban poor go to is the one who advertises where they see it – basically, the lender who chases their business, usually by advertising in that area or in that language. Every other lender is still available to them, but they go to the place whose advertising they see. They think “This guy wants my business. He does business with people like me all the time. He can get me the loan.” The problem is that all too often, this loan provider has chosen to chase this market precisely because the people in it, most often urban poor, do not understand they’ve got other choices, and do not understand effective loan shopping, and so this loan provider makes six percent (the legal limit in California) on every loan plus kickbacks and arrangements under the table. They make more on one loan than I do on half a dozen for roughly the same amount of work, and the loan they do are not as good for their client as others that can easily be found.

Most people are better loan candidates than they think they are, and qualify for better loans than they think they do. It’s more often the property they have chosen that creates an untouchable situation than the people themselves. Even then, there are usually options available.

(I got a ten minute lecture a while back from a nice young couple telling me they “deserved” a rate of four to five percent on a 100% loan for a manufactured home sitting on a rented space, because it was “the same rate everyone else is getting”. Well, if it had been on a regular house sitting on owned land I could have gotten them that loan on very desirable terms, but nobody does 100 percent on manufactured homes, and if there’s no ownership interest in the actual land involved then it’s a loan secured by personal property, not real estate, and it becomes a personal loan, for which the rates are much higher.)

So keep this in mind if and when you’re in the market for a real estate loan, and shop multiple lenders, and shop hard. Remember that all of the times your credit is run in a two week period for mortgage purposes only counts as one inquiry, whether it is just once or whether it’s five dozen times. A loan provider does not have to run credit themselves to get a quote, but the information must be complete, accurate, and in a form they can use.

Keep in mind that the loan market changes constantly. A quote that’s good today almost certainly will not be good tomorrow. If it’s not locked, it’s not real, and a thirty day lock is not valid unless extended on the thirty-first day, for which you will pay an extension fee if necessary. So shop hard, with a real sense of urgency, get it done quick, and make your loan provider get it done quick. Any additional stress will more than pay for itself (and the longer the loan takes, the greater the opportunity for stress, too). Apply for a back-up loan, and if it’s ready first, it’s probably a good idea to go with your backup. Sight unseen, I will bet money that a loan done in thirty days or less from the time you say that you want it is a better loan than the loan that takes sixty days or more.

Caveat Emptor.

Life Insurance – Proper Prior Planning Prevents…

Life Insurance is something that nearly every adult should have, and almost every adult who buys goes about purchasing it the wrong way, at the wrong time, for the wrong reasons, and buys the wrong policy.

Is that an indictment of the system or what?

Let’s start with what life insurance is. Life insurance is a bet that you make with an insurance company that you will or will not live. The idea is that if you die, while nothing can replace you, your family will get money to replace your salary. If you die while the policy is in force, the insurance company loses the bet. If you live for the full time the policy is in effect, congratulations for being alive, but you lost the bet. If you die after the policy stops, not only did you die, but you spent all that money and your family got nothing. Now it is critically important to understanding life insurance to understand that nobody gets out of life alive. Unfortunately, everybody has to die sometime. As of this writing, the chances of you missing out on this one final life experience that practically everyone wants to avoid forever are zero. So you might as well make plans that include anybody you leave behind benefitting from it, because (I have it on excellent authority) dying stinks. (Yes, I’d use a stronger word except that I try to keep the language here family safe as much as possible)

There are two major types of life insurance, term and cash-value, and the latter type has several subtypes which I will explain in due course. Term can be thought of as “renting” life insurance, while cash value can be thought of as “buying” it. Like owning versus renting a home, there are arguments on both sides of this story as to which is better. I will attempt to cover the pros and cons of all of the major camps, and there are people for whom each makes sense, but like buying a home, if you choose the right policy, cash value life insurance is a losing proposition in the short term while becoming fantastically remunerative after a few years. The vast majority of all people would do better to consider cash value, particularly when you crank the actual numbers and consider the alternatives.

Another thing that needs to be crystal clear is that life insurance is the second most tax advantaged investment you can make, right after buying a home. In fact, it’s better in many ways although it requires more planning. If you plan properly, and die while it is in force, the death benefit comes to your heirs tax free. Furthermore, all investments in the cash value of a life insurance policy earn money tax deferred, and any money withdrawn from the cash value of a life insurance policy gets “first in, first out” treatment – something no other investment can say. There is no legal dollar limit on this tax treatment for life insurance. There are no income limits for this tax treatment of life insurance. Literally anyone who can qualify for a policy can receive these tax benefits, and so long as you comply with federal guidelines to retain this treatment, there are no dollar limits to the amount you can invest. Even if you violate those limits, the only consequence is that the tax treatment on actual withdrawals flips to “Last in, first out,” and since there is no limit on the number of policies you can have, either, there aren’t many reasons to violate those guidelines.

You can also take loans against the cash value of any life insurance policies you may have, and loans are not taxable. Let’s say that again. Loans are not taxable. Remember that. It’s going to be important later. When put together with the other parts of the tax advantaged nature of life insurance, it’s an awesomely powerful tool if used correctly.

Now I’m going to violate one of my cardinal rules for this site: no graphics. The reason is that this picture is too darned important to the essay. It’s graphic of some features of a life insurance policy. The vertical axis is money – dollars – and the horizontal axis is time. And the reason I’m putting it up is to illustrate a generic life insurance policy. It doesn’t look like much at first, but here it is:

(Restored! Thanks Chris!)

Now I’m going to explain it. There are three areas: red, yellow, and gray. Grey is just background – dollars above policy value. Like the altitude above an airplane, it’s useless, unless you climb into it later, as some policies can, painting ever larger numbers first red, then yellow. Red, or actually, the top of the red line, is the total dollars your family (or other heirs) will receive when (not if) you shuffle off the mortal coil. Yellow is the cash value of the dollars in your policy. The difference between the two is the amount of insurance you’re actually paying your hard earned money for at any given time. Get it? Got it? Good.

Now it is necessary to note and remember that the cost of the red dollars – the difference between the top of the red curve and the top of the yellow curve – get more expensive with time. Sometime in your sixties, dollars of actual life insurance start getting expensive. Mind you, they are always getting costlier from the first day you buy any policy of life insurance out there. But in your sixties, this process accelerates rapidly, and this has all kinds of implications later in the essay as well as later in life. And now that we’ve covered the basics, it’s time to cover policy types.

Term life insurance, as I said, is like renting your life insurance. It’s like the red line, without the yellow curve in there at all. For the entire time your policy is in effect,you are going to be buying the full amount of insurance dollars every time you make a payment. This means that in an unaltered term policy, your premium goes up every year; sharply so once you’ve hit your sixties. If you are initially purchasing at a young age, most companies will give you the option of paying more starting right now, so that for a certain period your premiums will not increase. If you buy young enough, most companies have at least a 30 year fixed term product. It’s very difficult to find a company that will sell you a policy allowing this fixed period to go later than your sixty-fifth year, however. In all cases, once the fixed term is over, it converts to yearly renewable term, where you can expect the yearly bill to go higher every year. What happens when people start getting these suddenly much larger bills? They cancel. This is what the insurance companies want. Fewer than three percent of all term policies ever pay a death benefit because they are canceled. When you cancel, you’re letting the insurance company off the hook on your bet, and all that wonderful money you spent on their pretty policy bought you some peace of mind for a while, but now it’s gone, and you have nothing. Term is very expensive insurance, when you talk about real cost to the consumer in aggregate, and very profitable to the insurance companies. It doesn’t require writing a check for nearly the number of dollars now, but it doesn’t provide nearly the benefits either. Remember that stuff I told you about how tax-advantaged life insurance is? Term makes almost no use of this fact. It’s kind of like buying a Ferrari body, and putting a Yugo engine into it.

Now we’re going to move into cash value life insurance in all its variants. They’re called cash value because they have one. Now we’re putting the yellow curve back into the picture above. What these policies are calculated to do is endow at a certain age. This used to be 100 for all policies, now the companies are trending more towards 120. This is a good thing because with more people living to 100, they are getting checks when they really want life insurance. Policies endow when the yellow curve rises to meet the red line, off to the right of the rest of the picture above. If it’s your policy, you get a check for the amount of the red line in exchange for your policy of life insurance. This ends the tax benefits, and can have adverse effects upon your tax liability, too. So most folks want to get their policy value as a death benefit to their heirs, not as a check while they’re still alive. Confused? Follow me.

The first major variant of cash value is whole life. This is what that default picture above is all about, because that’s pretty much what a policy of whole life insurance looks like. The difference in dollars between the cost of the term insurance and the cost of the policy is invested with the general account of the company. It earns about eight percent or so, and they pay you about three, which is pathetic. Nonetheless, that three percent is tax deferred, tax free, First In First Out, so it’s probably close to an effective 5 percent for most folks. Like all cash value life insurance, there are provisions for tax free withdrawals and zero percent effective rate loans and all of that. Also like all cash value insurance, to an ever increasing degree over the life of the policy, this moves from paying the cost of the insurance from the check you are writing, which is after tax dollars, to money already within the policy, which is before tax dollars. Finally, like all cash value life insurance, over the life of the policy you are buying progressively smaller amounts of actual life insurance (the difference between the red curve and the yellow one), which means that your actual cost of insurance is less, particularly later on when the cost of that actual insurance goes up. Because of this, cash value policies are likely to stay in effect your whole life and not get canceled. Nonetheless, this is a putrid return and makes the insurance company even more money than term insurance. Many people would have you believe that whole life is the only variety of cash value life insurance out there. It isn’t. But you would not believe the number of straw man arguments against cash value life insurance I have read in the financial press that did their best to read as if that claim were true. For someone who is supposed to make their living informing consumers about the financial industry, this is either fundamentally ignorant, or fundamentally dishonest.

Sometime around 1950, some bright young person working at an insurance company realized that the need for life insurance may not be constant throughout life, and so came the first major addition to the choice of “whole life or term.” This was Universal Life. The concept was simple. You could decrease the amount of insurance in set units, or increase it in set units, up to a certain value, and the initial underwriting would still cover it. This was really cool at the time, because it meant that you didn’t have to apply again for life insurance and go through the underwriting and health insurance exam and health insurance questions all over again, and possibly get “rated” for some new health problem that wasn’t there last time, or possibly even turned down. Unfortunately, in Universal Life Insurance, you’re still investing your money in the general account of the life insurance company, and they are still only paying you about four percent. Once again this has all of the neat tax advantages, but even an effective six percent return is nothing to write home about. To most folks, it’s almost embarrassing. Nonetheless, Universal Life Insurance has broad applicability to small dollar value policies, mostly for older folks. The return is guaranteed, the company assumes the investment risk, and the policyholder gets peace of mind for the rest of their life, knowing that whatever expenses they had in mind are covered.

Not too long after the enterprising young person had the idea for Universal Life, another one had the idea for Variable Life. This is a truly different product, but it really didn’t go anywhere until the late seventies, when inflation was rampant and things were generally going south in a hand-basket until Ronald Reagan et al brought them back under control. The concept is simple: Instead of investing in the general account of the company, you have the opportunity to invest in a certain number of sub-accounts that act a lot like mutual funds. These sub-accounts are basically comparable to the ones in variable annuities, having roughly the same advantages and disadvantages except that most people do not have qualified money in life insurance because the interplay of withdrawal requirements with funding requirements gets nasty complex.

Now in those articles that do admit the existence of variable life, they most commonly write against it because “They have this expense and that expense and the other expense,” ad nauseum, with the strong implication, never proven, that they are somehow more expensive than other policies. The fact is that these are expenses associated with all life insurance. The only additional expense that the variable life insurance policy has that the term life insurance policy (or any other) does not is the expense of running the mutual fund-like sub-accounts, which actually average a bit lower than the equivalent mutual fund upon which these are usually based. Every other expense is part of every life insurance policy – indeed, most of them are part of every insurance contract of any sort. Administration, Insurance, etcetera. They buy the stuff that makes the cash value life insurance policy an interesting and potentially worthwhile investment – the death benefit, that wonderful tax treatment, among other things. But because you’re dealing with something regulated by the SEC, the agent and the company have to tell you about them in variable annuities, whereas with every other insurance policy, they are a “black box” into which money goes and insurance comes out.

Variable Life Insurance, like Variable Annuities, requires not only a life insurance license, but also an NASD Series 6 or Series 7 license to sell. This means that it is generally sold through financial planners, not “pure” insurance agents. These folks are competition for the financial “do it yourself” press, and if you are working with a professional you trust, you’re not nearly as likely to go back to the bookstore or magazine stand for generic drivel with no fiduciary responsibility towards you. Admittedly, some advisors abuse it – and when they are caught, they are prosecuted and the insurance they are required to carry pays. The generic advice in books, newspapers, magazines and websites never has this responsibility in the first place. They are specifically exempted by the Investment Company Act of 1940. But Variable Life Insurance has all of the advantages possessed by all cash value policies that I listed above, and it also has the advantage that you are getting market returns, which the tax advantages leverage significantly in your favor.

Finally, in the early 1970s, another bright young person had the idea of combining the features of Variable Life Insurance with Universal Life Insurance. This product, called Variable Universal Life Insurance, is about the most flexible, most versatile financial investment there is, because you can do so much with it, and it facilitates changes in plans like nothing else. You get market rates of return via the mutual fund-like sub-accounts, effectively augmented several points above market rates because of favorable tax treatment. You can withdraw your principal tax free, and take loans at zero effective interest rate against the earnings after that. Remember, loans are not taxable. You can increase or decrease the dollar amount of insurance within limits. Actually, variable universal has the unique ability that both the red and the yellow areas in the graph above usually start climbing into the gray area somewhere about twenty-five to thirty years in, getting to the point where the cash value of the policy can be multiple times original issue value. All of this amounts to things like you can start saving for your children’s college as soon as you decide you’d like to have some someday. You can save for literally anything, because of all of the options you have for putting money in and taking it out. Matter of fact, you get the biggest advantage from overfunding the policy, putting more money in than you have to, although there are federal limits on how much and how fast you can overfund and retain the most important tax advantage, that of “First In First Out” tax treatment. (It is to be noted that there are “single payment” policies that intentionally throw this benefit out the window, and are still an excellent investment in a lot of circumstances.)

There is one danger to variable life, and to a lesser extent variable universal life. It is possible that through inopportune timing of market declines and/or excessive withdrawals that there will not be enough money in the policy to keep it in force. This is, to use Orwell speak, double plus ungood. Let’s say you took invested some number of dollars as principal, and later withdrew them. Then you took loans of $30,000 per year every year for ten years. But then your investments went through a market decline, and you kept taking the full $30,000 per year for another ten years. If you die with the death benefit still in force, it’s all just a loan against the death benefit and therefore nontaxable because the death benefit is nontaxable. But if the policy self-destructs, now you have to pay the taxes on that $600,000 of income I’ve just described. The IRS is utterly unimpressed by “blood from a turnip” type arguments. They can usually figure a way to get their money a way that you won’t be happy with.

The oldest of these policies are still only about fifty years old, and there were a lot of improvements made in the early years, so there’s no experience, as yet, with the first generation they were really designed for as lifelong financial instruments. The first people who bought them in their twenties are only just now starting to turn sixty, approaching retirement age. Going back via market performance in the last century or so, there does not appear to be major danger of self destruction on policies given time to mature and prudently advised, but there have been people who withdrew more than the market could really support, who had major adverse experiences as a result. Especially with the variable universal policy, there are alternatives to prevent losing the policy completely, but it’s still not something you want to have happen. I will point out, however, that the same danger exists for investors of any stripe, it’s just that the sword here is especially terrible. This is one of the good reasons why these policy require dual licensing to sell – to insure that there’s someone involved who should understand the structural limitations of the policy, and can help you avoid the lurking gotcha! by keeping your withdrawals and loans to a sustainable level.

One strategy many people, particularly in the self help financial press, advise is “buy term insurance and invest the difference.” This isn’t a bad strategy, especially if you plan on dying while the fixed term period is still in effect. But most people in their twenties and thirties are going to live well past their sixty-fifth birthday, and the fact is that most people who are young today are going to work well past it, as well. The reason why insurance premiums start to climb then is largely because that’s when folks start dying off in larger numbers. Investing in life insurance is something best begun while you are young, with few health problems and lots of time. Whatever the strategy you begin while you’re young, you’re typically stuck with the decision, even if you do figure out what’s wrong with it around the time you’re fifty. At that age, your effective compounding is marginal in most cases, even if you’re planning to delay retirement a few years. But I encourage everyone with a potential life insurance need to look at projections of not what’s likely to happen for merely the next thirty years, but for the entire rest of your life. Buying variable, or better yet, variable universal, especially while you’re young is a better way to end up with more usable money later on in life for most people. And that’s the whole purpose of retirement planning, right?

Caveat Emptor

Lenders and Insurance Proceeds

The question that inspired this was

can a mortgage company use the flood insurance claim money towards homeowners mortgage loans?

This is equally applicable to every other form of insurance on your home – earthquake, regular homeowner’s insurance, and any others that you may have or require.

The short answer is yes.

The reason that the lender requires being added to every policy of insurance you have on your home is so they have a claim on the policy proceeds. Let’s say you buy a $500,000 home for nothing down, and the value of the structure is $150,000 while the value of the land is $350,000. Let’s say the house burns down next week. If they weren’t on there as beneficiary, you could theoretically take that check for $150,000 and split, leaving them with a $500,000 loan that they’re maybe going to net $270,000 for by selling the property that secured it – after all the time for foreclosure, et al, which means they’re out all those costs plus thousands of dollars in interest. If you’re a lender, you’re going to suffer this loss once at most before you decide not to trust anybody.

On the other hand, the lender doesn’t want the property or a partial repayment. They want the loan repaid in full. What they’re going to do is sit on any funds they get and make certain they’re used to rebuild, unless they have some reason to believe that rebuilding is a bad risk. Banks don’t throw good money after bad, so if this is the case, they’re going to keep the money. On the other hand, if you’ve been keeping your payments up, they’re going to want you to rebuild. Their taking custody of the money is a way to make certain that you do.

Caveat Emptor.

Games Lenders Play, Part V

Hello, I’ve been reading your website for awhile now, and have found it very helpful as I’m learning to navigate this crazy loan process! I had a question I was wondering if you could write about/answer.

We currently have a mortgage and a secondary line of credit on our condo (we didn’t have a down payment, so we had to do it like this). We have been here one year, and the home values in our complex have gone up about $70,000 – $100,000 in that time period. (We live in Southern California.)

Recently we got a notice in the mail telling us that they can reduce our monthly payments (“by as much as $1,500!)” if we refinance with them. Frankly, it sounds way too good to be true, and I have a feeling they’re not really telling us the truth in this notice. But it did raise a question in my mind: would it be wise to attempt to refinance, in the hopes that our higher valued home would allow us to refinance with only one mortgage, instead of two? I’m not even sure if that’s possible…I’m having a hard time understanding how refinancing works. I should mention that we are currently in an interest-only loan, with no prepayment penalties. Our first loan is 4.75%, and our secondary line of credit is 6.375%.

Any help would be greatly appreciated.


Your feelings that they aren’t telling the whole truth are justified.

Refinancing is the process of replacing one loan for another on the same piece of property. The idea is that the terms of the new loan are more advantageous to you than the terms of the existing loan. There are three main issues that you need to be aware of, however. The first is that there are always costs associated with doing the new loan. The second is that there may be a prepayment penalty to get out of the existing loan. The third is to make certain the terms you are moving to are enough better, for your purposes, than the existing terms to justify the costs associated with the first and second issues.

You state that you’re in California, which is where I work. Realistic costs of doing the loan are about $3500 with everything that is necessary. This doesn’t include origination, to pay the loan provider for the work they do on the loan, or discount, to pay for a rate the lender might otherwise not offer. I explain those costs, the difference between them, and many of the games lenders play in my article on Good Faith Estimate, part I. There will also be the possibility of you having to come up with some prepaid items, explained in Good Faith Estimate Part II.

Note that not every loan has points. I actually think that, given most client’s refinancing habits, it’s usually better to pay for a loan’s cost, and the loan provider’s compensation, through Yield Spread. Yield spread can be thought of as negative discount points, and discount points can be thought of as negative yield spread. Discount points are a fee charged by the lender to give you a rate lower than you would otherwise have gotten. Yield Spread is a premium paid by the lender for accepting a rate higher that you would otherwise have gotten, and can be used to pay the loan provider and/or loan costs. Each situation must be considered upon its own merits, of course.

Now, let’s take a look at your specific situation. Your current first mortgage is at 4.75% interest only. You don’t mention what sort of loan this is (updated via email: it’s a 5/1 Interest Only ARM), but there is no such thing as a thirty year fixed rate interest only loan. At most they are interest only for a certain period, usually five years, before they begin to amortize over the remaining twenty-five. On the other hand, you said you bought one year ago, and that rate didn’t exist on thirty year fixed rate loans then and it doesn’t exist now. (Via later email, the first mortgage is a 5/1 Interest Only ARM). Your second loan is a line of credit at 6.375. I’m also guessing that either you, or the person who sold to you, paid a good chunk of change in discount points to buy the rate down, and I’m hoping it wasn’t you.

Now, there’s no way that this is a loan that’s going to serve you indefinitely at that rate. There hasn’t been a 30 year fixed rate loan comparable to that available since Spring of 2004, with any lender I know of, no matter how many points you paid. So what you have is at most a hybrid ARM (Yes, 5/1 Interest Only). No worries; I love hybrid ARMs. They are the only loans I consider for my own property in most circumstances. But they do have one weakness. There is likely to come a time when it is in your best interest to refinance, because after the fixed period the rate on them adjusts every so often, based upon a stated index plus a contractual margin, and the sum of these two is likely to be significantly higher than the rate for refinancing into another hybrid ARM.

Now what are they offering you? They’re talking about cutting your payment by $1500 or more. But there just aren’t any rates that much lower than yours available. Nothing even vaguely close. I don’t think I could get you a 4.75% rate, even fully amortized, right now. So how are they going to cut your payment?

The only hypothesis I can come up with that is not contradicted by available evidence is that they are offering you a loan with a negative amortization payment. I explain those in these articles:

Option ARM and Pick a Pay – Negative Amortization Loans and Negative Amortization Loans – More Unfortunate Details

There is more information on marketing games with this loan type in these articles: Games Lenders Play (Part II) and Games Lenders Play (Part IV).

Finally, there are a few more issues that may not be relevant to everyone in these articles: Regulators Toughen Negative Amortization Loans? and Negative Amortization Loan Issues on Investment Property

One thing to understand is that when lenders are sending out advertising, they are not looking for Truth, Justice, and the American Way. They’re looking to get paid for doing a loan, and most lenders will do anything to get you to call, and then to get you start a loan. The Creative Fiction on many Good Faith Estimates and Mortgage Loan Disclosure Statements is only the start of this. If you find a loan provider who will pass up loans that they could otherwise talk you into because it doesn’t put you into a better situation, keep their contact information in a very safe place, because you’ve found a treasure more valuable than anything Indiana Jones ever discovered. A valuable treasure that you can and should nonetheless share with friends, family, and anybody you come into contact with because you want them to stay in business for the next time you need them. Most lenders and loan providers could care less if they are killing you financially – what they care about is that they get paid. A negative amortization loan pays between three and four points of yield spread. Assuming your loan is $300,000, they would be paid between $9000 and $12000 not counting any other fees they charge you for putting you into a loan where the real rate is at least 1.5 percent higher than the rate you’re paying now, and month to month variable. Warms the cockles of your heart, right? Didn’t think so.

In short, they’re offering you a teaser no better than a Nigerian 419 scam for most people in your situation. My advice is not to do anything unless you’re coming up on the end of your fixed period, in which case you need to talk with someone else, who might have your interests somewhere closer to their heart than the Andromeda Galaxy.

Caveat Emptor

Bridge Loans

One of the things I’m seeing a lot of these days is blanket advice on bridge loans.

A bridge loan is a loan that you take out with the explicit intention of having it be short term. The most common situation is a loan against property A, which you own but plan to sell, so that you can put a down payment on property B right now.

The motivation for this comes from the fact that people get paid to do bridge loans, and they are typically very easy loans to do. Frankly, the people making the recommendation make more money by doing the bridge loan than by not doing it, and they are not motivated to do the calculations and legwork to see which is the better deal for the consumer.

When it comes to money, blanket recommendations of any sort are automatically suspect, and usually wrong. Every situation is different, and there can be factors that cause an ethical professional to recommend something in one case where they would recommend against in another superficially similar one.

Bridge loans are no exception. The advantage is that they make you a more qualified buyer, and can get you better rates on the loan for the new property. The disadvantage is that their closing costs are just as high as any other loan. So you’re spending about $3500 extra plus points plus junk fees (if any). They are also, by definition, cash out refinances. The rate-cost tradeoff for cash-out refinances is less favorable, all things considered, than purchase money loans.

The next major issue that arises is that they can make it more difficult to qualify for the loan on the new property, which can often mean that you need to go stated income or NINA when you might otherwise have qualified full documentation, which means you got a higher rate on the new property anyway, and that you’re going to want to refinance your new purchase as soon as Property A sells anyway, sending another set of loan costs down the drain. Don’t get me wrong, I love to do loans, and my pocketbook loves for me to do loans, but it’s a good loan officer’s job to look after your interests first.

Finally, choosing a bridge loan can force a choice upon you: A good loan that puts you in the position of having a need to sell within a specified time frame, and a mediocre loan that may not. The best (lowest) rates are for short term loans. Always have been, always will be. However, if the market sours, this can cause you to either accept an offer you would not have otherwise considered, or flush another set of closing costs down the toilet, when if you had chosen the mediocre loan, you would have been okay indefinitely.

Let’s crunch some numbers. Let’s say you have a property currently worth $250,000 that you bought for $125,000 and have paid down to $100,000. You want to upgrade to a $400,000 property now that your promotion and raise have settled in.

The first thing you do is pull cash out to 80 percent. On a 30 day lock of a 30 year conforming fixed rate loan, assuming you’ve got good credit, this is about a 6.5 rate without points, and you’ll actually get about $96,500 of that $100,000 you take out. I looked at shorter term fixed rate loans as well, but with the yield curve inverted right now since you’re planning to sell, anything without a prepayment penalty is about the same, and a prepayment penalty is contra-indicated, as it means you’ll have to pay thousands of dollars when you do sell.

You take and put that $96500 down on a new home purchase loan on a $400,000 home. It’s over 20% down, so no PMI concerns, and no splitting into a second loan. But because you’ve got that $200k loan sitting over there, now you have to go stated income on the loan for the new home. This means your rate is about 6.75 without points. Soak off another $3500 in loan costs, plus purchase costs of maybe another $1000. You now have two loans, one for $200k at 6.5 and one for about $312,000 at 6.75. Now the original home sells. Let’s say you got full value of $250,000. You pay 5% in real estate commission, and maybe 2% more in other costs. That’s $17,500, so you get $32,500 in your pocket. You have three choices, two of them productive. You can 1) Spend the money, 2) Invest the money, or 3) Use it on the other mortgage. Now a paydown, where you just plop the money down and keep making your same old current payment is a good idea (Unless there’s a “first dollar” prepayment penalty), but most folks are obsessed with lowering their payment. So they take that $32500, and of which $3500 is loan expenses, and (because now they can do full documentation), they end up with something like a $283,000 loan at 6.25 percent, assuming rates don’t move. Total cost of loans: $10,500 assuming you pay no points for any of your loans. Perhaps possible for someone with above average credit. Not likely if your credit is below average.

Suppose instead, that you just leave that $100,000 loan sit on your original property. You’re still going to have to do stated income on the new loan on the new property. But instead, you go with a 80 percent first, 15 percent second because you can come up with $25,000 until the first property sells. Same 6.75 rate on the first, and the second is an interest only at about 10.25, just to use the same lender whose sheet I happened to pull from the stack for the exercise. Loan costs, $4000 without points, which I priced the loan to avoid. First house sells, you get $132,500, replace the $25,000, and pay off that second, leaving you a $320,000 loan and about $47,500, holding cost assumptions constant ($1000 in non-loan costs). You could do a paydown, leaving $272,500 balance on a 6.75 loan, or you could take $3500 in closing costs and refinance to 6.25, just as above, leaving a balance of $276,000 if you don’t pay any points. Total loan costs, $7500 and you only have to avoid paying points twice (once, as opposed to twice, if you take the paydown option. It takes a little under 37 months to break even on your interest savings). Furthermore, in less than hot markets, it gives you greater leverage with your seller to pay some part of your closing costs: “Do this, or I don’t qualify”. They have the home on the market for a reason, and they can help the buyer in hand or they can hope for another buyer to come along.

In this example, not doing a bridge loan saves you about $6500, less the additional interest (about $512/month) for the second mortgage until your first home sells, but plus approximately $541 per month interest every month between the time you initially refinance your original property and the time it finally sells, a longer period of time. Plus one set of possible mortgage points. So it’s not difficult to construct scenarios where it’s a good idea not to.

Let’s look at a different scenario, however. Let’s say instead of upgrading, you’re already in the $400,000 home, and looking to downsize to a $100,000 condo. Furthermore, let’s say you bought for $200,000 and are now down to $160,000 owed, just to keep the proportions consistent. You borrow out to $265,000 (paying $3500 in loan costs), which you qualify for full doc at 6.25. You then pay cash for the condo (including $1000 for purchase transaction costs, and you’ve still got $500 in your pocket). Furthermore, an all cash, no contingency transaction is a powerful negotiating tool for a seller to give you a good price. Then when your original property sells, costing you say 7%, or $28,000, in selling costs. You net $107,500 in your pocket. If you did no bridge loan, let’s still assume you can come up with $25,000 on the short term, and you still qualify full documentation. Your rate on the condo is 6.375 without points, holding assumptions consistent. Then you sell the first property for the same $400k, paying the same 7% ($28,000) and paying off the $80,000 loan on the condo as well as replacing the $25,000. Net still $107,500 in your pocket, less additional interest charges for a little longer period, but you cut your stress level and put yourself in a stronger bargaining position, which is likely to be worth doing.

There are any number of reasons and factors to do a bridge loan or not to do a bridge loan. You may not have a minimum down payment without a bridge loan. That’s probably the most common, as not all properties and purchases are eligible for 100 percent financing, and some require as much as a forty or even fifty percent down. The way a necessary transaction is structured. The presence or absence of 1035 exchange considerations is often a factor. Your credit score may limit you, or your ability to qualify full documentation may dictate the advantage lies in a different direction. Every situation has the potential for factors that may dictate an answer other than that given by pure numerical computation, and there are therefore, no valid blanket answers to the question of whether or not to do a bridge loan.

Caveat Emptor

Smoker’s Vs. Non-Smoker’s Rights

Digger’s Realm trackbacked to my article on California declaring secondhand smoke a pollutant, angry at the “violation” or “smoker’s rights” and saying “Searchlight Crusade who thinks smokers should be taken out and shot.”

No Digger, I don’t want you shot, and that’s not what I said. Read the article. I want you to grow up.

Even a stopped watch is right twice a day, and this is one case where the People’s Republik of Kalifornia has it more right than anyone I’m aware of.

Either you are an adult, and you may choose to smoke, or you are not, and I am justified in keeping what has been more than adequately proven to be a deadly habit out of your reach.

But being an adult means more than just “I’m old enough to choose for myself!” which any five year old can claim, and most do. It means being responsible for the consequences of your actions, not just to yourself but to others.

I, and a fair sized minority of people out there, are allergic to tobacco byproducts. Cigarette smoke, among other things. Your rights stop at my nose, but your tobacco smoke doesn’t. In my younger days, when California was less enlightened on this subject than we are now, I regularly spent entire weeks going around sneezing my face off, coughing and hacking and wheezing, because some immature child could not be responsible about their emissions. Usually, about the time the attack was starting to let up, some other egotistical child brought another one on. It still happens even today.

Nor are the people like myself, who are allergic, the only ones to suffer adverse effects. Your tobacco byproducts stink. They cause clothes and drapery and carpets and offices and elevators and taxicabs and everything else used by members of the public to stink. I know any number of people who become nauseated, some to the point of involuntary emission, because spoiled immature brats insist upon their so-called “right” to pollute the community environment to zero beneficial purpose. And there are even larger numbers of people who Just Don’t Like It.

When you claim that you’re an adult, and therefore have the “right” to smoke, you are also claiming responsibility for the emissions. There is no system of “rights” that I’m aware, under which you have the “right” to choose to lessen or eliminate anyone else’s ability to enjoy the fruits of the community, much less the “right” to make someone else physically ill. Quite frankly, I’d rather you took a punch at my nose. That I can see coming, and that I have a pretty fair chance at blocking, and even if I fail to block the consequences are likely to be less severe, and also if I believe offensive action in self defense (I think a Louisville Slugger is about appropriate for most, reserving firearms for only the most egregious actions 😉 ), then the standards of the community anywhere have no serious difficulties with such responses when you have chosen to initiate force that way.

Smoker’s clubs? Fine, so long as they are private property, and the sign at the entrance, all advertising, all logos, all business cards, and especially all help wanted ads include some prominent graphic or words that indicates smoking is allowed, and you are prepared to accommodate any persons who choose not to smoke whose employment duties carry them there (Delivery persons, repairfolk, etcetera. If they didn’t choose to be employed there, but you need them to stay in business, and therefore an adult is responsible to make it so they don’t have to breathe your poison. A good breathing apparatus with an air tank should be sufficient for most purposes). In public conveyances, on public lands, in public offices? No. Not under any circumstances that could lead to unwilling persons being exposed. The irresponsible behavior of smokers as a group has made it such that nobody rational should be willing to give that proportion of the smoking community who perhaps are mature enough to qualify as adults the opportunity.

In short Digger, your claim that any of your so-called “rights” has been violated is utterly without merit, as you would realize were you an adult in fact, instead of merely de jure. In fact, it is smokers in general who are violating the rights of the rest of us to breathe air unpolluted by at least that particular group of noxious chemicals.

So grow up. Or don’t light up.

Should I Buy A Home? Part 3: Consequences

Continued from Part 1: Preparation and Part 2: Process

This is about the long term consequences of the decision to buy or not to buy a home, and economic benefits analysis into whether you should want to buy. In order to answer the question of whether it’s better to buy or rent and invest the difference, you need to compare the costs and benefits of owning to the costs and benefits of renting over a comparable time frame. If you know you’re moving in three years or less, it can be hard to come out ahead, just due to transaction costs. On the other hand, if you’ve got the wherewithal to turn it into a rental property after any future move you already know you’re going to make, that can make the owning calculation move decisively in favor of owning. Be advised, all the headaches of being a landlord are greatly magnified if you’re not within easy commuting distance to keep an eye on the property yourself. Also, if you cannot achieve positive cash flow on a rental property, odds are good that you should sell it. This isn’t a blanket recommendation, just a rule of thumb.

Now it happens that I’ve programmed a spreadsheet to answer the “buy or rent” question in a time dependent manner, which is the only way it really can be answered. I keep using a $300,000 home and $270,000 loan as my default assumptions here. I’m going to pull a few more assumptions out of my hat, but I’m going to do my best to make them reasonable assumptions. 6.25 first trust deed, 10% second for any loan amount over 80 percent of value. Five percent annual property appreciation (perhaps a tad low in the long term), 1.2% yearly property tax (darned close for most California properties), yearly tax increases of two percent (Prop 13’s legal maximum in California), non-deductible homeowner’s expenses of $200 per month, 4 percent inflation, $1500 in non-housing deductions on Schedule A, marginal tax rate of twenty-eight percent, and a return net of taxes on any alternative investment with the same money of ten percent. I also assume you’re married (That makes a difference on how much your default deduction is).

Since state and local income taxes are different everywhere, I’m going to neglect those. They would functionally move the equation in favor of home ownership, but the effects are relatively minor in most cases. Furthermore, because investments are only worth your net proceeds after you actually sell them, I’m going to deduct seven percent of the theoretical market price of your home investment in any given year before I compare the net benefit of buying a home to renting and investing any money you didn’t spend on buying. This is questionable to be sure, as most people will just spend at least a certain percentage, but I’m in the mood to be generous. You’ll see why in a moment.

I’m also going to assume here, very unrealistically, that you never refinance, but that’s actually a middle of the road assumption, as far as net benefit goes. The actual spreadsheet has works a couple of other assumptions, and refinancing every five years and making a minimum payment usually comes out better, while refinancing every five years and keeping a thirty year payoff goal usually comes out worse.

Here are the net results:

Year Value Rent Equity Net Benefit

1 $300,000.00 $1,500.00 30,000.00 -21,000.00

2 $315,000.00 $1,560.00 47,979.07 -12,556.04

3 $330,750.00 $1,622.40 66,906.50 -3,638.14

4 $347,287.50 $1,687.30 86,833.25 +5,776.42

5 $364,651.88 $1,754.79 107,813.09 15,711.05

6 $382,884.47 $1,824.98 129,902.79 26,189.84

7 $402,028.69 $1,897.98 153,162.25 37,237.49

8 $422,130.13 $1,973.90 177,654.70 48,879.30

9 $443,236.63 $2,052.85 203,446.90 61,141.06

10 $465,398.46 $2,134.97 230,609.35 74,049.01

11 $488,668.39 $2,220.37 259,216.47 87,629.77

12 $513,101.81 $2,309.18 289,346.90 101,910.18

13 $538,756.90 $2,401.55 321,083.67 116,917.22

14 $565,694.74 $2,497.61 354,514.53 132,677.85

15 $593,979.48 $2,597.51 389,732.17 149,218.82

16 $623,678.45 $2,701.42 426,834.57 166,566.51

17 $654,862.38 $2,809.47 465,925.28 184,746.65

18 $687,605.50 $2,921.85 507,113.76 203,784.11

19 $721,985.77 $3,038.72 550,515.76 223,936.96

20 $758,085.06 $3,160.27 596,253.68 245,391.54

21 $795,989.31 $3,286.68 644,456.99 268,228.87

22 $835,788.78 $3,418.15 695,262.65 292,534.88

23 $877,578.22 $3,554.88 748,815.58 318,400.79

24 $921,457.13 $3,697.07 805,269.15 345,923.37

25 $967,529.98 $3,844.96 864,785.74 375,205.33

26 $1,015,906.48 $3,998.75 927,537.24 406,355.67

27 $1,066,701.81 $4,158.70 993,705.71 439,490.05

28 $1,120,036.90 $4,325.05 1,063,483.99 474,731.24

29 $1,176,038.74 $4,498.05 1,137,076.39 512,209.54

30 $1,234,840.68 $4,677.98 1,214,699.45 552,063.23


Yes, after 30 years you are $552,000 better off from having bought a $300,000 home, as opposed to continuing to rent for that whole period. Not to mention that you own it free and clear for the cost of maintenance plus property taxes, as opposed to paying over $4600 per month rent.

This is a fascinating study in leverage. If, on the other hand, taxes start out at 2 percent and rise by 4 percent per year, the peak year in absolute terms is year 22, at $101,964 net benefit. On the other hand, I’m running rent increases at exactly the general rate of inflation and they almost always go up faster. Back to the first hand, resetting variables in the last set of suppositions to default and changing the appreciation rate to approximately like the long term average – 7 percent – while making a net return of 8.5 percent on investments bumps the net benefits of buying that home to $1,630,195.38. Five and a half times the original purchase price!

One more scenario: Restore to default values. Say you lose $30,000 of value, or ten percent of purchase price, in the first year. It does take longer to be ahead of the game – more than 6 years – and the net benefit after 30 years is “only” $437,223.05. For the mathematically challenged, this is still nearly one and a half times the original value of the property! Yes, the money will be worth less in thirty years. We all know about inflation. Would you turn me down if I offered to give you $437,000 in thirty years time?

I’ve been playing with this spreadsheet for weeks now. Under the basic assumptions I’ve listed above, it’s kind of hard to be ahead of the game by buying a house instead of investing in the stock market after less than two years under any kind of reasonably average assumptions. On the other hand, it’s very difficult not to be ahead after five to seven, and way ahead after ten.

After thirty years, most sets of even vaguely reasonable assumptions have you so far ahead by buying the home that if you didn’t watch over my shoulder as I built the spreadsheet, a reasonable person would be sceptical. Heck, I knew which calculation the numbers favored, but I really never stopped to think how strongly they worked in favor of home ownership. It is difficult to come up with a reasonable set of assumptions and starting numbers where you aren’t ahead by significantly more than the original purchase price of the home. Yes, we’re all aware of the issues with inflation, and the ratio illustrated here, with a 4 percent rate of inflation, is a little more than three to one (which remembering the rule of 115, seems reasonable, so the first approximation check validates this). So what this means is that by purchasing a $300,000 house that you’re going to live in for the rest of your life now, you’re adding more than $100,000 in today’s dollars to your net worth in thirty years. Actually, it’s usually more. That safe, conservative, middle of the road $552,000 net result after thirty years from the first example converts to more than $177,000 in today’s money! No flipping, no games, no wild schemes, no re-zoning jackpots and no wealthy benefactors to come along and pay you twice what it’s worth. In fact, in this scenario you never talk to another real estate or loan person as long as you live, and you’ve still effectively “gifted” yourself with almost sixty percent of the property’s purchase price immediately upon taking possession.

This should persuade most folks that they should want to buy a home, and that you don’t want anyone else to. After all, the more poor schmoes there are, the better this will work for the rest of us. Actually, that last crack about poor schmoes isn’t true, because the law of supply and demand is always in effect. But is shows how good for the overall economic health of the nation encouraging home ownership is.

Caveat Emptor.

Should I Buy A Home? Part 2: Process

Continued from Part 1: Preparation

I am considering buying a home, although I have not made up my mind on the subject. This is not due to indecision, but rather due to a lack of necessary information. There are many factors to be considered in my case, and in order for me to make an informed decision about buying, I need to solve for several variables involving cost.

My questions to you involve what steps I can take to solve those variables. Should I begin with a pre-qualification or loan approval? Will a lender invest time and resources in me when I have no specific property in mind, and I may ultimately decide to continue renting? Should I start by speaking with realtors in order to guage what is available in my price range? Will realtors invest time and resources in me when I have no loan arranged and I may ultimately decide to continue renting?

Also, what is the proper sequence of action for someone who is seeking to collect all the relevant information in order to make reasoned decisions about buying a home?


Well, as I said in Part I, a major question is whether you can trust real estate agents to answer the question honestly. Some will, most won’t. If they tell you to buy, they make money. If they tell you to keep renting, they don’t. Mind you, if you can afford to buy, the numbers are overwhelmingly in favor of that, as we’ll see in Part 3. Nonetheless, one trusts that you see the potential for abuse.

Nobody should have a specific property in mind when they first approach an agent. Smart buyers won’t make an offer without looking at a certain number of properties first. The only exception is if you’re buying the old family home from your parents or something. You’ve agreed on the price, and the terms, and now you’re going to pay an agent to make sure all the paperwork is done and filed correctly and the inspections are done and all of that sort of stuff. This is a smart thing to do, by the way, but most people in this kind of transaction seem determined to save money when a low percentage agent’s fee or some flat fee would be an astoundingly good investment.

You needn’t worry about whether lenders and agents will “invest time in you.” Those who are unwilling to spend time on you in such circumstances should be avoided. Yes, I want my time to be spent on people who really want to buy and are capable of buying, which is why a basic pre-qualification is among the first things I usually do. I don’t want to waste your time showing you stuff you can’t, or shouldn’t, afford any more than I want to waste my own. But there’s a lot you can do to qualify yourself, so that you know how strongly you’re inclined to buy, and approximately how expensive a property. This way, you know that the agent or lender isn’t leading you down the primrose path with properties you cannot really afford. This is a severe problem right now, especially in expensive areas. I’ve said it before and I’ll say it again. You need to know how much house you can really afford in a sustainable situation, and you have to make certain your agent knows and sticks within your budget. The one who shows you the five bedroom house, when you can really only afford the three bedroom condo, is not your friend. I’d fire such an agent the first time they showed you something you could not reasonably get for your known housing budget (which is one reason I recommend against Exclusive Buyer’s Agent Agreements, and don’t ask for them unless I’m giving them something beyond MLS listings for their exclusive commitment). The agent who shows you the three bedroom condo you really can afford when everybody else is showing you the five bedroom house you can’t, is your friend, whether the “Oooohhh” factor is there or not, and even if the “Eeewww!” factor is there. Curb appeal is how sellers sucker buyers (and yes, when I’m a listing agent I’ll help you with that in every way I can. It’s the most important part of my job to help my client get the best deal they can. But right now I’ve got my buyer’s agent hat on, and my job is to help buyers see the diamonds in the rough and not pay more than they’re worth).

Once you’ve done your self-qualification, that’s when I’d go find a real estate agent. I wouldn’t worry about an actual lender’s prequalification as long as you know what your credit score is. A good agent is going to do a pre-qualification anyway, and if they’re a loan officer as well, they’ll set you up there. An agent who doesn’t do loans should be able to provide recommendations for someone to do the pre-qualification, and if they don’t recommend the same loan provider for the loan as did the pre-qualification, I’d go back and check with the provider who did the pre-qualification anyway, as well as finding other prospective loan providers, not to mention pointedly not accepting the new recommendation for a loan provider. Despite the fact that I’m a loan officer who also does real estate, I’m not sure I’d trust a real estate agent with my only loan application. I came to being an actual real estate agent from being a loan officer for several years first – and then I went and learned how to do real estate. The average real estate agent who does loans never spent an apprenticeship doing loans, never learned the ins and outs, and has no clue whether they can deliver what they put on the Good Faith Estimate (Mortgage Loan Disclosure Statement in California). They just figure “It’s the same license, so I can, and it’s an easy way to earn a lot more money from the same clients!” They don’t really know loans, they’ve just figured out that it’s a way to make more money. Furthermore, there are too many shady personalities out there, and way too many real estate agents think they know how to do loans but don’t. There are a fair number of crooks and incompetents and just plain gladhanders, who only care about whether they’re getting a commission on this particular offer, out there, but most of what I do as a real estate agent can be plainly seen and understood by my clients. What a loan officer does is much less transparent to even the most sophisticated borrowers until it is too late to change to another provider. I’ve seen way too many people burned by only applying for a loan with one provider. I’ve only ever not been able to do one loan on the terms quoted and locked (and I did my darnedest to help the provider who could, where most loan providers in my shoes would have obstructed to the best of their ability, as I’ve also learned by bitter experience), but I’ve seen a lot of people who applied with the loan provider who talked a better deal but who couldn’t deliver any loan at all, much less the one they talked about. Many times they have come back to me in desperation two days before escrow expires, or seven days after it was supposed to expire, and I can’t always help them in time then.

Take any newspaper advertisements you see about rate, however, with great heaping cargo ships full of salt. I’ll cover what’s really available later on, but for now what you need to know is that loan companies advertise with teasers like negative Amortization Loans and short term ARMs and hybrid ARMs that takes five points to buy the rate and you still won’t get it when it comes time to sign the final papers. The whole idea is to get you to call, so that they can sell you what they really do have. I don’t think I’ve ever seen a real rate on a real loan that I would be willing to get for myself advertised anywhere, in any medium. Even the so-called “best rate” websites and newsletters are notorious for cheating. I’ve gone right down the line calling them and asking about loans that were supposedly the standards they were quoting to, and gotten not one answer that was within half a percent of the rate quoted on the website or in the newsletter. Nor were any of the websites or newsletters I’ve complained to (or my company complained to, when I worked for an internet lender that was signed up with them) interested in enforcing the rules. I don’t know one single loan provider who advertises actual rates that they can actually deliver anywhere. Those few companies who are actually willing to do it have all quit advertising in disgust and gone to finding clients in other ways.

Should I Buy A Home? Part 1: Preparation

I am considering buying a home, although I have not made up my mind on the subject. This is not due to indecision, but rather due to a lack of necessary information. There are many factors to be considered in my case, and in order for me to make an informed decision about buying, I need to solve for several variables involving cost.

My questions to you involve what steps I can take to solve those variables. Should I begin with a pre-qualification or loan approval? Will a lender invest time and resources in me when I have no specific property in mind, and I may ultimately decide to continue renting? Should I start by speaking with Realtors in order to gauge what is available in my price range? Will Realtors invest time and resources in me when I have no loan arranged and I may ultimately decide to continue renting?

Also, what is the proper sequence of action for someone who is seeking to collect all the relevant information in order to make reasoned decisions about buying a home?


Well, a major question is whether you can trust real estate agents to answer the question honestly. Some will, most won’t. If they tell you to buy, they make money. If they tell you to keep renting, they don’t. One trusts that you see the potential for abuse.

The question here of “Should I Buy A Home” really separates into two basic questions: “How much home do I qualify for?” and “Is there a better alternative, financially?” You can then decide if buying or renting is the better alternative for you.

Qualifying yourself to buy a home, or to use better phrasing, figuring out how much home you should buy, is easier than most folks think. You can look in the classifieds section or on any number of internet sites to find out what the asking prices for properties like ones you might want to buy are in that neighborhood.

The personal information needed is easily available. First, you need to know how much you make per month, as you make mortgage payments monthly. Next, how much your mandatory payments are. Third, about what your credit score is.

Most people know how much they make per month. “A paper” guidelines go between thirty-eight and forty-five percent of gross income for your total of all required monthly debt payments. Subprime lenders will go up to anywhere between fifty and sixty, with most limiting your debt to income ratio to fifty or fifty-five percent. I’d recommend staying within A paper guideline, but calculators are easy to use. So multiply your monthly income by thirty-eight percent, forty-five percent, fifty percent, and fifty five percent. This gives you a set of four numbers, which you may call anything, but I’m going to call A0, B0, C0, and D0. They correspond to what should by standard current loan guidlines be easy total debt service payments for most folks, moderate payments, difficult payments, and extreme payments.

Now most people have recurring debt of some sort. Credit card payments, car payments, furniture payments, etcetera. This does not include monthly bills that you are paying as you go. You know what your monthly obligations are. Whatever this number is, call it $X. Subtract $X from each of those four numbers above, so that you have the numbers that you really have available to spend on housing in each of these four scenarios. I’m going to call these numbers created by subtraction A1, B1, C1, and D1.

Now these numbers you have must cover all the recurring costs of owning a home. These include not only the principal and interest payments on the loan, but property taxes, homeowner’s insurance, homeowner’s association dues if applicable, Mello-Roos districts here in California, and anything else that may be applicable where you want to buy. Within the industry, the acronym most often used for this is the PITI payment, for Principal Interest Taxes Insurance, with the understanding that it includes anything else necessary as well. Association dues and Mello-Roos districts are a function of where you buy. Every condominium or coop is going to have Association dues or some equivalent. Mello-Roos districts are limited time property tax districts assessed to pay for things like municipal water and sewer service for new developments. Most newer developments here in California have them, and the equivalent districts are becoming more and more prevalent in newer developments elsewhere. Homeowner’s Insurance is mandatory if you’re going to have a loan – no lender is going to lend money on an uninsured property, but note that even the best homeowner’s policy does not include flood or earthquake coverage, so if you’re buying in an area where that is a consideration, the extra cost of a flood policy or earthquake policy is probably worth it. Condominium owners should have a master policy of homeowner’s insurance paid for by their association dues, but it’s still a good idea to have an individual policy for your unit, called an HO-6 policy here in California.

Property taxes are paid to city, county, state and possibly utility districts, but your county tax collector should be able to quote overall rates. There is no way to know how much they will be from here, but you can make an estimate, if nothing else by calling the county and asking. Note that they usually quote taxes in terms of a percentage tax value per year. Multiply assessed value by tax rate to get a per year tax bill, then divide by twelve to get a per month value. In California, there’s a rule of thumb that property taxes per month are approximately one dollar per thousand dollars purchase price per month in most places (it will be more if there’s been a bond issue approved or any number of other circumstances), so take the last three digits off the purchase price and that is usually close to your monthly tax liability. $250,000 purchase price? $250 per month. $500,000 purchase price? $500 per month.

By subtracting off all those figures, you get a range of monthly payments for the loan that you can actually afford. Call these A2, B2, C2, and D2. Armed with these and your credit score, you can figure out what kind of rate you might qualify for. Right now thirty year fixed rate A paper purchase money loans of no more than eighty percent of the value of the home can be had without points at something between 6.25 to 6.5 percent. Make allowances for a significantly higher rate for the last twenty percent if you don’t have a down payment, and for the whole amount if your credit is below average, or if you cannot document income via w-2s or income reported to the IRS for the last couple of years. I’ve got an article here that might be helpful in gaging how much of a loan you’ll qualify for. You can usually get significantly lower rates by being willing to accept a hybrid ARM (I’ve been doing it for fifteen years), but right now with the yield curve the way it is, the difference is marginal.

Knowing the payment you can afford, the interest rate, and the term of the loan, you can calculate how much of a loan you can afford. Knowing any three of principal, interest rate, payment, and term, a loan calculator can tell you the fourth. Do this with your four values, A2, B2, C2, D2, and you get four potential loan principal amounts, A3, B3, C3, and D3. These correspond to loan amounts where the payment should be easy, moderate, hard but doable, and a real stretch. To this, add any money you have available for a down payment, and subtract projected purchase costs (maybe $1000 plus 1 percent of home value). This gives you four values A4, B4, C4, and D4. These correspond to the purchase price of the homes you can afford under those four prospective loan amounts. You can then compare these amounts with what is available, and at what price, in those areas you might wish to buy.

Continued in Part 2: Process

Finished in Part 3: Consequences

Caveat Emptor

Reserves

Thanks again for the terrific posts. I’ve learned more about mortgages in the past two months than I ever dreamed I might.

I am looking to buy my first home soon, and have myself in a good credit position to do so. My credit score is over 800 and I have no back-end debt – no car payments, alimony, student loans, etc. My annual salary is well over $100K, and while my down payment will not be as much as I would like, I should be able to put up 20% of the purchase price.

Before I shop for a loan, I have some questions and would appreciate your insight.

1. Do monthly “subscriptions” such as landline phone bill, cable, internet, cell phone, etc. come into consideration? As I have no cell phone and no cable (and don’t intend to get them), I see my monthly expenses in this regard as significantly lower than most other borrowers.

2. Do my retirement savings come into play? I have saved conscientiously for several years and between IRA’s and pension funds (fully vested) I have a significant amount put away.

Thanks again for the teachings


Gosh, I didn’t think a dream client like this existed any more!

In general, there are only three instances when reserves really come into play. They are:

1) Stated Income. Since you are not documenting your income, for a true stated income loan they are looking for evidence that you are living within your means. The measurement that has evolved is six months PITI (Principal Interest Taxes and Insurance) in a form where you can get to it – savings accounts, investments, something. If you have a retirement account, such as a 401, IRA or similar, most lenders will allow you to use a discounted amount, most often 70 percent, as the money would require the payment of taxes and penalties. Roth IRAs may be treated differently, as the rules are different. There is a Stated Income Stated Assets loan programs, but when you get right down to it, those loans look more like heavily propagandized NINA (No Income, No Assets, aka No Ratio loans) than they do a true Stated Income.

2) Payment shock. If your payments are going to be much higher than rent was (or previous payments were), many lenders will require two to three months reserves of PITI payments in reserves.

3) Cash to close. No matter what the loan, the underwriter is going to be looking at the loan to make certain that you have the cash to close, and any reserve requirements are in addition to this. If your loan is going to require a certain amount of cash, either in the form of down payment or loan costs or most often, for prepaid interest or an escrow account, then the underwriter wants to see evidence you’ve got it. It’s no good for the bank for the loan to be approved, the documents printed and signed, the notary paid, and then the loan doesn’t close because you didn’t really have the cash. Seller paid closing costs are getting to be a really touchy point with many banks, by the way, as they indicate the property may not really be worth the ostensible sales price.

In any of these cases, the underwriter is going to want to see evidence as to where the money came from. They want to know that you’ve either built it up over time or have had it for quite some time or that you can document where you got it from. What they are looking at with these requirements is the possibility that you got a loan from somewhere that you’re going to have to pay back, and the payments on which may mean you no longer qualify under Debt to Income ratio guidelines.

Mind you, it never hurts to have money socked away. But it’s not worth any huge amount of contortions to prove. For A paper lenders, the guidelines are razor sharp, and excessive reserves are not a part of them. You’ve either got the required amount or you don’t, and the fact that you have $100 million in investment accounts isn’t relevant – and it may cause some underwriters to start wondering why you’re not paying for the property in cash or putting more of a down payment (Anytime you give an underwriter more information than required, you run the risk that they will ask you questions about it). Some subprime lenders may approve a loan they would not otherwise have approved, or maybe offer better terms than they might otherwise, but there have been enough adverse experiences with this that it is becoming more rare.

Monthly subscriptions (utilities, etcetera) are why the permissible debt-to-income ratio (DTI) isn’t higher. You can cancel cable TV, you can cancel dish network, you can cancel pay per view, you can cancel magazines, although most folks want phone, gas, and electricity. They do not count against your DTI, just payments that you are required to make to keep the accounts on money you have borrowed current. So if you owe the utility company money because you got behind on your payments, that will count, but not the money to keep the utilities current.

Caveat Emptor