“Home is where the heart is. And for those who own their homes, home is also where the equity grows.”
– Kate Phillips
Last month, we printed part one of the Home Buyer’s Guide, an excerpt from Kim Butler’s upcoming Busting the Interest Rate Lies book, in our post, “Buying Vs. Renting (A Home Buyer’s Guide, Part 1).” Today, we continue with the second and final part, which examines the ins and outs of financing and finding a house that can be an excellent investment when you are thinking of financial planning to buy a house, as well as “home sweet home.” (To learn more about how home-buying fits into your overall financial strategy, read our Ultimate Guide to Financial Planning Myths.)
Purchasing a Home
There are many things to consider when purchasing a home. You’re not just purchasing a house or a condo, you are also (typically) obtaining a mortgage and signing a long-term financial contract.
Assessing the Down Payment
With real estate, you can control a $200k real estate asset with $40k, $10k, or even less in some cases! That’s because a mortgage allows you to use “OPM,” or “other people’s money” when you purchase a house. Whether you put nothing down or 20% down, the value of the home does not change, only the rate of return.
A surprising truth about mortgages is this: the bigger the down payment, the lower your rate of return on your investment! This is because a lower down payment allows you to increase your leverage. Real estate investors understand this, and we can demonstrate it on the Truth Concepts Real Estate Analysis calculator. If we use the same example but increase the down payment to 20%, or 40k we see that our rate of return actually drops (from 15.72%, see Part One). We can see this in our example:
The rate of return goes DOWN from 15.72% to 11.37%. It decreases because the homeowner brings more cash to the table and borrows (leverages) less. In the above example, if you purchased the home with cash, you’d be earning only a 4% rate of return (minus costs) because that is the appreciation rate without any advantage of leveraging.
Many financial gurus teach home buyers to not even THINK of buying a home until they save a 20% down payment. Meanwhile, the home you want could be appreciating out of reach while you’re trying to save up your 20% down payment! We recommend escaping the rent trap as soon as you are able to do so with payments you can manage.
Choosing a Mortgage
If you qualify for a zero down VA loan (Veteran’s Administration) or a nothing down USDA loan (U.S. Department of Agriculture mortgages for more rural areas), you may want to take advantage of it! These loans have low or no mortgage insurance charges and decent interest rates for buyers with good credit.
Conventional loans often have the lowest interest rates, as compared with FHA, VA, and subprime options. The downside of conventional loans is that you’ll have to pay mortgage insurance unless you’ve saved that 20% down payment.
FHA loans are easier to qualify for, credit-wise, but are unfortunately laden with fees, especially since the government got stuck guaranteeing so many failed mortgages in the Great Recession.
If you are in a rural area, USDA loans can help you obtain conventional loan rates with lower down payments and fees than typical FHA loans.
Getting the Best Deal
When weighing your choices, you may want to ask for recommendations and check with both a brokerage and a bank. Competition and options can be good for you as a buyer.
There are also usually options to lower or even avoid closing costs, just as there are options to pay extra to obtain a lower rate. You may want to run the numbers to consider the impact over 5 or 10 years before deciding to do either, both in terms of money-out-of-pocket and how your equity will be affected.
You’ll want to make it a priority to make sure your credit score is as good as it can be prior to getting a mortgage. The difference in the mortgage interest rate you’ll qualify for with a 620 FiCO score and an 820 FICO score is enormous.
We used a 5% mortgage interest rate in our example of a $200k mortgage loan, which gave us a PITI payment (principle, interest, taxes and insurance) of $1324. However, a borrower with poor credit could end up paying as much as 10% interest for a loan, or $1718 per month – a $570 a month difference! Over 30 years, the challenged credit borrower will pay a stunning $141,840 more than the good credit buyer will pay.
To ensure you don’t overpay like that for a home, be sure to get prequalified before you start shopping, and stay within the price range you are qualified for. If necessary, clean up your credit or work to raise your score. Paying down credit card balances, making all payments on time, paying off collections, and disputing negative and inaccurate information can work wonders to raise a score. And if your credit history is lacking or non-existent, work to establish positive credit through secured credit cards, department store cards, and/or an auto loan.
Finding a Home
There is much to consider when buying a home! It can be overwhelming, but when you find the right one, you’ll be grateful.
Affordability. This might sound obvious, but be sure to buy a house you can afford! Too many people are “mortgage poor” because they take on a mortgage that doesn’t allow them to save or take vacations, or even make needed repairs to the house! There is nothing wrong with “stretching” a bit to get yourself into a home, just make sure it is a stretch you can handle.
This is another reason why a smaller down payment can be savvy… it allows you to keep more in savings so that IF you need a new toilet or even a new roof, you have the liquidity to make needed home repairs. Ample savings also allow you to handle other emergencies – or opportunities – without worrying about how to make the mortgage payment.
Many will say your home is the biggest investment you will make. Yet as Robert Kiyosaki points out in Rich Dad, Poor Dad, while you are living in it, a home is an expense, not an asset. Sometimes the rate of return can still make it an investment, depending on many factors.
Upside Potential. Don’t buy the best home in the neighborhood. Is the home you want larger and nicer than those around it? Unless it is an excellent neighborhood, it might not be the best investment to make. The surrounding home values will be less and may slow the appreciation of your home or make it hard to sell. On the other hand, purchasing a smaller home and/ or a cosmetic fixer in an excellent neighborhood gives you lots of upside potential.
Expert Assistance. Some buyers think they are going to save money by finding a home themselves instead of having a realtor help them. There are risks to being a “do-it-yourself” home buyer. Practices and laws vary from state to state, but often the terms of a home listing with a real estate brokerage specifies that if the buyer has no realtor, the listing agent (who represents the SELLER) receives the commission that the buyer’s agent would have received… plus the listing agent commission! The listing agent can collect both commissions, however, they can NOT represent the best interests of the buyer alone!
Imagine walking into court and finding that the opposing teams counsel is also representing YOU! You’d feel like there was no one looking out for your best interests. While real estate transactions aren’t necessarily adversarial in nature, unless you are a real estate expert, you’ll want someone on your side. It’s not essential that this person is a realtor. An experienced real estate investor, contractor, appraiser, attorney and other professional can also offer great advice. Just make sure you have a person or a team who can help ensure that –
- You are not overpaying for the home or under-estimating potential problems.
- You have the proper earnest money and mortgage pre-approval in hand.
- The contract is a legal document that protects your liability (even your earnest money) should the deal not close for some unexpected reason.
- All of the appropriate inspections are done, not just an appraisal (which is for the lender’s benefit).
- Repairs are negotiated or the price renegotiated if serious issues are found, or, at the very least, you have an “out” if you decide you no longer want to purchase the home after a poor inspection.
- You receive sound advice relevant to your current market if you have to compete against other buyers.
Time to shop! Now that you have your preapproval and your team, it’s time for the fun part! Make a list of what’s important to you in a home… your “must haves,” “would like to haves,” and “can’t haves” in a home. Then go house-hunting. Be open minded, listen to your gut, and always consult your advisors.
How Does Real Estate Fit Into YOUR Personal Economy?
We love to discuss this with our clients! The second of our Principles of Prosperity is to SEE your finances from a Big Picture, or macro-economic point of view. Your home, your savings, your investments, and your insurance are all connected, because the money comes from the same wallet!
For more on our 7 Principles of Prosperity ™, pick up your complimentary Prosperity Accelerator Pack today!