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How to Buy A House with a Mortgage

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Owning a home – a.k.a. “The American Dream” – is considered by many as the true sign of “making it”.  There is a right way and a wrong way to make this dream a reality.  The last couple of years have shown that if you do not go about it the right way, you could end up with a real mess on your hands.  Foreclosures and short sales are at an all time high, so I wanted to discuss a few  tips to help you avoid negative housing situations.

Save for a down payment

It is possible to get a mortgage loan with very little down.  This could be considered good in certain circumstances, but overall it’s a bad thing.  It makes buyers think they can afford more than they can.  I suggest instead, saving up at least 20% for a down payment. So, if you’re looking at homes in the $100,000 range save until you have at least $20,000.  That sounds like a lot of money, because it is!

There are two advantages to this strategy: (1) it will insure that you will get a house you can afford.  If it takes you a couple of years to save up $20,000, it will appear clearer to you that you probably shouldn’t push yourself further by purchasing a $150,000 house.  Saving will also prevent you from making an impulse buy.  Trust me, you will want to think through a decision much more critically when you are writing a $20,000 check versus just coming up with $500 to cover closing costs. (2) it will help you avoid PMI insurance.  Most banks require that you pay for this insurance if you don’t have at least 20% down.  It protects them, not you, if you default.  For you PMI is a waste of your hard earned money.  PMI rates vary, but common amounts are $65-$70 per month on a $150,000 mortgage.  That’s money you could be putting to better use right? Like paying down credit card debt or saving for something awesome.

Monthly mortgage payment amount

This is extremely important.  If you want to do anything to get ahead financially (insert your favorite use for money here), it will be almost impossible if you are house poor.  For example, if 50% of your take home pay goes toward your mortgage, you will be lucky to cover the rest of your essentials such as food and utilities.  The math just doesn’t work. Instead keep monthly mortgage costs down below 25% of your gross income (after taxes).

Matt’s note: I suggest you keep you mortgage costs down to 10% of your monthly income, especially if you’re looking to buy in this amazing buyers market.

Here’s another tip if you’re a two income family – base the 25% rule on just one of your incomes.  Are you really comfortable assuming you’ll both be making the same income for the next 15-30 years?  I know we’re not!  Many young couples I’ve counseled start with two incomes then want to go down to one when a baby comes along.  When Mandy and I bought our first house, we kept our payment under 25% of our take home pay but we based it on both incomes.  When our oldest daughter was born and Mandy wanted to quit her job to stay home, it caused a problem.  All of a sudden our payment was closer to 30-35% of our take home pay.  It wasn’t killing us, but we could no longer accomplish many of the goals set when we had two incomes.  We ended up having to sell our house and move into something more economical.  It would have saved a lot of hassle to buy our current home the first time. Even if both spouses continue to work, you can always use the extra money to give, save, or do whatever you wish.

Shorter mortgage terms

This tip is simple math.  What law says you must take out a 30 year mortgage?  Hint: there isn’t one. Why is thirty years the standard?  Banks set that as the standard so they could make more money (interest on your debt).

Let’s look at an example.  If you take out a 30-year, $100,000 mortgage at 5%, your monthly payment will be $537.  The total interest you pay over 30 years will be $93,259!  If, instead, you took out a 15 year mortage, your monthly payment would be $791, but you would only pay $42,347 in interest over the life of the loan.  I don’t know about you, but $51,000 in savings is a lot of money to me!

Buying a home is a decision to think through very carefully.  Mandy and I learned these tips the hard way and my hope is that you don’t have to.

Use these tips to make sure your American Dream is a dream come true… and not a 30-year nightmare!

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Understanding Debt [Part 2]

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In part 1 of Understanding Debt, we discussed credit card debt, student loan debt, payday loans, financing a car, and personal loans.  This time, let’s take a look at four more types of debt:

1. Medical debt

Medical debt isn’t sought out. Instead it typically results from an unexpected medical emergency.  The best way to avoid medical debt is with sound preparation.  Having a health insurance plan that fits your situation is a must.  People often tell me they can’t afford health insurance, and my response is always “you can’t afford not to have it.”  You can make a bad financial situation much worse by not having health insurance.  It is easy to accumulate a $100,000+ bill when involved in a medical emergency. Insurance is there to insulate you from those huge bills.  You also need to have an emergency fund to cover deductibles or copays as well.  Also, having a baby is expensive (typically around $15,000).  I know many people who are “paying off” their child, which seems ridiculous, but is actually quite common.  If you know the baby is coming you need to do everything you can to save money.  That may mean taking a second job or temporarily stopping retirment savings.  Having a baby is not an emergency, so you should plan for the medical costs.

2. Home equity loans and HELOC

This is one I get asked about a lot.  A home equity loan is often used as a consolidation loan.  There is nothing naturally evil about a consolidation loan.  There can be problems with them however.  The first is that you are leveraging your most important asset, your home.  If something happens where you cannot pay it back, you could lose your home, and that’s a large risk to take.  I have worked with many clients who have consolidated debt in the past.  Two years later, they are contacting me with debt problems again.  According to Cambridge Credit Corp, 70% of Americans who take out a home equity loan or other type of loan to pay off credit cards, end up with the same amount of debt (or more) within two years!  That’s a pretty sobering statistic.  While debt consolidation can work, it’s certainly not an automatic problem solver; if you do it you need to do it right.  I have often seen that taking out a consolidation loan gives people the feeling that they fixed something without addressing the root of the problem which is usually overspending and not living on a budget.

A home equity line of credit (or HELOC) also falls under this category.  The only reason to have a line of credit is to cover overspending.  A better plan is to not overspend (now there’s a novel idea)!

3. Unsecured bank loans

The major problem I see with unsecured loans is that they usually comes from overspending as well.  “I need money fast and don’t know where else to get it.”  Usually, an emergency fund or saving up to buy a large ticket item will make an unsecured loan unnecessary, and is a much safer way to ensure you are buying stuff you can actually afford.  Plus, it takes all the risk out of having a loan.

4. Mortgage

Finally, a kind of debt that I don’t have a major problem with.  Although I would ideally like to see someone buy a house with cash, it’s not typically feasible because of the large amount of money involved.  That said, it is extremely important to buy a house you can actually afford.  My wife Mandy and I found this out the hard way as we sold our first house in order to move into something more in tune with our budget.  I recommend buying a house where your payments will be 25% or less of your take home pay – based on a 15 year (or less) mortgage. Why?  If you take out a loan for $150,000 with a 3% interest rate, you will pay $77,666.90 in interest over 30 years.  If you take out a 15 year loan for the same amount, you will only pay $36,459.76.  That is a huge difference, and when more than 25% of your pay goes toward your mortgage, it’s near impossible to accomplish other financial goals. Another must is to put 20% down at closing.  Doing so will help you avoid private mortgage insurance  (PMI), which is basically just money down the drain.  One final rule: base all of these numbers on one income, even if you’re both working.  You never know what will happen when kids enter the picture.  Even if you both plan on continuing to work, living on one income is always a good idea!  In fact, Mandy and I had to sell our first house because we based what we could afford on both our salaries.  Once our first baby arrived and we decided Mandy would stay home, which through all our budgeting numbers out the window!  If start living on one income but both continue to work, great, now you’ll have more money to give, save, live your mission!

These are obviously just my thoughts on debt.  I will say however that they don’t just come out of thin air.  They’re based on facts, personal experience, and the experience of working with clients who have had these types of debt totally ruin their lives – and to me, the debt just isn’t worth the cost!

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What are your thoughts?

Understanding Debt [Part I]

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Statistically speaking, it’s very likely you’re in debt.  Although the data is all over the place, most people agree that somewhere around 80% of people (excluding minors) have debt.  There are many ways you can borrow money, so I wanted to take a look at the different types of debt and my thoughts on each.  In part I, we’ll discuss credit card debt, student loan debt, payday loans, vehicle loans, and personal loans.

1.) Credit Card Debt

The average credit card debt per household with credit card debt is $15,799.  Considering the average APR on a credit card with a balance is 13.1%, people are wasting way too much money paying interest.  I have yet to meet anyone who has purposely gone into deep credit card debt.  It happens slowly.  A little emergency comes up, you take a vacation you can’t afford, or you just can’t seem to stop buying new clothes.  Either way, it tends to creep up on people.  Credit card debt is a major problem in our country and I suggest staying away from them at all costs.

2.) Student Loan Debt

This one is a major hot topic.   I used to think that student loan debt was a necessary evil.   The more I read, talk with experts, and work with clients who have tons of student loan debt, I am convinced that student loan debt is also a terrible idea.  In fact, delinquency rates on student loans are now higher than mortgages, home equity loans, and auto loans.  Credit cards are the only other debt that has a higher delinquency rate.  Not only that, but you cannot bankrupt student loans.  Contrary to popular belief, it is possible to go to college without debt.  Working hard to get merit scholarships, having a job (or two) while in school and in the summer, and utilizing community and in-state schools are just a few ways to make it happen.

3.) Payday Loans

Payday loans are a terrible way to make poor people poorer.  If you notice, there usually are not millionaires filing in and out of a payday loan store.  It’s a place for desperate people to go to find money and they pay dearly for it.  The APR on most payday loans range from 390% to 780%.  Wow!  How would you like to pay that rate on your mortgage?  You woudln’t and you also shouldn’t get anywhere near a payday loan store!

4.) Vehicle Loans

Vehicle loans are not a terrible thing.  Most people have them and most  people always will.   There are nothing like credit cards or payday loans in terms of interest rate.  There are two problems I do have with vehicle loans, though.  First, when you do not have a vehicle loan and instead, pay yourself a car payment to your savings, then  you have much more flexibility.  There have been quite a few months when things have run tight for Mandy and I and we simply didn’t put our “car payment” into our savings that month.  If we would have had to make a car payment, that would not have been an option.  I am not sure what we would have done other than raid our emergency fund, which we try to avoid if at all possible.  The second problem is that people often buy cars they cannot afford when buying with payments.  By saving and paying cash for a car, it is impossible for Mandy and I to buy something we cannot afford.  We either have the money or we do not.  I have met with way too many people who have a  $25,000 with a $40,000 a year income.  That is just crazy and I have only seen it happen when someone buys with a vehicle loan.

5.) Personal Loans

To be clear, by personal loans, I mean borrowing from a friend or family member.  Not a good idea.  It really changes the dynamics of the relationship.  For example, instead of just Dad/Daughter, it is now Lender/Borrower.  It often leads to an inappropriate amount of control in the life of the borrower by the lender.  Personal loans are certainly better than payday loans, but I suggest avoiding them as well if at all possible.

In part two, I discuss medical debt, home equity loans, unsecured bank loans, and mortgages.  Stay tuned and let me know what you think so far!