Presentation to the Society of Automotive Engineers Club Buying a Home March 16, 2011 Bryan Sudweeks, Ph.D., CFA. From the Marriott School of Management’s “Personal Finance: Another Perspective” web site at http://personalfinance.byu.edu from lessons on Understanding Credit Understanding Consumer and Mortgage Loans The Home Decision
Definition House: a hole in the middle of the yard that you pour money into.
Abstract Buying a home is for most the single largest purchase for most families and individuals. Yet many couples put the same effort into buying a home as they would into buying a TV or automobile. I propose that couples spend significantly more time in the home buying process as it will save them significant amounts of money in the long-run. This presentation gives suggestions where most of that research and time should be spent. I discuss what our leaders have said about buying a home, the risks, and a four step process for buying a home. My advice is the same as Dave Ramsey who said “Live like most people won’t for the first 10 years after school, and you will live like most people can’t after that.” Buy a modest home, fix it up and pay it off quickly.
Objectives • A. Understand what our Leaders have said Regarding Buying a Home • B. Understand risks in home ownership • C. Understand the Four-Step Process for Buying a Home: • Step 1. Understand your limits • Step 2. Find your home • Step 3. Negotiate your loan • Step 4. Enjoy home ownership
Understand what our Leaders have said Regarding Buying a Home We must have a correct perspective for life. It is based on four key principles of finance: • 1. Ownership: Everything we have is the Lords • Things we have are not ours but on loan • 2. Stewardship: We are stewards over all God shares with us • We must learn to be better stewards • 3. Agency: the gift of choice is a wonderful gift • We must used that agency wisely • 4. Accountability: We will be held accountable for all our choices in life • We must make the best choices we possibly can as we will be held accountable for them
Our Leaders Counsel (continued) • We have received wise counsel on the subject of buying a home. • President James E. Faust stated: • Over the years the wise counsel of our leaders has been to avoid debt except for the purchase of a home or to pay for an education. I have not heard any of the prophets change this counsel. (“Doing the Best Things in the Worst Times,”Ensign, August 1984, 41.)
Our Leaders Counsel (continued) • President Gordon B. Hinckley commented: • We have been counseled again and again concerning self-reliance, concerning debt, concerning thrift. When I was a young man, my father counseled me to build a modest home, sufficient for the needs of my family, and make it beautiful and attractive and pleasant and secure. He counseled me to pay off the mortgage as quickly as I could so that, come what may, there would be a roof over the heads of my wife and children. I was reared on that kind of doctrine. (italics added, Gordon B. Hinckley, “The Times in Which We Live,” Ensign, Nov. 2001, 72.)
Our Leaders Counsel (continued) • He further counseled: • I recognize that it may be necessary to borrow to get a home, of course. But let us buy a home that we can afford and thus ease the payments which will constantly hang over our heads without mercy or respite for as long as 30 years. … I urge you to be modest in your expenditures; discipline yourselves in your purchases to avoid debt to the extent possible. Pay off debt as quickly as you can. … That’s all I have to say about it, but I wish to say it with all the emphasis of which I am capable (italics added, Gordon B. Hinckley, “To the Boys and to the Men,” Ensign, Nov. 1998, 51).
B. Risks in Home Ownership • You buy too big a house • Your other goals (retirement, missions) are not met • You buy a fixer-upper without the skills or time • It stays a fixer upper • You buy the wrong type of house for your lifestyle • You must pay others to keep it up • You buy a house without the necessary inspections • You pay dearly for someone else’s problems • You buy a more expensive house than you can afford • You lose your house, credit, and your self-respect
Risks in Home Ownership (continued) • The single biggest mistake young couples make out of school that impacts them the most financially is they purchase too big a house • Their other goals cannot be realized as they are paying so much for their house • They go farther and farther into debt to furnish and maintain the house • They cannot save for their other goals as they have little after housing costs to save • Their marriages and families suffer from the added financial strain
Understand the Home Buying Process • Purchasing a house is a four-step process: • Step 1. Understand your limits • Know yourself , what you can afford and what you need when • Step 2. Find your home • Make sure you know what you want, and get it • Step 3. Negotiate your loan • Know what lenders need and want so you can be ready • Step 4. Enjoy home ownership • Realize you are a steward over all God has blessed you with. Be the best you can be
Step 1. Understand your Limits • Know yourself and your limits relates to 8 areas: • a. Know your budget and how much you can afford • b. Know your credit score • c. Calculate your front and back-end bank ratios • d. Calculate your bank ratios for LDS • e. Choose your preferred loan type and term • f. Know what you need for a down payment and upfront costs • g. Have two years of copies of taxes • h. Get pre-approved
1.a. Know Your Budget and How Much You Can Afford • YOU MUST HAVE and Live on a Budget • President Spencer W. Kimball said: • Every family should have a budget. Why, we would not think of going one day without a budget in this Church or our businesses. We have to know approximately what we may receive, and we certainly must know what we are going to spend. And one of the successes of the Church would have to be that the Brethren watch these things very carefully, and we do not spend that which we do not have(Marvin J. Ashton, “One for the Money” pamphlet, Intellectual Reserve, 1992, inside cover).
Budgeting: The Old Way Income Tithing Expenses Available for Savings Personal Goals
Budgeting: A Better Way Income Pay the Lord Pay Yourself Expenses Other Savings Personal Goals
A Better Way (continued) • Elder L. Tom Perry said: • After paying your tithing of 10 percent to the Lord, you pay yourself a predetermined amount directly into savings. That leaves you a balance of your income to budget for taxes, food, clothing, shelter, transportation, etc. It is amazing to me that so many people work all of their lives for the grocer, the landlord, the power company, the automobile salesman, and the bank, and yet think so little of their own efforts that they pay themselves nothing(L. Tom Perry, “Becoming Self-Reliant,” Ensign, Nov. 1991, 64).
1b. Know Your Credit Score • Know your Credit History • Review your credit history every year from all three agencies • Three major credit reporting agencies • Experian (www.experian.com), Equifax (www.equifax.com), and Transunion (www.tuc.com) • You can get a free copy of your credit report from each agency each year by going to: • www.annualcreditreport.com • Fill out the info and you can get a copy online • Make sure it is correct
Know Your Credit Score (continued) • Pay for your Credit Score • After checking your credit report for errors, order a copy of your credit score. I recommend a FICO score. You can order it directly from FICO at www.myfico.com for $16.95 (less with coupons) • What determines your Credit Score or lending risk? • Payment History: What is your payment record? • Amounts Owed: How much do you owe? • Length of Credit: How established is yours? • New Credit: Are you taking on more debt? • Types of Credit Use: Is it a healthy mix?
1c. Know your Front- and Back-end Bank Affordability Ratios • Know the rules for lenders • Know your affordability ratios, and be sure to take into account your savings and tithing when you calculate these ratios • Ratio 1: Housing Expenses (front-end ratio) Monthly PITI* <28% Monthly Gross Income • Ratio 2: Debt Obligations (back end ratio) Monthly PITI* and other obligations < 36% Monthly Gross Income *PITI = Principal, interest, property taxes, and property insurance
1d. Calculate Your Ratios for LDS • As members of the Church, we have other important obligations that we also pay, i.e., tithing and paying ourselves, i.e., saving • As such, should have smaller houses (at least less expensive), because we pay the Lord first and ourselves second. • For a spreadsheet that takes into account the fact that we pay the Lord first and ourselves second within this front-end and back-end ratio framework, see: • Teaching Tool 7: Maximum Monthly Mortgage Payments for LDS Spreadsheet (from the website)
1e. Choose your Preferred Loan Type and Loan Term • Choose your preferred loan type. • The best type of loan takes into account your: • Goals, budget, income stream, down payment, and view on risk • There are a number of different types of mortgage loans available. These include: • Fixed Rate (FRMs) - RECOMMENDED • Variable or Adjustable Rate (ARMs) • Interest Only (IO): Variable or Fixed Interest • There are also special loans (if you can get them) • FHA o(best for students) or VA
Fixed Rate Mortgages (FRMs) • These are mortgage loans with a fixed rate of interest for the life of the loan. This is what I recommend • Benefits • Higher but constant payments—you pay down principle faster • No risk of negative amortization • Interest rate risk is transferred to the lender • Risks • Interest rates are higher • Higher monthly payments may make payments more difficult, particularly for those not on a regular salary
Adjustable Rate Mortgages (ARMs) • Mortgage loans with a rate of interest that changes periodically over the life of the loan • Benefits • Lower initial interest rates • Generally lower monthly payments, as you assume the interest rate risk • No risk of negative amortization • Risks • You assume the risk that interest rates rise • Possible “payment shock” as interest rates rise, perhaps beyond what you are able to pay
Interest Only Options (Fixed or Variable) • These are FRMs/ARMs with an option that allows interest only payments for a set number of years. After that, payments are reset to amortize the loan over the remaining years of the loan (it is not like a credit card) • Benefits • Lower monthly payments as you are paying interest. • You can afford more house due to lower payments • Risks • There will be a major rise in payments when the interest only period ends • There is no paying down of principle
Mortgage Loans(continued) • Insured Loans • FHA (Federal Housing Administration) Insured Loans • FHA does not originate any loans, but insures the loans issued by others based on income and other qualifications • There is lower PMI insurance, but it is required for the entire life of the loan (1.5% of the loan) • While the required down payment is very low, the maximum amount that can be borrowed is also low
Mortgage Loans(continued) • Guaranteed Loans • VA (Veterans Administration) Guaranteed Loans • These loans are issued by others and guaranteed by the Veterans Administration • Are only for ex-servicemen and women as well as those on active duty • Loans may be for up to 100% of the home value
Recommended Loan Term • Choose your loan term • Generally, I recommend a 30 year fixed rate loan • However, I recommend you make additional payments on principal to pay off the loan sooner if possible
1f. Know How Much You Need for a Down Payment and Upfront Costs • Know what you will need for a down payment and upfront costs, and begin saving for it • Down payments: • You will need a larger down payment to get into your home now versus two years ago • Begin saving for that now • Conventional loans – 20 % recommended, but you can get in with 5% • FHA loans – 3.5% • VA loans – 0% no down payment required • Once you realize how hard it is to save, it will help you not to spend too much
Down Payment and Up-front Costs (continued) • Upfront costs include closing costs and points • Down payment (3-20 percent of the loan amount) • Closing costs including points (3-7 percent) • Closing costs include: • Credit report • Termite inspection • Prepaids (property insurance & taxes, mort. interest) • Points • Title insurance • Attorney’s fee • Property survey • Recording fees • Lender’s origination fee • Appraisal
Up-front Costs (continued) • What are points? • One percent or one hundred basis points of the loan • This money is paid to the mortgage broker (not the lender), is deducted from the loan proceeds (you still must pay it back), and is essentially another fee for helping you arrange the loan (minimize points) • Why do lenders charge points? • To recover costs associated with lending, to increase their profit, and provide for negotiating flexibility • Do I have to pay points? • Origination points (likely), buy-down points (no)
1g. Have Copies of 2 Years of Taxes • Lenders want confirmation that you can pay back the loan • As such, they generally want to see two years of tax records • Have copies of your last two years of tax records, even though you were a student • If you have a confirmed job letter with salary, that may also be helpful as well
1h. Get Pre-approved—Not Pre-qualified • Get pre-approved for your loan by a number of lenders • Pre-approved means that lenders have pulled your credit score, looked at your tax records and approved you for a specific amount of a loan • You can borrow up to this pre-approved amount without a problem • I recommend you check with multiple lenders • Remember however that you do not need to borrow that amount • I recommend that you borrow less than that amount
Step 2. Find Your Home • There is a five step process to finding your home • a. Determine what is important to you • b. Develop a plan for finding a home • c. Use a realtor/team approach to find a home in your price range • d. Once you are serious about the home, get a home inspection (offers can be contingent on the home inspection) • e. Determine any CCRs/fees for potential homes • f. Negotiate the price
2a. Determine what is Important To You • Determine what is important to you and what you will and will not do without! • This may include: • Location, • Home style and layout • Future plans, i.e., kids, work, schools, etc. • Realize that you will probably move within five to seven years (if you are like the average family)
2b. Develop a Plan • Establish a Plan for finding your home • Once you know your limits, what you can afford, where you want to be, and what you want (your Plan): • Then start driving around • Then start looking in earnest • But keep to your plan • Use Zillow.com to find current home values in other areas you may be interested in
Develop a Plan (continued) • Be Patient and take your time • Estimate the time you will be in the house • If it is less than 3-5 years, look into renting • You must make 6-7% on your house price just to break even when you sell it (realtor fees are 6-7%) • You will be in the house for years—don’t make the decision to quickly • It will likely be your largest financial commitment you will make for a long time • Often renting a luxury apartment for 6 months will give you time to search thoroughly
2c. Use a Realtor/Team Approach • Get a good realtor • While realtors are working for sellers, it may be wise to have a buyer’s broker that works for you • They should know the ins and outs of the neighborhood you are looking at • Take matters into your own hands • Be proactive—talk with friends and others • Use the internet and other tools that may help • Stay true to your Plan and have patience • Be liquid and ready to react quickly • Be creative if necessary
Realtor/Team Approach (continued) • Use a team approach—get lots of good help • Use others to help • Buyers broker • Appraiser • Attorney • Don’t become emotionally attached to a potential house • Be willing to walk away
2d. Have home inspections before you Buy • Once you have found the home you like, can afford, and is where you want to live, have a home inspection • This may alert you to potential problems with the home • Many should be fixed by the seller prior to purchase • Don’t buy someone’s problems
2e. Determine any CCRs/fees for potential homes • Look to potential homes and potential costs • Look through Determine Covenants, Conditions and Restrictions (CCRs) for a potential home • These can be quite restrictive as to what you can and cannot do with your home • For condos or town homes, determine the amount of the transfer/setup fees • Understand any other homeowners/association fees for potential homes and what they include
2f. Negotiate the Price of the Home • Use the best available resources to negotiate a price for the home • Use wisdom and judgment in determining what you can and should pay for the home • Realize your best negotiating technique is walking away • This is a negotiation process—do not be afraid to haggle • Realize that closing costs, things that need to be fixed, and other things can all be part of the negotiated price
Step 3. Negotiate the Loan 1. You’ve found a home that suites your lifestyle and budget, using resources such as a realtor. 8. Lender sends out the documents to escrow for signing 7. Broker, Title, Escrow, and Lender work to fill all conditions 6. Lender takes the loan package, structures the loan and conditions for any additional information they need to close the deal. 9. Lender audits the documents, verifies all conditions are filled, and funds the loan! 2. The realtor refers you to a mortgage broker. 3. The broker pulls credit, determines your needs and tries to find lenders among the competition to meet those needs. 4. Each lender has unique programs. Lender and broker negotiate points, rates, fees, PPP, and other features of the loan. 5. Broker recommends the best loan to the consumer, reviewing the features agreed upon. Consumer makes the final decision.
Negotiate the Loan (continued) • Negotiate the loan is the final part of the process • a. Choose multiple lenders to compete for your business and get Good Faith Estimates from each of your lenders • b. Take the various loan offers from the lenders to calculate your lowest Effective Interest Rate • c. Negotiate with your best lender the best rate
3a. Choose Multiple Lenders and Get Good Faith Estimates • You will get a lower interest rate when lenders compete for your business • Work with multiple lenders • Talk with friends and others who have gone through the process for their favorite brokers • Get Good Faith Estimates from each lender (not just a Summary) • These are the costs you will likely pay
3b. Calculate your Effective Interest Rate • Estimate how long you will be in the home • This is important as it helps determine over what period you can allocate points and other costs • Calculate your effective interest rate for each loan • Your effective interest rate is the interest rate you will pay after all your points, costs, and fees are taken into account • The lowest effective interest rate is the best indicator that you got a good rate on your loan