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Sunday, 13 September 2009

Seven New Rules for the First-Time Home Buyer

By RON LIEBER

Too many people bought too much house for too many years.

Yes, the financial system almost collapsed because mortgage bankers and brokers told lies about loan terms and loosened standards in dangerous ways, and investment bankers packaged those loans into bonds that were far more toxic than ratings agencies predicted.

But the roots of the mortgage contagion lie with all of us and our desire to own just a bit more house.

So as the one-year anniversary arrives of our near financial collapse, it’s a good time to blow up a long-standing but underexamined maxim of real estate — that you should always stretch financially when buying your first home.

No one is quite sure who came up with this idea, though suspicions rest on real estate agents or kindly parents with the best of intentions who never expected that real estate prices could fall. Whatever its origin, the economists and financial planners I spoke with this week are almost unanimous in their rejection of it.

Here’s how they dismantled the old saw — and a list of seven suggestions they offered up in its place.

START WITH THE BASICS Let’s begin with some other standards, tried and true advice that served banks and borrowers well for years, until they forgot all about them in the race to write more loans and buy bigger houses. Put 20 percent down, so you have less of a chance of owing more than your home is worth if prices fall again. Get a fixed-rate mortgage, so the biggest part of your monthly housing bill remains stable.

If you’re determined to be truly conservative, don’t spend more than about 35 percent of your pretax income on mortgage, property tax and home insurance payments. Bank of America, which adheres to the guidelines that Fannie Mae and Freddie Mac set, will let your total debt (including student and other loans) hit 45 percent of your pretax income, but no more.

That said, if you end up with an adjustable-rate loan, banks may not be concerned with whether you’ll be able to afford the maximum possible payment when the interest rate adjusts in five or seven years. But you should be worried about it.

CONSIDER YOUR INCOME The best case for stretching for a first house is that first-time home buyers in their 20s and 30s will probably see their incomes grow more quickly than older people buying their second or third home.

Harvey S. Rosen, a Princeton economics professor, finds in a forthcoming Journal of Finance article that he co-wrote with two Federal Reserve Bank economists, Kristopher Gerardi and Paul S. Willen, that the size of a house that someone buys tends to be a good indicator of what their income will be later. “People can, on average, make reasonably good predictions of their future incomes and act on them in sensible ways by buying bigger houses,” Mr. Rosen said.

Indeed, much of the mess in the mortgage market has been because of people borrowing money with loans that they didn’t understand — or betting that housing prices would continue to rise enough that they would be able to refinance their loans before the payments rose. Income overconfidence may have had something to do with it (and high unemployment worsened the problems), but it’s probably not the primary cause.

BOW TO UNKNOWNS This research is all well and good as long as you continue to work. But if you’re buying your first home before you have children, you may feel quite differently about work once you become a parent. And if you do, you may not want a mortgage boxing you in to going back to the office three months after the baby is born.

Bobbie D. Munroe, a financial planner with Fraser Financial in Atlanta, encourages younger clients in this situation to model out their budget, including any proposed mortgage, three ways — with both spouses working full time, one working part time and one staying at home for a few years. She also suggests imagining or even practicing living on one income, to see if it’s truly realistic.

“What people should do is ultimately their own decision,” she said. “But they should do it with eyes wide open.”

Even people who don’t want to have children need to consider this. Besides the obvious possibility of sustained unemployment, what about the need to escape a dying industry or an early midlife crisis that necessitates career change to stave off depression? Even government employees and medical residents who believe that their incomes are set for life ought to consider this possibility.

MAP OUT EXPENSES It stands to reason that anyone tempted to stretch for a house will be inclined to play down the expense of maintaining it. These costs are anything but ancillary, though.

For many years, Dennis G. Stearns, a financial planner in Greensboro, N.C., has been alarmed enough by clients’ unrealistic expectations that he’s maintained a home cost spreadsheet that he shares with clients shopping for houses. He also updates it periodically with aggregate, real-world data based on their subsequent experiences.

Mr. Stearns estimates that owners of a newer home that do some work for themselves but contract major work out to others will pay 3.6 percent of the original purchase price annually for maintenance and 4.5 percent if it’s an older home. So if you own a $400,000 home, your costs will probably hit the five figures each year — and may rise with inflation. These expenses will be another 20 percent or so higher if you live in a severe weather area. He does note, however, that the tax benefits of home ownership can offset half or more of these costs in some areas of the country.

BUY BEST (OR CHEAPEST) All of these caveats have given rise to some unusual strategies. Michael Kalscheur, a financial planner with Castle Wealth Advisors in Indianapolis, suggests buying the dream house you covet (if you can afford it) or an inexpensive starter house but not anything in the middle.

“If people have their heart set on something, inevitably, if they can’t afford what they really want, they buy the next best thing,” he said. “That’s absolutely the worst thing you can do. Not only do you not get what you want, but it sucks you dry.”

Why? Well, if you buy that entry-level home instead of the silver-medal home, you can save a lot more money each month after making the house payment (as long as you’re disciplined) than you would if you were paying a big mortgage toward that next best house. And all of your other housing costs will be lower, too. Then, several years later, you’re in a much better position to buy what you actually want.

STRETCH THE HOUSE Better yet, keep in mind that you don’t ever have to move from that first home — and incur all of the transaction costs associated with selling and buying and moving again.

J. Michael Collins, an assistant professor in the department of consumer science at University of Wisconsin’s School of Human Ecology in Madison, suggests paying less for a home that you can upgrade periodically when your income is stable and your savings or available credit make it possible.

In other words, stretching out your tenure in a home (and the physical boundaries of the home itself) may make more sense than stretching for each successive mortgage in a series of two or more houses.

THE EIGHT-HOUR RULE One rule about all of these rules is that it’s unlikely that every one will apply to every circumstance. Individuals and their income streams are too varied, and real estate markets are themselves unique.

When all else fails, however, you can always fall back on the eight-hour test. Whatever the size of your mortgage, you have to be able to sleep soundly at night. So if an impending loan has you stretching for the Ambien, it’s a pretty good sign that the loan is a bit of a stretch as well.

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