Chapter 9 – Home Ownership

Chapter 9 – Home Ownership

“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.” ~Franklin D. Roosevelt, U.S. president

* Personal Finance Tip:  When buying a house, make sure you contact recent buyers about escrow increases.  In order to lure buyers into focusing on the affordability of the home, banks often focus their attention on the first year’s mortgage payments, which can be much lower than subsequent years.

Home ownership is widely known as a  cornerstone of the American dream.  Similar to first-world-countries’ healthcare, the real estate market is greatly complex with multiple genome connections transparent to the basic home owner.  Simply understanding the way home values and financing work escapes most of us.  We’ll discuss that more later, but understanding the entire process can help you maneuver through the complex system smartly.  Just like how we started exploring the entire genome, we’ll start with you, the home buyer.  We’ll explore how you purchasing a home, primarily by financing, creates this massive market in the financial genome.

As we discussed in Chapter 8, renting is a good option while you’re saving up for a down payment or when rent prices are a better return on investment than buying.  Once you have a 10-20% down payment, you can start looking for a home to buy.  Let’s be clear, though, you may own your home after paying off the mortgage, but the government still owns the land and property, plus there will always be maintenance costs.  Real estate owners will always owe property taxes to the government, and there is always the threat of the government using Eminent Domain to seize your property.  For more about Eminent Domain check out this site (http://ij.org/issues/private-property/eminent-domain/).

You usually start the process of buying a house by getting pre-approved for a loan at a bank of your choice.  This is where your credit score becomes incredibly important.  Your annual income and credit score determine the amount of financing you can get and your credit score determines your interest rate.  To make home ownership more affordable, Americans have created 30-year home loans.  Due to the amazing power of compounded interest, a home owner can end up paying close to 2-3 times the total value of the house in interest alone.  We’ll discuss credit scores in a future chapter.  It’s also important to note that banks are very “gracious” in loaning us money and will usually offer a pre-approval amount way above your means.  For example, I was pre-approved for $485,000 on my first house.  I found a house for $242,000—which was still above the price range I was looking for.  People who find confidence in having an expensive house, relative to their income, are referred to as being “House Poor.”

Let’s say you found a house selling for $200,000, and let’s also say you’re going to buy a house using a realtor.  In most cases, the seller of a house pays closing costs, yet there are plenty of other costs (e.g., title fees) the buyer will face.  The national average for realtor commissions is 6%[1].  If you, the buyer, use your own realtor, you’ll pay half, or 3% of the commission.  So, if the seller pays the commission costs, it will cost the seller $12,000 (6% of the $200,000 house).  Additionally, the seller will have to pay closing costs, which on average are $2,500 to $5,000 and are used to pay for the administrative costs for the banks and governments.[2]  The seller must keep in mind that the profit will be $200,000 less the $12,000 commissions (if paying both), less the closing costs (if seller pays for those), less the remaining balance on the loan.

Sell Price

$200,000
less Commissions – $12,000
less Closing Costs – $2,500
less Remaining Loan Balance – $125,000
Total Profit

$60,500

A recent trend, leveraging the internet, is the For Sale By Owner (FSBO, pronounced FIS-BOW) process.  Some states make the process easy, and this saves buyers and sellers quite a bit of money.  Some states make the process difficult, primarily to protect realtors.  I personally believe that realtors will be replaced with automation over the internet and the FSBO movement.  FSBO is also called “self-directed”, and is up 20% since the 80s.[3]

Once you and the seller agree on the price, you’ll need to secure the loan that you were pre-approved for.  After approval, you’ll enter the closing process.  The national average for closing on a house is 30 days[4]  and varies by state and the type of loan.  Your bank transfers the full amount of the loan to the seller’s bank.  The seller keeps the difference between the selling price and the amount owed on the original loan.  It’s important to note that if you’re a seller, you’ll have to pay capital gain taxes if you made a profit or you get to claim a capital loss if you lost money.  If you’re tracking, we pay property taxes every year and then capital gain taxes on profit when we sell.  Once escrow is completed, meaning, once a neutral party collects the funds (loan and fees) and ensures all the paperwork is completed accurately, the house is yours and you begin paying your mortgage.

Based on how much down payment you applied to the house, your mortgage payment is split it in many directions.  First, your payment goes to interest.  A 15- to 30-year loan is amortized with the total cost split into equal monthly payments.  Conveniently for banks, you pay the majority of the interest up front.  The interest is how banks make money immediately, so they can make more loans and earn more interest.  As many homeowners frequently experience, banks will often sell the mortgage immediately to another bank.  Banks will often sell the loan early and at a lower amount, to utilize the money now, than wait until the entire value of the loan is paid off.  For the first five years of a mortgage, barely any of your mortgage payment goes to the principal, and you’ll see your mortgage change banks  at least once, and sometimes several times.

The second direction your mortgage payment goes to is principal.  Most banks are required to allow extra principal payments.  Even small amounts of extra principal can reduce the life of your loan by several months or years.  Some certified financial planners often recommend paying one extra mortgage payment a year (13 payments instead of 12), to take off several years, and savings thousands of dollars in interest, on the life of the loan.  In the current low interest rate environment, you may find a better return on investment by investing your money instead of paying additional principal payments.  For example, if you have 3.5% interest on your mortgage, but your investments are yielding you 13% returns, you’ll get a better return on investment if you add additional money to your investments, versus paying additional principal payments.  Remember, you must completely pay off the principal to actually own your home.

Premium Mortgage Insurance (PMI) was described a little in Chapter 8 and is another portion of your mortgage payment.   Banks are allowed to use PMI to offset potential losses when buyers default.  It’s a massive drain for buyers since banks have many more protections against buyer defaults.  PMI is an outdated practice that started in 1930s by the federal government.[5]  Since PMI is pure profit for banks, there’s no systemic move to get rid of it.  Once buyers reach 78% Loan-to-Value (LTV), banks must automatically cancel the payment.  LTV is the ratio between the balance of your mortgage to the appraised value of your house.  Automatically cancelling PMI wasn’t always automatic.  Banks made it incredibly difficult to cancel PMI, so consumers made Congress pass the Homeowners Protection Act of 1998.[6]  To avoid PMI altogether, it’s best to save a 20% down payment, or if you’re eligible, using a government loan like a Veteran’s Affairs (VA) loan.

The next portion of your mortgage payment is the escrow payment.  Escrow ensures that you pay your property taxes.  Until you make your last mortgage payment, the bank actually owns your house and is ultimately responsible for the property taxes.  They prefer taking that money from you in an escrow payment and lump it into your mortgage payment.  Remember the finance tip I mentioned at the beginning of the article?  The majority of first-time home buyers receive a nice surprise the second year of their mortgage.  For some undocumented reason, your escrow never fully pays for property taxes, so the second year your mortgage payment increases significantly for the first year’s shortfall and for future tax payments.  This technique is to lure buyers into focusing on the affordability of the first year’s mortgage payments, and then Surprise! you get hit with a sudden, and sometimes significant, increase in your monthly payment.

Lastly, your mortgage pays for homeowner’s insurance.  Unlike car insurance, you can legally own a home without homeowner’s insurance.  That being said, nearly all lenders require homeowner’s insurance when granting loans to buyers.  This, plus PMI, protects banks against defaults and damage to the house while the bank still owns the property.  Homeowner’s insurance prices depend on potential damage to the house.  For example, along the Gulf Coast, homeowners can safely assume the insurance will be high due to the threat of hurricanes and floods.  But remember, flood insurance may not be automatically covered by your homeowner’s insurance.  We’ll go over insurance in much more detail in later chapters.

So, these costs  make up your monthly mortgage payment.  As in previous chapters, this was just a cursory look at your monthly mortgage payment.  This is not an inclusive list of all the financial genome connections that the housing market makes up.  In chapter 8 (LINK) we discussed renting and this chapter we discussed buying a home as two of the primary ways of paying for housing expenses.  After we get through all the normal expenses, we’ll circle back and really focus on the entire real estate market.

[1] http://www.bankrate.com/finance/real-estate/real-estate-agent-commission.aspx

[2] https://www.quickenloans.com/blog/closing-costs-and-fees-explained

[3] https://www.forbes.com/sites/steveudelson/2017/01/17/selling-your-home-by-owner-whats-really-happening/#6e26cef65fd7

[4] https://www.thebalance.com/the-home-closing-process-1798319

[5] http://faculty.haas.berkeley.edu/JAFFEE/Papers/094lRIO2006.pdf

[6] https://www.federalreserve.gov/boarddocs/supmanual/cch/hpa.pdf

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