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Don't Overpay for a House, Even in
Today's Market
by: Christopher Mallon
If there's one thing American investors love, it's an
over-inflated market. Which is why they keep buying
houses and new ones keep coming onto the market.
According to the latest data, housing starts rose an
annualized 3.4% in September, matching a 17-year high.
Whoo-ha! Go, baby go.
I wonder if the people buying these houses, for
ever-rising prices, are the same people who couldn't get
enough Amazon.com stock at $100 or Lucent shares for
$75? Having been burned in the stock market, I guess
they decided to re-invest what was left in their homes.
Are we in a housing bubble? I don't know, but I suspect
that we are, at least in some areas of the country.
Don't misunderstand me, now. I own a home, and I
think home ownership is one of the great freedoms we
enjoy in this country. I get nervous about the people
who are pulling all the equity out of their homes with
new mortgages. I suspect that most of these people are
spending the equity, not investing it. What they're left
with is a larger mortgage, and a bunch of worthless
Chinese made goods.
The current low-interest rate environment is a
once-in-a-lifetime chance to lock in a cheap 30-year
mortgage on your home. If you refinance the balance of
your current mortgage, you've won. If you refinance, and
max out on your equity, you're probably hurting
yourself. You might say that by refinancing the equity
in your home, you're just cashing in on your home's rise
in value. Well, not exactly.
What you're really doing is collateralizing the
portion of the house that you own to get a cash loan,
with the intention of paying back the loan at a later
date. You've really transferred ownership of the equity
in your house to your lender, not cashed it out. If you
want to cash out your equity, you have to sell your
house, plain and simple.
For those who are buying new homes, the low interest
environment is a double-edged sword. On the one hand,
you can get a tremendous rate on a 30-year mortgage, the
likes of which you see once in a lifetime. On the other
hand, because we live in a world where the monthly
payment is all that matters, lower interest rate mean
higher home prices. The monthly payment stays the same,
but now you've got a much higher mortgage balance, which
could turn around to bite you in the future.
The dangers of refinancing the equity out of your
home are readily apparent, but why shouldn't you buy a
home in the current environment?
I'm not saying you shouldn't. What I'm saying is you
have to be careful. Most real estate professionals
understand that the monthly payment matters, not the
price of the house, when selling a house. Therefore, the
lower interest rates fall, the more money can be charged
for a house. If you're a home buyer, with a set amount
of money for a downpayment, the price of the house will
determine how much equity you start with. And, it
determines whether you get a conventional mortgage, with
20% down, or some other form with less downpayment. That
equity percentage will determine whether you'll be
paying for the great rip-off known as Private Mortgage
Insurance (PMI). Trust me, it's just another monthly
payout that goes down a giant rat-hole. There's no value
in PMI, and you don't want to pay it.
For the sake of argument, let's assume that you won't
be paying any PMI. Now, let's compare two neighbors,
with identical houses, who have the same monthly
payments on thirty year mortgages. The first neighbor
has a $100,000 mortgage at 10% interest, the second has
a $146,000 mortgage at 6%. You may think this is
extreme, but I can tell you that this is what has
happened in my neighborhood over the last 5-7 years. The
type of house I'm living in retailed for under $100,000
in 1999, and retails now in the $130,000's.
Back to our example. Both of our neighbors are paying
about $875 per month on their mortgage. Now lets
suppose that both of them decide to pay extra on their
mortgages, upping their payments to $1,100 per month.
Both neighbors are reducing their principal balances by
$225 more per month, and heres where the first
neighbor has the advantage. The balance on the $100,000
mortgage goes down much quicker than the $146,000
mortgage, such that while the first neighbor is paying
more in interest every month than the second neighbor,
by sometime in the seventh year, neighbor one is
actually paying less in total interest. Neighbor one
will pay his house off in a little over 14 years, while
neighbor two will take about 18 years to pay off.
In this example, we dont even take into account
the possibility that neighbor one could refinance the
balance on his mortgage when interest rates decline.
This would lower his required payment, and allow him to
pay off his house even faster. In the meantime, the
market value of his house has risen to about what
neighbor two paid ($146,000). When neighbor one decides
to sell his house, hell walk away with a lot more
cash.
Obviously, this is a simplified example, but one that
has been occurring over and over again in the last few
years. I know that its expensive right now to buy a
house, no matter where you go. What do you do in this
situation? I recommend looking for, and buying, a home
that needs some work. You should look for houses that
are selling at about 80% of the average market value in
a neighborhood. These houses will generally need only
cosmetic work, and maybe a few minor repairs, but
youll save on the price of the house and have extra
equity right off the bat. Stay away from houses that
need plumbing or electrical work, unless you know
someone that will fix it for free. Those fixes cost big
bucks, and will eat up much of the savings on the price
of the house.
Buy the house, make the cosmetic changes, then have
it re-appraised. Youll be surprised at how much the
value of the house has gone up. (I put value in
quotes because the only real way to judge the value of a
house is to sell it. An appraisal is simply an estimate
of value.) This will also help you get rid of the PMI,
if you didnt have the 20% downpayment, because once
the balance of your mortgage falls below 80% of your
appraised value, you can petition to get rid of the PMI.
Houses can be investments, and like any investment it
takes a work to find good value. But it can be done.
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