Monday, March 17, 2014

20% Down?

There are two ways to pay for something. You can save, letting the power of compound interest work in your favor, or you can take out a loan and let compound interest work against you at much higher rates. Either way, you pay. Cash is almost always the preferable option, unless you are lucky enough to have a 3.5% mortgage from the early 1960s in the 10%+ stagflation of the late 1970s. Unfortunately for most couples, 100% down on their first home is simply not an option.

So how much of a down payment do you need to buy that new home?

The new answer is 20% down. That is the minimum requirement to avoid Lenders’ Mortgage Insurance generally termed, Private Mortgage Insurance (PMI). Unless you can come up with a 20% down payment, the lender will require you to pay for an insurance policy to protect his bank from the possibility of your default. Typically the annual cost of PMI runs from about 0.3% to 1.15% of the original loan. On a $200,000 home that might be something like $200,000 X 0.01/12 = $166.67 a month for the next 30 years. That could be $60,000 that is not going into your Roth IRA or some other worthy cause. If that money went into your Roth at the rate of $166.67 a month for 30 years at a very realistic 7.0% rate of return, you would lose $203,340.68 that you could have spent in retirement. Small decisions involving the power of compound interest can drastically affect the outcome of our lives.

If you live in a high cost metropolitan area, double those numbers!

While most private mortgage loans will allow you to drop PMI payments when you reach 20% equity by some combination of paying down the original loan and an increase in the value of your property over time, it is up to you to notify the lender and prove that this is a fact by paying for a home appraisal. Finding a qualified home appraiser who will realistically value your home is not a given. Short sales or foreclosures can skew the comparable home values in your neighborhood. Fannie Mae and Freddie Mac lenders can not work directly with appraisers. Therefore they work through Appraisal Management Companies. Some of the people who work for these companies are unqualified or may be unfamiliar with your particular neighborhood.

Some mortgages will require PMI for the first two or three years of the loan, no matter how your equity position changes during that time period. Some of the new FHA loans will require PMI for the entire term of the loan. I have a sneaking suspicion this might well become the new normal, so be careful what you sign.

To avoid PMI on a home valued by an appraiser at $200,000 the buyers need to cough up $40,000 in cash. That is a very tall order for a young couple. However, that is the best path in the current environment.

There is another reason to bring a substantial down payment to the table when buying your first home. When the real estate bubble popped in the slow motion train wreck of 2006 to 2009 as many as one third of the home owners in America found they were underwater. This condition is also called upside down. This occurs when you still owe more on the house than the house is worth. In such a situation you can not sell the house unless you can come up with the difference between the sales price and the mortgage balance in cash. As the unemployment rate spiked to the highest levels in nearly 30 years, far too many Americans lost their jobs at the same time they could no longer sell their homes in order to avoid foreclosure. Even if they found a new job in another city they were still saddled with a mortgage in another town. If they couldn’t find a renter, they were forced to continue payments for an empty home or face foreclosure and personal bankruptcy.

Under the best of conditions, debt is a dangerous companion to invite into your life. Be careful. I know that paying rent seems like throwing money down a hole. We did it for twelve years. Your genes, your Government, the banks, and your friends are all telling you to buy a home without carefully counting the cost. Waiting an extra three or four years to build an emergency fund and a substantial down payment may prove to be the best and cheapest mortgage insurance policy you can possibly buy.

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