013, Mortgaging a House

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So, we covered ratios in the last post. The focus of that post was to show you the basics of a ratio for buying a house. Now you know and understand the ratios that are recommended in relation to your income. You understand that the 20% recommended down payment is the minimum you should put down on a house. Let’s run through a few examples to show you the impacts of a few scenarios. Sometimes a picture is worth a lot of words. In this case, the picture will be a spreadsheet. Before we get started, here are some of the areas we’ll cover.

I ran all of the calculations through Mortgagecalculator.org. It has the most complete variables necessary to truly capture all of the costs. Be wary of the bank calculators that only show principle and interest. While that’s a big portion of your monthly rate, it’s not the whole picture. So, I’m going to lay out a few things in this post to help you truly capture the total costs you can expect.

First, there’s the purchase price. You may hear people say things like “I paid $200,000 for the house”. They are referring to the purchase price. By the end of this post, you will know the cost of the house will be much more than the purchase price… unless you pay in cash.

Then there’s the down payment. You’ll want to put 20% or more down on a house so you avoid paying PMI (Private Mortgage Insurance). Remember that’s where you get to pay for the bank’s insurance in case you don’t make good on your money. That 20% should be your minimum. You can put down as much more as you want.

Next comes taxes. You can’t get away from taxes. Taxes can be a considerable expense…especially in Texas, where I’m writing this post. What Texas loses in income tax, they make up for in property taxes.

You’ll also want to have insurance. This isn’t the PMI insurance. This is the homeowner’s insurance that you pay for things like a hail storm that trashes your roof, fence, etc. The bank will require you to have insurance if you finance. If you pay in cash, it’s a good idea to pay just to protect your home from an unexpected diseaster.

What we’ve covered above is referred to as PMTI. PITI is simply Principle, Interest, Taxes and Insurance. Everyone will pay those when financing a home. But don’t forget or confuse PITI with PMI. Remember PMI is that insurance for the bank that you get to pay. So, the total monthly cost will be PMTI plus PMI. The less you put down the more PMI’s cost goes up.

In order to show the differences in PMTI plus PMI, I’ll set a few variables so you can see the impact of the changes. I’ll also randomly choose Grand Prairie, Tx as our city of choice to nail down the exact taxes for a property. Limiting the variables should help you see the long term impacts to your finances for the choices you make.

The house will be a $200,000 house in Grand Prairie, Tx. The interest rate is going to be set to 4.33% which is fairly close to the current rate. Your rate will likely vary somewhat based on down payment and your credit score. So, 4.33% is good for illustration purposes. The property taxes for Grand Prairie are 2.921736% of your home value or $5,843.47 every year. That amount will be divided by twelve and added to your monthly payment. Homeowner’s insurance is set at $1,000 per year. Again this will be broken down and spread across your monthly payments. The three scenarios will be putting 5%, 10%, 20% down for your down payment.  The Term will also be either a 30 year or 15 year fixed rate mortgage.

Price Down Pmt % Down Term (yrs) # PMI Pmts Montly Pmt Total PMI Pd Total Int Paid Cost for House
$200,000.00 $10,000.00 5% 30 79 $1,592.98 $7,679.17 $149,698.07 $357,377.24
$200,000.00 $20,000.00 10% 30 71 $1,539.23 $5,325.00 $141,819.22 $347,144.22
$200,000.00 $30,000.00 15% 30 40 $1,485.40 $2,833.33 $133,940.37 $336,773.70
$200,000.00 $40,000.00 20% 30 0 $1,364.90 $0.00 $126,061.53 $326,061.53
$200,000.00 $10,000.00 5% 15 37 $2,086.49 $2,929.17 $68,666.11 $271,595.28
$200,000.00 $20,000.00 10% 15 26 $2,006.69 $1,950.00 $65,052.11 $267,002.11
$200,000.00 $30,000.00 15% 15 14 $1,926.89 $916.70 $61,438.10 $262,354.80
$200,000.00 $40,000.00 20% 15 0 $1,780.42 $0.00 $57,824.10 $257,824.10

Take a good look at the chart.  Study it for a bit and see if you can find the Big Rocks.

The first thing I see is that the final cost for the house could be anywhere from $257,824.10 to $357,377.24.  So, depending on how you set up financing for your house, you could pay a lot more.  Maybe this would help with some perspective on just how much that is.  Let’s say you make $57,000 per year.  If you are inefficient you would work for more than 3 years just to pay for the interest and PMI if you put minimal down and finance for 30 years.  You’d only have to work for one year to pay for the interest if you put 20% down and got a 15 year mortgage.

The second thing I see is that by far, the biggest difference in what you pay in interest is determined by the length of financing.  The longer you finance, the more you pay in interest.  Many folks say that they will finance for 30 years and pay early.  Statistically, they don’t though.  So, if you are in that small percentage, you’re likely not. I tried that and didn’t do well.  It wasn’t until I locked myself into the 15 year mortgage that I actually stuck to it.

The last thing I see is more of a reflection.  Being in the military, I’ve never truly owned any houses. I mortgaged them.  So, I’ve pretty much have been paying interest for most of my adult life.  While I did make money on every house I’ve mortgaged, it was done through improvements, etc.  I’ve never run the numbers, but I’d be lucky to break even considering all the interest I paid.  I wonder if I would have come out cheaper if I only rented and paid cash for a house.

So, as you can see from the chart above, there’s a lot of ways you can buy a house. This post points out a few different ways and for many different lengths of time.  Use this information and the thoughts to do it as efficiently as you possible can.  In just this one example, it could mean you save about $100,000.  What can you do with $100,000????

You now have the tools to make an efficient decision. Don’t be Average!

012, Financial Ratios, It’s all About the Numbers

What’s in a number? A number standing alone is meaningless. Especially in personal finance. Something like $10,000 without comparing it to other factors is surrounding the number is just an amount of money. If that $10,000 is buying someone’s car outright with cash for someone who makes $30,000 a year, it’s a significant amount to that person. That same $10,000 paid as a down payment on someone’s $250,000 Bugatti sports car who is making $5,000,000 per year is less significant in that person’s personal finance. That $10,000 is hardly anything compared to the $5,000,000 annual income. But someone who’s buying a $100,000 car outright with cash for someone making $300,000 per year, the financial impact is exactly the same as the first person buying the $10,000 car in the first example. The ratio is what matters in these examples.

We started to touched on Ratios a little bit in the last Post with Warren Buffet’s house. In that example we were comparing his home’s value to his net worth as a percentage. His house is really a very, very small part of his net worth. This post will look at important financial ratios that banks, landlords, and many other people who try to manage personal finance.

Financial Ratios Everyone Should Know, Wallet Hacks and Millionaire Mob are just a few sites that give some ratios. The first is the most basic. Then each one after that give some more ratios to understand. I give you those three so that you can dig in at your own time and at your own pace.

Since several of the readers have asked about buying a house in the near future, we’ll cover a few ratios for buying a house. I first heard of a ratio for buying a house when I purchased my first house. During the application process, the loan officer informed me that I could get a loan for up to 28% of my income for the house. But there was a caveat. The total of all my debt could not be more than 32% of my income. Since I was an Average person, I had more than 4% (32% – 28%) in consumer debt. This limited my first home to less than the standard 28%. I don’t remember exactly what the numbers were at the time. The point is that I had a lot of credit card debt and it effected my loan to buy my house. That was one of the earliest wake up calls that I may be in trouble. So, I started tracking these ratios periodically.

I’ve never really thought about that ratio for several years now. While writing for this Blog, I’ve noticed these ratios have changed! They haven’t changed for the better either. The newer ratios are 28% for your house and 36% for the total debt ratio. While that may seem better, it’s not. This is not in your best interest at all. Here’s why I don’t agree with the ratio.

The 28/36 ratio allows for 4% more than the old ratio. That’s a 100% (4% to 8%) increase in consumer deb! So what they are doing is allowing you to charge more depreciating assets! They haven’t increased from 28% for the generally appreciating asset called your house. Not that I’m a fan of financing to the maximum, but the above shows where the banks interests are focused. What they did was basically allowed for the Average consumer to borrow more money for the highest interest rate category. That means they make more money and you lose more money to interest.

So, you loose the flexibility to use that second 4% that you could put towards an emergency fund, for food, or for investing. You are also loosing the opportunity cost of that 4% compounded over the years if you invest it in your retirement. That’s worth you seriously considering before you decide to max out how much you can borrow on a house and credit cards. Let me say it again:  That’s worth you seriously considering before you decide to max out how much you can borrow on a house and credit cards.  The old 28/32 ratio was hard enough to recover. The 28/36 ratio would be much harder. So, don’t be Average and max out your credit. Live below your means and invest the remainder in your future.

By now, most of you by now have read about how much credit can cost you. You know to avoid it on depreciating assets. Assets that don’t appreciate in value or provide income should never be financed.  So, when buying a house, don’t forget that wasting money on depreciating assets can really mess up your chances to minimize your interest costs. Remember all numbers in relation to your objectives of financial independence. Don’t get caught up in the Average American dream of owning a house at the expense of your financial future.

Maxing out your credit to purchase a house will significantly hinder your ability to save for your future. It will strap you for cash and for emergencies if you don’t have those in place before you finance a house. So, before you even consider buying a house make sure you have a fully funded emergency fund and an appropriate down payment.

Why is the down payment of 20% or more stressed by so many financial people? Because of two major reasons. Fist, it shows the mortgage company that you have skin in the game. You have 20% equity, so the bank has less risk. You are more likely to pay on time and not walk away leaving the bank with a house. They are not in the house buying business. They reward you for this by giving you a favorable interest rate. So, you’ll be financing less and at a lower interest rate. Over the life of your loan, the reduced financed amount and the lower interest rate will be a significantly less amount you pay to the banks.

Secondly, you won’t have to pay for Private Mortgage Insurance or PMI. PMI is insurance that the bank makes you pay for to insure that they actually get the money back that they lent you. That’s right, they make you pay insurance for them! You get absolutely no value for this either. So, you are losing money here too. In most instances, 20% down will eliminate this PMI. PMI increases with the cost of your house. More expensive house will require a more expensive PMI payment. So, just save at least until you get the 20% down to avoid throwing this money away by paying for the bank’s insurance for your home loan. Don’t do it. If you can’t afford this 20% down, wait until you can.

So, don’t be Average. Learn your financial ratios so you get a better picture of your major purchases such as a house.