Attorney John Mlnarik
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Tips for First Time Homebuyers
As we approach the summer home buying season, here is some practical advice for first time homebuyers from my experience both as a real estate litigator and a recent first time homebuyer:
• Don’t fret about the market: I am often asked if I think now is a good time to buy. My response to this recently has been “Well, what are you buying – a house or a home?” The market seems dangerously inflated at present and may very well decline in the short term. However, given long term inflationary trends, it seems highly likely prices will before too long return to these levels and ultimately go higher. If you are a speculator who wants to flip, or somebody that wants to sell in a few years and move somewhere else or upgrade off accumulated equity, it is a bad time to buy and there is a fair probability you will get hurt at these prices.
However, if you want a home to reside in indefinitely and are ready, willing and able to purchase, do not hesitate because of market concerns. Prices will return to these levels; moreover, interest rates, while slightly off their bottoms, are at historic lows and even if the price declines a little, you may find that locking in these low interest rates is even more valuable than a little bit of equity. If you are waiting for 2010 prices again, you will probably never see them absent some unforeseen deflationary economic catastrophe. Even if that were to occur, you may not be in the same position to buy then that you are now.
• Use a mortgage broker: Do not just walk into the large commercial bank you’ve done business with your whole life and apply for a loan. Mortgage brokers have access to many different loan products and banks that compete with lower interest rates for your business and, by extension, the broker’s business. In all likelihood, if you just walk into the bank where you do your personal banking, rather than using a skilled mortgage broker, you will pay .5%-.75% more in interest on your loan. Furthermore, a broker will not just take your application; he or she will actively help you qualify. If you are close on qualifications for the loan you seek, a good broker will put you over the top: his or her commission depends on it.
With that said, not all brokers are the same. Shop around for someone who really shows you that he or she knows what they are doing and seems to have good connections. Find someone you like, trust and get along with. Don’t just use the person your real estate agent recommends – they may have their own motives for the referral.
• Get to 20% down if possible: Currently, you can get a loan with as little as 3.5% down. If you happen to be a veteran or a family farmer, you might even qualify for a 0% down loan. However, if you put less than 20% down, you have to pay the dreaded FHA mortgage insurance premium, which is effectively insurance for the lender against your own default. This will require you to pay each year, in equal monthly installments, an amount between .8% and 1.05% the value of your initial principal amount. In addition, you will be required to pay an upfront mortgage insurance premium at origination equal to 1.75% of the loan’s initial principal. This is usually financed into the loan, but you still have to pay it plus interest if you finance it.
These premiums, like interest, are tax deductible; however, it is still a raw deal. The only way to avoid it is to get to 80% loan to value. For most of us this is not possible; however, if there’s any way you can beg, borrow, or steal (just kidding, do not steal, it’s bad and you might end up in jail, not enjoying your new home) to get to 20% down, do it by any means necessary. It will pay off in the long run. If you do get stuck with it, refinance it off your loan as soon as possible. If interest rates go up and stay up, which given historical averages seems likely, you could be stuck in a conundrum where the only way to get rid of the PMI is to lock in a much higher interest rate. Some servicers have programs where after many years of good behavior they’ll release you after applying. Do not get lured into a false sense of security by these promises. You will almost certainly be able to refinance it off much sooner. Interest rates permitting, do it as soon as possible.
• Look outside your comfort zone: If you grew up in Santa Clara, for example, you may be reluctant to leave. Prices everywhere right now are historically high in absolute dollar terms, but Silicon Valley is more inflated than other places and you’re likely to find better places outside of the Valley. Lots of places are commutable including Gilroy, Santa Cruz and Livermore. You’ll almost certainly find better value elsewhere. You might even find that you like living in one or more of those places better. The same logic applies if you work in San Francisco or Oakland, or another bubbly area.
• Use a buyer’s agent: A real estate agent is a fiduciary who is required to look out for your best interest. Typically a dual agent looks out for the seller before the buyer. I would even go so far as to argue that an agent legally cannot be a dual agent and meet their fiduciary duties. However, it is standard industry practice and is not illegal in itself, although it does lead to many avoidable lawsuits. Today with the internet, buyer’s agents have become less necessary. However, they are no less desirable. If you find a home on Zillow and seek to visit an open house of the home you want and decide to offer, odds are the seller’s agent will try to act as a dual agent. They have good reason to: typically they receive 5% commission and split that with the buyer’s agent. If they able to act as a dual agent, they double their commission. Not to mention, they have an additional conflict of interest in the amount you offer, to which their commission is tied.
Buyers agents have a different incentive scheme and should always be used. They will take you around town, show you many houses and give you access to houses even when no open houses are occurring. They are also less inclined to urge you to bid more than you want to pay or can afford since they have no one on the other end to which they answer. Some will be greedy and push you anyway, but most buyers’ agents are happy to get their 2.5% and are more inclined to work for your interests. As with mortgage brokers, do not be afraid to shop around.
• Pay additional principal if possible: Just as we learned in grade school the wonders of compound interest, a similar principal is true for additional principal payments. Every dollar in principal you add to your monthly mortgage payment accelerates your repayment of principal, but also decreases the amount of interest paid each month for the life of the loan by a slight amount. In a 30-year fixed mortgage, this in turn increases the amount of your contractual payment, which goes to principal, adding up slowly over the life of the loan, and further has a compounding effect, feeding back on itself to slowly reduce interest even more. If you consistently make relatively small additional payments, you can reduce the term of your loan by as much as ten years and save a ton of money in the long run.
• Do not underestimate the value of the tax deductions: Often a huge discouraging factor for prospective buyers in the Bay Area and the surrounding territory is that, at least initially, the monthly mortgage payment once taxes and insurance are included becomes approximately what rent is anyway. Many people don’t like putting down their life savings only to find that they are still paying the same amount on an ongoing monthly basis. There are several reasons why this thinking is shortsighted.
First and foremost, the government wants people to buy homes to keep prices rising and has provided tax incentives for doing so. There are five components to each mortgage payment: Principal (the balance paid down on the loan), Interest, State Property Taxes, Homeowner’s Insurance and Mortgage Insurance (if applicable). Interest, State Property Taxes and Mortgage Insurance are all tax deductible. Since fixed payment mortgages pay monthly interest on the outstanding balance, the early years of the mortgage are very interest heavy. This means that in the earlier years when you are likely to need it most, you’ll be maximizing your tax deduction. The combined interest, tax and mortgage insurance deductions in the early years of a 30-year fixed will almost certainly take you down an entire bracket. If you have a significant other who is contributing, in order to maximize tax benefits, the higher earner should be making all mortgage payments directly from their earnings and the lower earner should be contributing in other ways or giving their share in cash directly to the higher earner. Only the person who makes the payment can take the deduction, and due to the way our tax brackets are structured, this will make a much bigger difference for the higher earner.
Further, when you commit to a 30-year mortgage, you are effectively hedging your rents and building equity at the same time. The amount you pay today may be approximately the same as what rent would be on a comparable home, but the macro trend has always been inflationary due to government spending habits and monetary policy, which will almost certainly not change. Thus, both rents and home prices will steadily climb over the years due to inflationary trends (it is important to distinguish inflationary trends from value, which on a single-family residence tends to remain roughly stable) and your 30-year fixed mortgage payment will be stuck at 2017 levels. At the end of the 30-year term, you will have a paid off home.
Finally, the corollary to this rent hedge thinking is that you’ll build equity on both ends. What I mean by this is that you’ll build equity from the principal you pay down over the life of the mortgage, yes, but you’ll also build equity from the inflationary trends. Thus, in the early years of your mortgage it might be frustrating that principal is paid so slowly. As mentioned earlier, the harshest effects of this can be alleviated by paying extra principal and there are associate tax benefits, but typically, for every dollar you pay down on the back end, you’ll also gain one on the front end from the inevitable inflationary trends in the market. Whether or not this is extra value is debatable, but it is certainly equity that can be saved or used.