Dont Overpay for a House, Even in Todays Market

If theres one thing American investors love, its 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 couldnt 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 dont know, but I suspect that we are, at least in some areas of the country.

Dont 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 theyre 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, youve won. If you refinance, and max out on your equity, youre probably hurting yourself. You might say that by refinancing the equity in your home, youre just cashing in on your homes rise in value. Well, not exactly.

What youre 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. Youve 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 youve 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 shouldnt you buy a home in the current environment

Im not saying you shouldnt. What Im 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 youre 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 youll be paying for the great rip-off known as Private Mortgage Insurance PMI. Trust me, its just another monthly payout that goes down a giant rat-hole. Theres no value in PMI, and you dont want to pay it.

For the sake of argument, lets assume that you wont be paying any PMI. Now, lets 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 Im living in retailed for under $100,000 in 1999, and retails now in the $130,000s.

Back to our example. Both of our neighbors are paying about $875 per month on their mortgage. Now let’s 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 here’s 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 don’t 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, he’ll 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 it’s 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 you’ll 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. You’ll 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 didn’t 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.