Investment questions re: home purchase...


T

Tim_D

Hello,

I've recently purchased a home, and while looking, was focusing on
future flexibility in using it as an investment or life-long
residence. I am a tenured professor, so have a relatively stable (if
meager!) income, but may have opportunities in the next few years to
take a better position. I also typically have opportunities to make
extra money in the summers (~$5000 or so).

After consulting numerous sources and advisors, I ended up buying a
home for $230K (4 BDR, 2 BTH, ~2500 sqft) on a roughly square shaped
lot that is 9 acres in size. I clear about $2700 a month, so had to
squeeze to afford this. The mortgage I obtained was a zero down,
interest only (5 year ARM), which results in a minimum (interest only)
payment of around $1500 a month for the first 5 years. I have no
other outstanding debts (car is paid for), roughly $45000 in an IRA,
and around $4000 is savings. I also am unmarried and have no
dependents, but that first one may change soon.

The size and comfort of the house are excellent for a family. The 9
acre lot is zoned agricultural, and borders a state highway to the
west, commercial to the south, a new residential subdivision being
built to the north, and several smaller residential lots (through
which I have an access easement) to the east. This area of Michigan
is currently low in population, but has experienced rapid growth in
the last 5 years.

A lot of people are now telling me "pay down that principal!", and
although the mortgage currently eats up over 50% of my monthly pay,
there is still some room to pay extra. Is this a good idea if there's
the possibility of a career move in the next two years?

The way I ran the numbers (and please tell me if I'm way off!), the
worst case scenario is that I get a property appreciation of 3% the
next two years, sell the home, and walk away at roughly a break-even
point. If this scenario materializes, is there any point in paying
off principal early? I read several people saying that interest-only
loans are appealing if you want a lower payment and are willing to
risk the property appreciating at a compensating rate. That was a
risk I was willing to take.

Better case scenarios include a rapid appreciation that would either
allow me to get out earlier or make more profit (if it was the latter,
I might choose to wait a bit and see what happens). Or, equally
appealing, is simply staying here and managing the payment as it
stands.

My voluntary contribution to my retirement account is currently at
maximum. If the rate of return on the IRA is lower than my mortgage
rate, does it make sense to tweak that number down, and use the
additional monthly money toward mortgage principal? (Note that I'm
not planning to withdraw money from the IRA to do this!)

Thanks for any advice. I'm somewhat new at the housing game, but have
been fiscally responsible my whole life. I didn't get hosed in this
deal, did I?

Thanks for reading, and all thoughts are appreciated.

Tim D.
 
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J

Jim

Hello,

The size and comfort of the house are excellent for a family. The 9
acre lot is zoned agricultural, and borders a state highway to the
west, commercial to the south, a new residential subdivision being
built to the north, and several smaller residential lots (through
which I have an access easement) to the east. This area of Michigan
is currently low in population, but has experienced rapid growth in
the last 5 years.

A lot of people are now telling me "pay down that principal!", and
although the mortgage currently eats up over 50% of my monthly pay,
there is still some room to pay extra. Is this a good idea if there's
the possibility of a career move in the next two years?

The way I ran the numbers (and please tell me if I'm way off!), the
worst case scenario is that I get a property appreciation of 3% the
next two years, sell the home, and walk away at roughly a break-even
point. If this scenario materializes, is there any point in paying
off principal early? I read several people saying that interest-only
loans are appealing if you want a lower payment and are willing to
risk the property appreciating at a compensating rate. That was a
risk I was willing to take.
Tim D.
Tim-

I assume this house is not in Flint, that's where I went to college
and I didn't think those real estate prices would change for LONG
time...

I see the main issues as whether you can:

SELL the house for what you paid for it
assure the house APPRECIATES in value before you sell it.

Appreciation will occur if that housing development goes up quickly
and sells at a premium. Appreciation could also occur if you improve
the property (add a deck, pool, guest house... morning room....).

Do not assume if you sell the house someone will pay what you did.
it's great when that happens, but in 2-5 years, who knows?

I would pay down principle by adding about $50-$100 each month to your
current payment. Start paying it down SOME and pay more as you feel
comfortable. Also consider putting 50% of your summer income to
paying down principle.

What happens in 5 years when the ARM is completed?
Are there closing costs inside the mortgage?

I wouldn't defer IRA $$ to house. I wouldn't reduce retirement
savings. I would try to make sure I started paying down principle,
and every little bit helps- stop eating out as much, pay down debts
(which it sounds like you have), and drive a cheap car.

Jim
 
J

Joakim Persson

[[email protected] (Tim_D)] wrote:
[ 61 lines in misc.invest.financial-plan ]
===================
After consulting numerous sources and advisors, I ended up buying a
home for $230K (4 BDR, 2 BTH, ~2500 sqft) on a roughly square shaped
lot that is 9 acres in size. I clear about $2700 a month, so had to
squeeze to afford this. The mortgage I obtained was a zero down,
interest only (5 year ARM), which results in a minimum (interest only)
payment of around $1500 a month for the first 5 years. I have no
other outstanding debts (car is paid for), roughly $45000 in an IRA,
and around $4000 is savings. I also am unmarried and have no
dependents, but that first one may change soon.

A lot of people are now telling me "pay down that principal!", and
although the mortgage currently eats up over 50% of my monthly pay,
there is still some room to pay extra. Is this a good idea if there's
the possibility of a career move in the next two years?

The way I ran the numbers (and please tell me if I'm way off!), the
worst case scenario is that I get a property appreciation of 3% the
next two years, sell the home, and walk away at roughly a break-even
point. If this scenario materializes, is there any point in paying
off principal early? I read several people saying that interest-only
loans are appealing if you want a lower payment and are willing to
risk the property appreciating at a compensating rate. That was a
risk I was willing to take.
Essentially, you're borrowing 100% of your home's CURRENT value, and half
you take-home pay goes to service this debt... This seems very risky to me.
Considering that ARM interest rates are VERY low right now, house prices
have already gone up quite a bit, and the high probability of interest rate
increases down the road, you're in a tight spot.

If interest rates increase, your mortage will be harder to bear. Also,
interest rate increases are bad for the housing market. Have you considered
what would happen if your home would decline 5% or 10% in value?

You're betting that house prices continue to rise faster than inflation.
That's a risky bet in today's environment. Ask yourself -- what if the
interest rate on your ARM 5 years from now is 2-3 percentage points higher,
and home prices stay flat or even decline?
My voluntary contribution to my retirement account is currently at
maximum. If the rate of return on the IRA is lower than my mortgage
rate, does it make sense to tweak that number down, and use the
additional monthly money toward mortgage principal? (Note that I'm
not planning to withdraw money from the IRA to do this!)
Yes. You should focus on paying down the principal as soon as possible.
Having zero equity is not good at all. Do not withdraw money from your
retirement accounts, but do try to at least clear some equity, in case the
less favorable scenarios (interest rate increases and/or home value
declines) come true.
Thanks for any advice. I'm somewhat new at the housing game, but have
been fiscally responsible my whole life. I didn't get hosed in this
deal, did I?
Actually, dedicating over half of your income to your home is playing with
fire, especially as you're not paying down the principal. Is it really
worth it to pay $1400+ FOR LIFE for your home, while owning zero percent of
it?

And if you're counting on further price appreciation, what kind of income
would those future buyers have to have in order to afford it? Since you're
already struggling to make mortage payments, think about how you would
manage this if you were to buy the same house in the future, after your
anticipated price increases...
 
D

darkness

Tim

Given your situation, I would recommend paying down principal in the
mortgage.

If you can get access to the Economist via your college library (back
issues) they have done a lot of work on house prices recently. Bottom
line is it is not likely that housing prices will continue to rise the
way they have in the past, and they may fall.

Also interest rates are at record lows. They are likely to rise.

In which case, paying down debt is the best strategy.
 
J

John A. Weeks III

Tim_D said:
After consulting numerous sources and advisors, I ended up buying a
home for $230K (4 BDR, 2 BTH, ~2500 sqft) on a roughly square shaped
lot that is 9 acres in size. I clear about $2700 a month, so had to
squeeze to afford this. The mortgage I obtained was a zero down,
interest only (5 year ARM), which results in a minimum (interest only)
payment of around $1500 a month for the first 5 years. I have no
other outstanding debts (car is paid for), roughly $45000 in an IRA,
and around $4000 is savings. I also am unmarried and have no
dependents, but that first one may change soon.
A few points here:

1) As others have pointed out, something is wrong with the loan
numbers you gave. A $230K interest only should be under $1000
a month. You need to figure out what you actually signed for,
and where the money is going.

2) Interest only loans are a very poor idea. It is like paying
rent. You have all the risks of increasing interest and losing
your tail if you are not able to sell it.

3) You are paying way too much of your income for housing. You
should pay no more than 25% of your take home for house payments.
Even that is too much for most people since you end up house
poor -- all of your spare money goes into maintaining the house,
and you have no money left over for fun or saving for the future.

4) What the heck does a single person need with a 4 bedroom home?
Do you play on raising rabbits, or have a lot of cats? You should
be looking at an entry level townhouse, and if and when you get
married in the future, then buy a bigger place with your new wife
as children start entering the picture. You will get a much better
return on your investment over the long run.

-john-
 
S

Sandra Loosemore

[much snippage]
3) You are paying way too much of your income for housing. [...]
4) What the heck does a single person need with a 4 bedroom home? [...]
This is my perception, too -- the OP has spent way too much money for
his budget on a house that is way too big for his needs. He needs to
stop thinking of housing as being an "investment" and start thinking
of it as an expense. Aside from the monthly payments, it sounds like
the OP doesn't have much of an emergency fund set aside to cover the
inevitable maintenance and repairs.

It also doesn't sound like the OP has enough money to cover the
expenses of selling the property and trading it in for something more
appropriate for his needs. My suggestion is that he start looking for
a housemate to occupy some of that extra space and bring in some
rental income that he can use to pay down some of the principal on the
mortgage and build up an emergency fund.

-Sandra the cynic
 
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E

Ed Zollars, CPA

Tim_D said:
Thanks for any advice. I'm somewhat new at the housing game, but have
been fiscally responsible my whole life. I didn't get hosed in this
deal, did I?
Well, you've made a major league bet on things breaking for you,
since you're currently stretched to the limit. It may work out, but
if it doesn't you'll have problems.

As others have pointed out, your current situation pretty much
demands that you have significant appreciation in the home so you
can "unload it" before the 5 year ARM runs out. If that doesn't
happen, then you *really* need interest rates to stay low or your
income to go up substantially *without* requiring you to relocate.

On appreciation--a number of commentators have suggested we are
pushing the envelope on housing prices at this time. The run up in
housing values have been driven by a number of factors, but reality
is that housing prices can only outstrip incomes for a limited
period of time before the supply of buyers effectively goes away as
the housing is priced out of the market. As well, one thing keeping
housing somewhat affordable (and keeping buyers in the market) has
been relatively low interest rates on a historical basis. Therefore
you may find you get hit with a double blow if interest rates go
up--it may take the wind out of the appreciation you are betting on
*AND* put you in a real crunch at the end of five years when your
ARM runs out.

Your house is one that would face a "more limited" market than
average to begin with. There are more buyers out there in any
market for "more reasonable" houses than for large houses on large
lots. The hitch is that fewer buyers can afford your house, so the
supply of buyers is lower based simply on who can afford to buy the
house.

If I were in your position, I don't believe I would have bought the
house you did--rather, I would have bought something more in line
with your current needs and considered trading up later when the
need for a four bedroom house was clear. I also am extremely
concerned in this market when someone has bought a house they can
only afford if they pay interest only.

So, back to your question--in your case, paying principal would
serve to lower your risk exposure on this one. True, if the
appreciation takes place and you are able to unload the property for
substantially more than you paid for it, then paying principal
wouldn't give you an optimal return. But if the appreciation
doesn't take place and/or you are unable to unload the property
before the 5 years are up, you will find that having paid principal
may allow you to survive the new, higher rate loan terms.
 
B

BreadWithSpam

Sandra Loosemore said:
"John A. Weeks III" <[email protected]> writes:
[much snippage]
3) You are paying way too much of your income for housing. [...]
4) What the heck does a single person need with a 4 bedroom home? [...]
This is my perception, too -- the OP has spent way too much money for
his budget on a house that is way too big for his needs. He needs to ....
It also doesn't sound like the OP has enough money to cover the
expenses of selling the property and trading it in for something more
He's in a college area and has three extra bedrooms.

Perhaps he ought to look into renting out two of them to
students. At a minimum, that added income should be
enough to either pay down some principal or, perhaps just
as important - save some cash for when his mortgage
gets adjusted and he _has_ to start paying principal.
 
M

Michael Sullivan

Tim_D said:
Hello,

I've recently purchased a home, and while looking, was focusing on
future flexibility in using it as an investment or life-long
residence. I am a tenured professor, so have a relatively stable (if
meager!) income, but may have opportunities in the next few years to
take a better position. I also typically have opportunities to make
extra money in the summers (~$5000 or so).
After consulting numerous sources and advisors, I ended up buying a
home for $230K (4 BDR, 2 BTH, ~2500 sqft) on a roughly square shaped
lot that is 9 acres in size. I clear about $2700 a month, so had to
squeeze to afford this.
The mortgage I obtained was a zero down,
interest only (5 year ARM), which results in a minimum (interest only)
payment of around $1500 a month for the first 5 years.
This sounds like a really bad idea already. You are going to be house
poor if you live in this house alone. The standard rule of thumb is not
to let your mortgage expense exceed 30% of your annual income, some
would say 25%, and those rules of thumb assume a mortgage that will pay
down in 30 years, so part of your payment is essentially savings. You
are at *double* this range on an interest only loan without a fixed
rate.

The only people who have made similar scale investments in housing
relative to their income that I consider sane, live in places like San
Francisco or NYC where real estate is ridiculously expensive, and
spending half your pay on housing is pretty much a fact of life if you
want to live decently.

Since you're getting a 2500 s.f. home on 9 acres, it's safe to say you
had other options.

A lot of people will tell you to buy the biggest, most expensive house
you can possibly afford because your house is "an investment". From a
purely financial standpoint, those people are *dead wrong*. A house is
not just an investment but a consumption item. Follow me for a moment,
while I demonstrate:

If you were to invest in rental real estate, is it a good investment?
Well, it certainly *can* be, but sometimes it isn't. Sometimes what you
can rent for doesn't cover your mortgage and expenses, and you end up
paying money every month. If you buy a house to rent and it goes
vacant, it's not an investment at all, but an albatross, draining your
money right and left. Vacant real estate is a 100% losing proposition.
Fully rented real estate is often (if not always) a very good
investment. This is an important distinction.

Knowing this -- what kind of investment is your house?

Well, you live in it, and if you didn't live in it, you'd have to pay
somebody rent, so you can think of your rent savings as money that you
are receiving to rent your house -- return on your real estate
investment. So the question is: are you getting anything close to
market value for your house in rent? What part of it is essentially
vacant?

What size and expense house would you be willing to *rent* if you did
not own a house? Would you pay $1500/month in rent to get the amenities
you now have? Or would you rather stick to an apartment or smaller
house that might cost only $700-$1000/month? Or even less? What were you
paying in rent before you bought this house? Were you reasonably happy
or constantly champing at the bit for something better? How much better
would have satisfied you and been worth the money?

Here's the key, if you were happy with an apartment or house that cost
you $750/m in rent before, and would have gleefully continued in that
price range if you hadn't bought your house -- then at $1500/m half your
house is going vacant. Yes, you're there and using it, but you've
essentially signed on to rent a house for $1500/m instead of the
previous $750 (and it's really even more since you are now responsible
for maintenance and insurance that your landlord would have taken care
of before). That's extra *consumption*, and it more than cancels out
the investment value of having a bigger house. The value of the house
over and above what you'd have rented is essentially *vacant* real
estate from an investment point of view, i.e. not a good investment.

So the deal is this -- if you want to have this house be a good
investment, you're going to have to rent out that vacant property. Get
housemates or rent some rooms to students or something until you
actually need that 4BR house. If you do that, and get some reasonable
return, your big house becomes a real-estate investment. If you don't,
it becomes a big, very expensive, yuppie showpiece that drains your bank
account.

Note -- while it is certainly possible for appreciation to bail you out,
you've given yourself a really bad deal here, as long as you are leaving
this home partially vacant. The biggest problem is what happens when
the home *doesn't* appreciate or goes down (that *does* happen and it's
very hard to predict) you are spending a ton more money and can get
really reamed.

Even when the bad scenario doesn't happen, it will take better than
normal appreciation (inflation +2-3%) just to break even with staying as
a renter. But that kind of appreciation is a solid source of capital
gain in a deal where you don't mortgage yourself to the hilt. (I ended
up with about $25K of net appreciation in my pocket when I sold a house
after 5 years recently -- it all went in my pocket, because I hadn't
paid a dime more in mortgage/etc. than I previously paid in rent. If I
had paid $750/month more for some huge (twice as expensive) house, I
could have netted 50K appreciation instead, but I would have paid 42K
more in mortgage interest over the 5 years which, had I saved it, would
have ended up being more than the whole 50K. So I'd have gone from
earning 25K from my appreciation, to earning *squat*, even though the
difference in price was twice as large.
The way I ran the numbers (and please tell me if I'm way off!), the
worst case scenario is that I get a property appreciation of 3% the
next two years, sell the home, and walk away at roughly a break-even
point.
That is not a worst case scenario. That's a sort of low expected case
scenario. Just 15 years ago, people bought homes in my area (and area
here includes most of 3 populous states -- CT, MA and NY) which
proceeded to decrease in value by near 10% a year over the next 3-4
years before bottoming out. A lot of people basically couldn't sell for
years, because they would have owed the bank a pile of money over and
above the sales price. If something happened to their income stream in
the meantime and they could not afford the mortgage, they would lose
their house to foreclosure and be forced into bankruptcy.

*THAT* is your worst case scenario. If interest rates spike a few
points and the economic recovery stalls, perhaps your area is
particularly hard hit -- something like that could easily happen. The
chance of a crash like that may not be huge, but it's a lot bigger than
zero, and the chance of flat or slight downward price movement for a few
years is higher than you want to think about right now.

BTW, you almost certainly need an appreciation of more than 6.1% total
to break even on a trade of housing -- closing costs that represent real
expenses (as opposed to adjusting for timing of bills) typically amount
to 8-10% of a house sale. That's how much you need to make up to break
even.
Thanks for any advice. I'm somewhat new at the housing game, but have
been fiscally responsible my whole life. I didn't get hosed in this
deal, did I?
I think you did, to be perfectly frank. This is simply *way* too much
money to spend on a house in your income range. If prices go down or
interest rates go up, you will have a time bomb on your hands.

It would have been much better to ask for advice before you bought this
house.

I would seriously consider putting it back on the market. Normally I
think that'd be crazy -- cheaper to eat the mistake and live with it,
than spend 6-8% of your selling price, but you're going to be
hemorraghing money while you live in this place.


Michael
 
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E

Ed Zollars, CPA

Michael said:
That is not a worst case scenario. That's a sort of low expected case
scenario. Just 15 years ago, people bought homes in my area (and area
here includes most of 3 populous states -- CT, MA and NY) which
proceeded to decrease in value by near 10% a year over the next 3-4
years before bottoming out. A lot of people basically couldn't sell for
years, because they would have owed the bank a pile of money over and
above the sales price. If something happened to their income stream in
the meantime and they could not afford the mortgage, they would lose
their house to foreclosure and be forced into bankruptcy.

*THAT* is your worst case scenario.
I would add that over the years in my tax practice I've seen a
number of cases like that in different parts of the country, where
properties dropped dramatically in value for various reasons--and,
frankly, given the frenzy that has accompanied home buying in the
past couple of years, I think the time may be ripe in a number of
areas for a similar drop in prices. A lot of residential real
estate is being bought right now for two reasons:

1. Pure speculation by individuals buying properties not to occupy,
but rather betting on appreciation.

2. People who see rising interest rates and who are accelerating
their plans to buy in order to beat a further increase in rates.

Group one would be buying dot com stocks if we were back in late
1999 <grin>--they are chasing the currently hot investment based on
the idea that because the assets *have* appreciated dramatically in
recent years, that pattern will continue forever. Or, to put it
bluntly, the group that will create a bubble and then be shocked
with it bursts <grin>.

Group two creates simply a "bunching" of purchases--at some point,
either the increase in rates that they fear would shut them out of
the market will take place *OR*, if it doesn't, the momentum would
seem to run out as we have exhausted the supply of people "ready to
buy"--perhaps just as group one tries to cash in <grin>.

That is, real estate is like any other good that is bought and sold.
You need both buyers and sellers, and depending on whether we have
an excess of buyers or sellers, you'll see price pressure going
upward or downward.

Unfortunately, I think a number of participants in this market have
either forgotten or never were involved in the real estate bust that
came in the late 1980s.
 

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