Editors' pick: Originally published Jan. 4.
If you're planning on buying a home in 2017, your top new year's resolution should involve honing that plan.
Ray Rodriguez, regional sales manager at TD Bank, notes that if you haven't at least figured out how much of a loan you can qualify for, that's an easy task to knock off the checklist now. Using the loan-to-value ratio -- which divides the loan amount over the appraised value or purchase price of the home (whichever is lower) -- you can determine just what you qualify for and how much of the full price it represents. If that ratio falls above 80%, it might mean a higher monthly cost and the added burden of private mortgage insurance (PMI).
That's why it pays to determine what you can afford by using yet another simple formula: the debt-to-income (DTI) ratio. If you divide all of your monthly expenses (mortgage payment, taxes, insurance, credit cards, auto loans, student loans etc.) over monthly gross household income (salary divided over 12 months), anything above 43% is going to be an issue. For some lenders, Rodriguez says, even 43% is a bit high. The obstacles standing between you and a mortgage can influence what you're hoping to get out of the deal.
"Are you most concerned with saving money overall?" says Eric Meermann, certified financial planner and portfolio manager with Palisades Hudson Financial Group in Scarsdale, N.Y. "Minimizing your interest expense? Securing the lowest possible monthly payment? Beyond your goals, think about your circumstances. Your stage in life, your family situation and the other assets available to you may all affect your decision."
However, those expenses aren't going to be the only ones homebuyers are going to face during the process. If you haven't considered the neighborhood's property taxes and some of the quirks that come along with any home, added costs are going to be an unpleasant surprise. As TD Bank found out in a recent survey, 17% of first-time buyers haven't set aside money for unexpected repairs and costs. That's unfortunate, considering that 62% spent close to $2,000 in unexpected costs during the mortgage process.
It's especially troubling given the amount of first-time homebuyers in the market right now. First-time homebuyers made up 33% of all homebuyers in October. That's down from 34% in September, which was the highest percentage since July 2012 (34%). Through ten months of 2016, first-time homebuyers represented an average of 35% of all homebuyers, up from 30% for all of 2015 and the highest since 2013 (38%).
However, according to Freddie Mac, the rate for a 30-year, conventional, fixed-rate mortgage rose to 4.08% by the end of December. That's up from this year's low of 3.41% in July and 3.89% at this time last year and is the highest it's been since summer of 2015.
That leaves first-time homebuyers facing a few more hurdles than they did at this time last year, especially if they can't afford a 20% down payment on a home. While the Federal Housing Administration offers insured loans to buyers who can only afford very small down payments, -- sometimes as little as 3.5% -- borrowers must also meet other FHA criteria to qualify and should expect more paperwork and a higher interest rate than those of a traditional mortgage. Also, when a down payment is below 20%, that typically forces a lender to require private mortgage insurance that increases monthly payments. A buyer can avoid PMI with a "piggyback" mortgage that lets you take out a second mortgage to cover part of the down payment, but that method also comes with higher interest rates.
You may try to see the flexibility of adjustable-rate mortgages, which offer relatively low interest rates for five- or ten-year terms, after which the rate becomes variable. If you don't plan on holding onto a house for a long time, it's a great deal. If you're in it for the long haul, Meermann notes that "rates are likely to be higher, possibly much higher, five to ten years from now." That makes a 30-year fixed-rate mortgages a far more reasonable choice. You'll pay more interest over the life of the loan than you would for a 15- or 20-year term, but you'll also have lower mortgage payments and more cash on hand. Whatever you do, avoid paying points on a mortgage for a lower interest rate.
"If you pay interest upfront, it becomes a sunk cost that you cannot recover if you sell your home before the end of the mortgage term," Meerman says.
Also look out for interest-only mortgages that build no equity at the beginning of the loan and can turn into disaster if property values drop. Also, if it's structured so you owe a lump-sum "balloon payment" at the end of the mortgage, that can be terrible as well.
However, if you already have a mortgage and are looking for ways to make it work better for you in the new year, there are several other options. Homeowners in their late-30s and 40s who have more earning power may be tempted to pay their mortgage off early, but that could be unwise if your mortgage comes with prepayment penalties or or if you invest in diversified portfolios of 401(k) plans, Roth IRAs or 529 college savings plans.
"If the expected rate of investment return is higher than the mortgage interest, including the benefit of deducting that interest, you benefit from leverage," Meermann says.
However, a very conservative investor who is averse to debt would be better of paying off his or her mortgage than sticking money in a money-market or savings account. Also, people who can't control their spending may be better off making extra mortgage payments is a form of forced savings.
Finally, there's the opportunity to squeeze more money out of your current mortgage. If you haven't refinanced your mortgage within the past seven years and have watched rates start to rise, now is the time to take advantage. If you're refinancing a 30-year mortgage you've held 20 years, for instance, you'll probably want to refinance with a ten-year fixed-rate mortgage.
However, if you're considering taking out a home equity loan (second mortgage) or a home equity line of credit (HELOC), be incredibly cautious. TD Bank estimates that 43% of homeowners secured a home equity line of credit between 2005 and 2008 -- right around the start of the housing crisis. They did so to renovate a home (38%), consolidate debt (24 %) and purchase a new vehicle (20%). A majority (64%) took out a HELOC loan for more than $50,000.
Unfortunately for those homeowners, they're about to get a tough lesson about the HELOC draw period. During the first ten years of a HELOC, a borrower can borrow money and pay it back as they wish, with only a minimum, interest-only payment. When those ten years are up, though, that line of credit shuts down and the outstanding balance requires payments to both the principal and interest, which can draw out to as many as 20 years.
Of the folks who took out those loans between 2015 and 2018, 53% have no idea what will happen once that draw period ends. Only 19% know that their payments will go up, while only 23% have a financial plan in place for when that draw period ends.
"If borrowers do not have a financial plan for the end of their draw period they should contact their lender as early as possible," says Mike Kinane, senior vice president of home equity at TD Bank. "A responsive lender will offer multiple ways for you to pay down your line of credit."
It's certainly worth paying it down, too. Greg McBride, chief financial analyst for Bankrate.com notes that a $30,000 balance at a rate of 3.25% would require a minimum payment of $81.25 during those first ten years. However, that same $30,000 balance on a 20-year repayment schedule of principle and interest more than doubles the monthly payment to $170.16.
"It is this conversion from interest-only payments to principal and interest payments that could pose problems for unsuspecting or ill-prepared borrowers," McBride says, "particularly at a time when household budgets are still very tight and income gains have been hard to come by."
Even the TD Bank has found that homeowners are uncertain and confused about the terms and conditions of a typical HELOC. Roughly 33% of those who opened HELOCs before 2011 have no idea when their draw period ends, with Baby Boomers particularly confused at 42%. The majority (63%) of Baby Boomers know a HELOC's expiration will affect their monthly payment, compared to 9% of Millennials. Over half (55%) of Baby Boomers have no plan for what to do when their loan's draw period ends, compared to just 6% of Millennials.
This isn't great, especially with home equity making up a huge chunk of retirement savings. According to the Center for Retirement Research at Boston College recently found that Americans over the age of 65 often have more cash in their homes than in 401(k)s, IRAs or other investments. The average U.S. homeowner age 65 through 74 has $125,000 in financial assets. By comparison, those same individuals have an average of $150,000 in home equity. That disparity grows to $115,000/$160,000 between the ages of 75 and 84.
The Center also points out that roughly 30% of all income for folks ages 65 through 74 goes into utilities, taxes and upkeep on their homes. Meanwhile, the growth of home values in recent years has only given retirees more equity to work with.
"It can be tempting to view a home like a personal ATM, but if the home's value suddenly falls, it can be a bad situation," Meermann says.