Ric Werme's Finances for Young Adults

For both the first (1979) and most recent (1999) houses I've bought, I've used the same "formula." I was pleased, and a little surprised, to see it still made sense despite twenty years of changes to the general economy and my own finances, marriage, etc. Here are the key items.

- Put at least 20% down

No one ever recommended this to me, but there is a huge transition in how you are treated by the bank at this point. When you put less than 20% down, the bank will require mortgage insurance (this is insurance that pays*them*if you die or can't pay), and require you escrow for property taxes. While banks now pay a "reasonable" interest, they paid virtually nothing in the past, and I suspect today's interest rates approximate those on savings accounts, i.e. virtually nothing. It's important to pay property taxes on time, by now your budgeting and investing skills make any service foisted on you by a bank a bad deal.The mortgage insurance requirement triggers other Bad Things. Coming off a bad relationship in 1984, I chose to buy a condo because I had rented out my house. I was entering a period of high income as a consulting engineer at a small company, so while my net worth at the time presented problems, I had no doubt I could keep up with the mortgage. The bank I was dealing with had been advertising "5% down" and it seemed sensible to keep some cash on hand after the closing because I was going to need a new car soon.

I nearly lost the loan even after my client wrote a nice letter referring to me as a key member of the project, my self-employed status was a big red flag to the bank. When the bank pointed out that even if they accepted me, the mortgage insurers would raise the same questions.

"So, let's skip the mortgage insurance," I suggested.

"We require that on all mortgages with less than 20% down," the banker replied.

"Okay, I'll give you 20% down."

At this point the banker began to treat me as a human instead of a Geico caveman and things progressed much better after that. He never did tell me that 20% was the threshhold where they stopped requiring a property tax escrow account, and it wasn't until a few years into the mortgage when I calculated what I was getting for interest.

"I was just reviewing my records and figure that I'm getting only 2% interest on my escrow account since the start of the loan."

"Oh no, we pay 3%."

"I checked my math a couple times, I can't tell what I'm currently receiving, but it sure looks like only 2% over the last few years."

"Oh, that includes time before the state passed legislation requiring banks to pay more."

"What did you pay before?"

"About 1%."

I had asked at closing what the interest rate was and the bank's people didn't know. Nor did they offer the possibility of not having the escrow account. I was so glad when the bank eventually failed and got absorbed into another on. At the time, we were in a period of high inflation and interest rates, the mortgage rate was 13.54%, so the escrow rate was completely unjustifiable.

That was a longer aside than I meant, but do remember to understand every expense or financial commitment associated with buying a house. I won't list everything here, there are plenty of good sources. Don't get me started about the title insurance racket.

- Points are evil

Points confused me for a while until someone told me he thinks of them as a bribe you pay to the lender to get a lower rate. You may also hear lenders explain them as pre-paid interest. This is because they want you to think it's a feature. If we stick with the pre-paid interest definition and note it reduces the interest for the life of the mortgage, then it's safe to assume that points reflect interest that would be paid over the entire life of the mortgage. However, it's almost certain you'll sell the house (or refinance the mortgage) instead of holding the mortgage for the entire term. If so, the lender wins free money.Many times the money to pay for the points comes from cash that would have been part of the down payment. So you wind up with a bigger mortgage and will have a bigger payoff when you refinance or sell the house.

I figure that mortgage choices are so bewildering that ignoring all options that includes points simplifies the task and nearly certainly saves me money. Bzzt. It looks like I'm wrong on that. The Mortgage Professorshows that the money spent on points can be repaid in just a few years. Ah well, it still seems like an uncessary complication.

- Aim for a 20 year term

Today's low interest rates muddy the water a quite a bit, but check out the monthly principal and interest amounts for any mortgage you consider. For a 30 year mortgage, the initial payment is nearly all interest. The little bit left over will oh-so-very slowly reduce the remaining balance, so expect to be paying mostly interest for a very long time. For a 20 year mortgage, almost the same situation holds true. If you look at a 15 year mortgage, then you start paying much more principal and the monthly cost jumps substantially.If you conclude you can pay a 30 year mortgage but can't pay a 20 year mortgage, it might be worth scrounging enough cash to raise the down payment and take out a smaller 20 year mortgage that has a monthly bill equal to the 30 year term. That's easier said than done, so a good fallback position is to take a 30 year mortgage but try to pay it off at 20 year rates. If there is just a small difference between the 20 and 30 year rates, it's the way to go.

When you look into mortgages, you'll see options like variable rates, 5% down, 40 year terms, even interest-only mortgages. If you look at the newspapers, you'll see stories about the recent increases in the mortgage default rates and people who are stuck in large houses they can't sell because the proceeds from the sale won't pay off the mortgage.

While it may take you extra years to be able to afford 20% down, and you could lose it if the local economy falters and you have to move to find employment, at least that option will be available to you. If you have several years of paying off a 20 year mortgage, you'll have even more of a financial cushion.

Some of the people facing trouble now took out mortgages that they expected to cost more some day, and that's today. When I bought my first house, inflation was so high that I could make a case for a "negative amortization" mortgage where the initial payment rate wouldn't cover all the interest. Each year, the payment rate would go up, funded by inflation and merit pay increases. Today's low inflation make that sort of loan infeasible, and even the interest-only loans are quite risky, especially to buyers who can't expect substantial salary increases. Many of the people who took out those loans expected the worst outcome would be having to sell the house for a big profit and downsize. Never, ever believe anyone who says real estate prices only go up!

Don't rule out variable rate mortgages. If you are unlikely to have your mortgage for more than five years, a variable rate mortgage with a initial fixed five year term is just as good as a fixed rate mortgage. Plus you'll have five years of watching the economy and can plan what to do if the rate goes up. (It probably will, the initial rate is often less than the "target" rate is.) If inflation forces rates up, your salary should go up as well, so it may not be a problem to meet the higher payment. However, you must keep in mind that the payment increase will be a lot more than a year's inflation increase. If the rate goes from 5% to 6%, the monthly interest you'll pay will go up by 20%. The principal will actually go down a little, but that will have little effect. Be prepared! Variable rate mortgages should have a cap on what the mortgage rate can rise to. Otherwise, rate could rise to a little more than the "prime rate" set by the Federal bank. At the end of 1980 it was 21.5%, a rate you don't want to pay.

Consider what a mortgage is to a lender - it's a loan with some rate of return. It's really not that different to bond, it's just that the return comes from you, not a business, school, or town. Just as there's a market for bonds, there's a market for mortgages. Don't be surprised if you get a letter from your lender saying that your mortgage has been sold to some entity you never heard of and that all future payments will go through them. This has never happened to me, and for the most part I think has no significant impact on your affairs. Sometimes people have found the new lender completely intolerant of late payments or find their payment routine is not as easy as it was before. There have been enough problems so that lenders rates of selling mortgages have to be disclosed by closing time.

It may be worthwhile dealing with a local bank, or perhaps a credit union, instead of a mortgage broker, as they are the ones most likely to sell your mortgage to someone else. My current mortgage is with a credit union I joined at work, and their policy is to not sell mortgages. (Their disclosure statement says they may sell up to 10% a year, but that appears just to give them manuevering room if necessary some day.) They're really convenient, every month they transfer the payment from a savings account to the mortgage account automatically.

Of all the financial institutions out there, credit unions tend to be the most supportive of their members. A recent statement enclosure from mine touted their Second Chance Mortgage that recommend people refinance with 20% down to avoid the mortgage insurance requirement and suggests either an adjustable mortgage with the first five years fixed or one of their fixed rate mortgages. I'm impressed - they haven't even read this page yet. If they'd just discourage paying points, I'd be excited.

Let's take a closer look at mortgage lengths, rate, monthly payments, and interest with a couple small tables.

Monthly payment at various rates and terms | ||||||
---|---|---|---|---|---|---|

Rates | ||||||

Term | 3.00% | 5.00% | 7.00% | 9.00% | 10.75% | 13.54% |

10 | 965.61 | 1060.66 | 1161.08 | 1266.76 | 1363.39 | 1525.13 |

15 | 690.58 | 790.79 | 898.83 | 1014.27 | 1120.95 | 1300.98 |

20 | 554.60 | 659.96 | 775.30 | 899.73 | 1015.23 | 1210.25 |

25 | 474.21 | 584.59 | 706.78 | 839.20 | 962.09 | 1168.68 |

30 | 421.60 | 536.82 | 665.30 | 804.62 | 933.48 | 1148.56 |

35 | 384.85 | 504.69 | 638.86 | 783.99 | 917.50 | 1138.56 |

40 | 357.98 | 482.20 | 621.43 | 771.36 | 908.40 | 1133.53 |

Int-only | 250.00 | 416.67 | 583.33 | 750.00 | 895.83 | 1128.33 |

This table takes various rates and terms and provides the monthly payment for a $100,000 mortgage. The rates range from impossibly low to impossibly high, except note that I've held mortgages at the high rates. They may return! The most interesting thing about the table is how close the high rate, long term mortgages are to the interest only mortgage. The easiest way to appreciate this is to note that late in the life of a high rate mortgage you will be paying down the balance much faster than you would with mortgages featuring a lower interest rate. The high payoff rate at the end of the loan means that you must be paying off the loan more slowly at the start.

Consider the 30 year 13.54% mortgage. The first payment will include the interest (see the "interest only" payment) plus about $20 against the much bigger $100,000 loan amount. The 30 year 5.00% mortgage's first payment includes the interest plus $120 principal. Current mortgages are a lot closer to that 5.00% (our current mortgage is 5.00%) so despite the number of low down payment loans out there, at least the owners are paying down their mortgage and building home equity from (assuming stable house pricing) faster than we did during the high rate period. This makes a 30 year mortgage much more attractive than they are when rates are high.

That shift in paying off more of the loan in the early years brings some sanity to longer term mortgages. The following table gives how many years it takes to pay of the second half of a mortgage.

Years to pay off 2nd 1/2 of loan amount | ||||||
---|---|---|---|---|---|---|

Rates | ||||||

Term | 3.00% | 5.00% | 7.00% | 9.00% | 10.75% | 13.54% |

10 | 4.63 | 4.38 | 4.14 | 3.91 | 3.72 | 3.43 |

15 | 6.66 | 6.13 | 5.62 | 5.15 | 4.77 | 4.22 |

20 | 8.52 | 7.60 | 6.76 | 6.01 | 5.44 | 4.66 |

25 | 10.21 | 8.83 | 7.62 | 6.60 | 5.85 | 4.90 |

30 | 11.74 | 9.84 | 8.27 | 7.00 | 6.11 | 5.02 |

35 | 13.11 | 10.67 | 8.74 | 7.26 | 6.26 | 5.08 |

40 | 14.34 | 11.34 | 9.08 | 7.43 | 6.35 | 5.11 |

Look at the high rate mortgages - paying off the last half of the loan amount takes 4-5 years. So after 25 years of a 30 year mortgage, you're only half done! Today's low rates and better early payoffs let you reach that point a years before we could with the high rates, and you accomplish that with a much lower payment.

One side effect of the low mortgages is that more people can afford a house, and that encourages more people to sell or build new houses and encourages buyers to buy a larger houses than they could afford before. If interest rates go up quickly people may find they own a house few people can afford.

And one last thing - "mortgage" comes from the Latin for "death grip." Remembering that will help you see the mortgage process from the lender's view, and that will help you come up with terms that fit you instead of the lender.

Contact Ric Werme or return to his home page.

Last updated 2007 August 3.