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The Automatic Millionaire Homeowner In Higher Priced Neighborhoods

In 2005 David Bach wrote one of the very best books ever written for first-time homebuyers. You're probably aware of the book called The Automatic Millionaire Homeowner. First-time homebuyers would do well to read this book from cover to cover. The book are some great lessons for every aspiring homeowner. I thoroughly enjoyed the book and most highly recommend it to my clients. On my web site, this is the one book listed on the site that has my highest recommendation to buy.

As good as the book is, there are definitely some additions that could be made to the book to make it more applicable for higher priced markets like San Diego. Before I cover what additions I would recommend for this valuable book, let's do a quick recap of the major (and very wise) points that David Bach makes in his book:

- Don't try to buy a dream house on your first purchase.

- Creating an automated system of paying your bills and mortgage is really the only effective way to guarantee that you'll pay down the mortgage.

- Don't stretch too much to buy your first home.

- When you buy your 2nd home and subsequent homes after that, try to hold on to your previous homes and rent them out. This is one of David's major keys to wealth building. It takes planning to purchase a property that you will someday rent out profitably.

- Use a bi-weekly payment plan to pay off your mortgage early and save a lot on interest.

- You need to adopt the proper mindset to believe that all of this is possible.

- Make sure that the money you are investing in your primary residence is a long-term commitment and not based on short-term speculation.

- Use the older, more stringent (lower) "back-end" debt ratios to determine the maximum that you should borrower.

- Whatever your debt-to-income calculation says that you can afford, knock 10% to 20% off of this. Doing so gives you an income cushion.

- If you pay off a large debt during or shortly before you become a homeowner, continue to make the same payments except directed toward the mortgage or down payment fund.

- To acquire funds for down payment, set up an automatic transfer from your paycheck into a savings account that has no ATM card or check-writing privileges attached to it.

- While gathering down payment, change your spending habits for one year. Get rid of your "Latte Factor."

- Before you look at homes, get all questions related to the future mortgage and your desired monthly payment limits and qualifying ability resolved to your satisfaction first.

- Always keep in mind that most lenders are willing to lend you more money than you should borrow.

The above points are great advice. Had the majority of homeowners who purchased over the last five years followed such advice, there would be no subprime crisis and foreclosure spike today.

Here are some ways that David's book could be updated to create Automatic Millionaire Homeowners in high-priced home markets:

- Work as hard as you can to save up a down payment. You need to do more than just automate this process. You need to automate it and then add additional to the fund every month. In a higher priced market, a 10% down payment will normally be between $25,000 and $45,000. It would be difficult to gather this sum by simply automating an allocation of some percentage of your paycheck to your down payment fund. You will have to come up with additional measures to gather the large sum. Your down payment is your cushion against property value decline. You need this in the volatile, higher-priced markets.

- Avoid purchasing in areas that have a lot of recent short sales. A spate of short sales within an area indicates that prices have recently dropped significantly in that area. Try not to buy in areas that have falling prices. Wait at least until prices have stabilized.

- Try to get the seller to buy down your interest rate. A 1% reduction in rate can reduce the total interest paid on a $400,000 loan by $20,000 in the first five years. Also, a 1% rate reduction will lower the monthly payment of a $400,000 by approximately $300. As far as monthly payment goes, it is a much better deal for the buyer if the seller buys the rate down by 1% than if the seller covers all other closing costs. The loan amount needed by the buyer is typically reduced by the amount of the closing costs that the seller covers. If a seller covers $10,000 of closing costs, the buyer's monthly payments would be reduced by approximately $50. If the seller agrees to pay to buy down the buyer's rate, a 0.5% reduction in rate will reduce the monthly payment on a $400,000 loan by approximately $150. Buying down the rate is usually a better deal for the buyer than having closing costs covered.

- Try not to borrow from your retirement fund. Question - Why did you set up a retirement fund in the first place? If you dip into your retirement fund every time you need money, how much money will you have at the time of your retirement? If you borrow from your retirement fund, this borrower money typically has to be repaid in 5 to 10 years. If you don't repay this or you get a new job, you might have to pay the IRS a 10% penalty on the borrowed money. . Do remember though that you are able to take out $10,000 from your IRA for the purchase of your first home without penalty. Set up a separate account to save up for down payment. Don't touch your retirement fund if possible.

- David Bach provides an important discussion about the changes that a typical person must make in their lifestyle to accumulate a sufficient down payment. I believe that a much more detailed discussion of budgeting is warranted. Eliminating the "Latte Factor" is one thing, but probably not enough. Only through effective, disciplined, proactive, continuous budgeting will a person save up enough for a down payment in a high priced market.

- In addition to establishing a budget and thus enforcing frugality upon one's lifestyle. a person should make efforts toward earning more money as well. There are two schools of thought regarding saving up a down payment. One school of thought proposes that the best way is to reduce expenses and direct the savings to an account that is solely dedicated to acquiring down payment. The other school of thought asks, "Instead of emphasizing reducing expenses, why not work harder to earn more money?" The is a real and finite limit to the amount of money that can be accumulated through reducing expenses. A person will always have a certain fixed level of expenses. In a high priced market, this method can take quite a long time to accumulate a 10% down payment for a $400,000 home. On the flip side, a person's ability to increase income is unlimited. Knowledge, creativity, and drive are the factors that determine how much a person can increase his or her income. I would much rather accumulate my down payment by earning a lot more than by starving a lot more. Wouldn't you?

- Don't do interest-only payments. Opt for the fully-amortized (principal and interest) payments. Interest-only payments pay no principal down. You will accumulate no equity unless the underlying home value goes up, and stays up. Many of the high priced markets might see long periods of time before prices rise again. In this situation, renting would be the better alternative for the person who cannot afford to pay any principal down. You accumulate equity by one of two ways: paying off the balance on the mortgage or through property appreciation. If you are not paying down the mortgage, the property is not appreciating, and rent for a comparable property is cheaper, you're might be better off renting. Don't buy a home unless you can afford a fully amortized, fixed loan.

- Only buy a property if you expect to live in it for at least five years. The transaction costs of purchasing a home are high enough that you don't recoup them unless you are in a home for at least five years. Appreciation is not something to count on. The higher priced markets are the most volatile and the levels of appreciation in these markets in five or even in three years will likely be completely different than what they are today. Short and medium-term appreciation is not something to count on a high priced and volatile market, no matter what a real estate agent or loan officer tries to tell you.

- One very important part of the loan process is to determine what payment you can comfortably afford. One general rule-of-thumb is that homeowners can often afford to pay up to 50% more on monthly home expenses than they were paying while renting. The tax benefit that homeowners get makes this possible. The immediate write-off of mortgage interest and property taxes will result in either a large refund at the end of the tax year or an increase of several hundred dollars of monthly take-home pay as a result of reduced income tax withholding with the employer.

- Evaluate the worst-case future loan scenarios. Only take a loan if you are sure that you can handle the worst thing that happen in the future. For example, if you are out of work for three or six months, will you wind up in foreclosure? If rates adjust two points up by the time an adjustable mortgage becomes adjustable, can you afford it? If home prices in your area drop 5 percent and you have to sell for some reason, will you wind up in foreclosure because the mortgage balance would not be covered by the sale price or your reserves? How close are you to the edge? What reserves do you have available? You'll need to answer these questions before taking on a home purchase. Most of those in foreclosure or heading toward foreclosure today did not think these issues through before they purchased.

- Avoid certain mortgage folks. You only want to deal with mortgage loan officers that have your interests in mind. Here are some red flags that tell you that you are not dealing with a loan officer that has your interests in mind:

- The loan officer is suggesting that you get into an unsafe loan like an option ARM or a short-term adjustable rate. Loan officers like this are to be avoided with no exceptions. Run for your life!
- Ask the loan officer to guarantee the non-recurring closing costs that appear on the Good Faith Estimate within $200. You'll need to get this guarantee in writing. If the loan officer won't do this, get a new loan officer.
- Ask the loan officer to provide you with the rate lock confirmation from the lender and also the initial loan approval from the underwriter. If the loan officer won't do this, get a new loan officer.
- Ask the loan officer to show you the rate sheet from which they are quoting your rate and to explain to you in very clear terms how their yield spread premium (the money that the lender pays them based upon how high of a rate they can get the borrower to take) is calculated. If the loan officer won't do this or can't do it in a way that you understand, get a new loan officer.
- Make sure the loan officer has been in business for a while.

- Get your credit squared away first. One of the very first things a potential first time home buyer should do is to obtain a copy of the credit report from each of the three credit bureaus. This should be done well in advance of the home purchase. There are often surprises on credit reports that can take a long time to correct. The credit should be squared away before applying for a mortgage.

- Do not take a subprime loan. Avoid loan officers that bill themselves as "subprime specialists." These are the loan offices that made the majority of the bad loans out there today. Subprime loans are loans that are designed for people with credit issues. You should try to get your credit in good standing before thinking about purchasing a home. A credit score that is less than optimal will rise reasonably to a good rating if all further payments are made on time. I've had clients that had 700+ FICO scores within two years of discharge from a bankruptcy.

- Don't worry about the median home price in an area. First time home buyers nearly always purchase well below the median. In San Diego, the median price is above $500,000. That really doesn't matter at all for a first time home buyer. There are an enormous number of excellent condos and house priced from $200,000 to $400,000. As a first-time home buyer specialist, I rarely ever have to obtain financing for $500,000 homes. The median home price means nothing to the first time buyer and should not in any way deter a first time buyer from exploring the process.

- Before you make an offer, get the approval of an underwriter. A mortgage broker or a direct lender can both obtain an underwriter approval prior to an offer submission. I don't like to use the words "prequalify" or "preapproval." The difference is kind of confusing to people outside of the mortgage industry. The loan officer either has an underwriter's full approval, or he or she doesn't. Ask to obtain an underwriter's approval, and then ask to see the actual approval. The approval should state the rate, type of loan, loan conditions that you and the loan officer will have to satisfy, loan terms, pre-payment penalty, and the loan officer's yield spread premium. Go over all of the loan conditions to make sure that they are realistic. You need to get all of this information in writing up front from the loan officer. If he or she won't provide this, get a new loan officer.

- David Bach states that is important that the original lender remains the service of your loan. That is one of the few points that David makes that I disagree with. It really doesn't matter at all who the servicer of your loan will be. That should not have any bearing on your home buying or mortgage decision. Most likely, your loan will be sold between servicers at some point during its life. One service may have better customer service than another, but the loans terms won't change, just who you mail the check to should change.

- There are 40 and 50-year loans out today, but what is the point? These loans were created so that people could qualify for home that they could not otherwise afford. If you cannot qualify for a home using a 30-year fixed loan with a principal and interest payment, you are probably looking at a home that you can't afford and shouldn't buy. One of the main reasons for buying your home is that you will someday own your own home free-and-clear. You'll probably never arrive there if you take on a 40 or 50-year mortgage.

- A two-year prepayment penalty is probably OK. If you are going to be in the house over the long term, you are definitely better off with a prepayment penalty because your rate will be lower as a result. If you fully expect to be in the home for a long time and are willing to take a two or three year prepayment penalty, make sure that the loan officer is passing ALL of the lower rate to you. You would need to look at the loan officers' rate sheet and have him or her explain it to you in clear terms explaining what the rate is with and without a prepayment penalty. A rate sheet is not that hard to explain. If your loan officer cannot or will not explain the rate sheet to you in a comprehendible way, get a new loan officer.

- Do your best to use a local lender. If you are a first-time homebuyer, you will need more hand-holding than the average buyer. You will likely want to meet your loan officer at some point. I've done plenty of loans that I did not ever meet the borrowers personally. However, if I were a first-time homebuyer, I would opt only for a local lender. Under no circumstances use a lender such as to help with the purchase of your first home. You definitely will not get a local lender. You will probably not even get a loan officer in your own state. Out-of-state loan officers are not subject to the department of real estate in your state. They can get away with a lot more mischief than a local loan officer could. Using an Internet lender on your first home purchase is a complete crap shoot. I have on several occasions contacted Internet lenders posing as a first-time homebuyer. In each case, I was appalled by the incorrect information and flat-out incompetence of the person who was trying to get my business. Repeat buyers who have excellent credit, lots of income and assets, and experience buying homes can often get a good deal with Internet lenders. A first-time homebuyer's situation is usually quite a bit different. A local loan expert recommended by your Realtor is the best bet.

- Speaking of Realtors, only use a Realtor to act as your buyer's agent. A person with merely a real estate license is not a Realtor and is not qualified to represent you. Your buddy who recently got his real estate license should not be your buyer's agent.

- David Bach states that the option ARM is appropriate for some buyers on their primary residences. Not a chance. No way. Never on a primary residence. Ever.

- Get in touch with a loan officer than is a specialist in first-time homebuyer programs. If you're a first-time homebuyer and your loan officer is not familiar with the first-time homebuyer assistance programs in your county, get a new loan officer. You might be leaving a lot of money on the table otherwise.

- If you set up a bi-weekly payment plan, have it set up and run by a company. Don't tell yourself that you'll make the extra payments. You won't. This is one thing that needs to be automated even though it will probably cost a few hundred dollars to set up with a company.

- If you get a bi-weekly payment plan set up, make that that you are able to make at least 3 half-month payments during any month if necessary. This event will occur once or several times during the year if you are using the bi-weekly payment plan. Make sure you have sufficient reserves to cover it when it happens.

- While you're in your new property, do what you can to make the property more attractive to renters.

- When you move out of your property and it doesn't have positive cashflow from the rental income, rent it long enough that you will be eligible to 1031 exchange it for a property elsewhere that does have positive cashflow.

- Always maintain 6 months of income as reserve in the bank. You should not buy a home if you are living on the edge financially. You need to have a little breathing room before you get yourself into a mortgage. Many people buy a home and have almost no money left in the bank after the transaction. That is not a good place to be.

- Be careful about choosing the loan offer that has a significantly lower rate and fee structure for a similar type of loan than all other loan offers. In lending, if something looks too good be true, it is.

- David Bach mentions that you should negotiate fees with the lender. With exception of the points of origination and discount that the loan officer charges, all of the other fees on a Good Faith Estimate must be paid to third parties (provided that the loan officer has not padded the Good Faith Estimate with any junk fees that do not cover any services). All of these fees do have to get paid to someone by someone. If you are negotiating fees with the loan officer, you are asking him or her to pay your fees to third parties out of his or her commission. Just like you, the loan officer has to earn a living, If the loan officer has charged you a fair price in the beginning, he or she will have to charge you a higher rate in order to have those fees covered by the bank. The higher the rate the loan officer can get you to take, the higher will be the loan officer's commission from the bank, normally called the Yield Spread Premium. If you are asking the loan officer to pay your closing costs, he or she will have to charge you a higher rate to get a larger Yield Spread Premium from the bank. A higher rate is exactly what you don't want. As a loan officer, I can tell that most loan officers establish a minimum amount that they need to make on each loan. If the borrower demands that additional closing costs be covered by the loan officer, the loan officer has to pass the charges back to the borrower by charging a higher rate. This is exactly what you, the borrower, do not want. It is definitely in your long-term best interest to get the lowest rate possible on a loan. That won't happen if you demand that the loan officer pay closing costs that will be charged by third parties.

- The previous point leads to this point. Instead of asking the loan officer to cover closing costs, try to persuade the seller to cover closing costs. If the seller will make a large profit and the home has been on the market for a long time without many offers, the seller might be willing to acquiesce and cover your closing costs. From a previous point however, remember that it is your better long-term interest to get the seller to buy your rate down and get you the lowest possible rate rather than for the seller to pay closing costs.























Copyright (c) 2006 Mark Harmon
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