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
- 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
- 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
- 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
- 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
- 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
- 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
- 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 Eloan.com 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
Copyright (c) 2006 Mark Harmon
All rights reserved
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Mark Harmon, Realtor ®
CalHFA Preferred Loan Officer
USA Realty and Loans
Brokerage Main Office
3994 Carson St.
San Diego, CA 92117