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Mortgages For DummiesTM
A Reference for the Rest of Us!
By Eric Tyson and Ray Brown
Buying a home is the biggest financial deal many people will ever make. If you're about to buy your first home it pays to learn the ins-and-outs of mortgages. Structuring your mortgage properly can save you thousands or even tens of thousands of dollars over the life of the mortgage. Mortgages For DummiesTM by Eric Tyson and Ray Brown explains how mortgages work and how to get a great deal on your mortgage.
Mortgages For DummiesTM begins by asking the reader to evaluate how large of a mortgage he/she can afford. Tyson and Brown discuss budgeting, which is something many people will already know. The authors point out that in addition to covering your basic expenses, such as food and water, you must also allow for your other financial goals, such as retirement planning. Only through budgeting will you get a handle on how large of a mortgage you really can afford. Obviously, you don't want to wind up with mortgage payments you can't pay!
Lenders have separate evaluations of how much you can afford. Tyson and Brown suggest that lenders will expect your monthly housing expenses and repayment of non-housing debt to total no more than about 36% of your monthly income. And, your total housing expense probably shouldn't exceed 28% of your monthly, pretax income.
Tyson and Brown suggest not making an overly large down payment, "if it depletes your emergency financial cushion." And, don't accept a bigger mortgage than you think you can afford just because the banks say you can afford it!
If possible, you probably want at least a 20% down payment on your home. Lenders borrowing to people with less than 20% equity have found that there is an increased risk of default. Because of this, Tyson and Brown explain new homeowners with less than 20% equity in their homes will need to pay Private Mortgage Insurance (PMI). PMI can cost hundreds of dollars a year. PMI benefits the borrower, not the homeowner. Tyson and Brown suggest that as soon as you have 20% or more equity in your home, you should eliminate PMI.
Another option is to have the government insure or guarantee your loan. Mortgages For DummiesTM mentions FHA, VA, and FmHA government-guaranteed loans.
Chapter 3, Fathoming the Fundamentals, was one of my favorite chapters in Mortgages For DummiesTM. The chapter does a good job explaining the secondary loan market and the purpose of the Federal National Mortgage Association (FNMA, or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).
Mortgages For DummiesTM discusses the difference between conforming and non-conforming mortages. Tyson and Brown write: "This delicious tidbit of information can save you big bucks. Conventional mortgages that fall within Fannie Mae's and Freddie Mac's loan limits are referred to as conforming mortgages. Mortgages that exceed the maximum permissible loan amounts are either called jumbo loans or nonconforming loans. ... You pay dearly for nonconformity."
Mortgages For DummiesTM goes on to give the money-saving tip: "If you find yourself slightly over Fannie Mae's and Freddie Mac's limit, don't despair. You can either buy a slightly less expensive home or increase your cash down payment juuuuuuuust enough to bring your mortgage amount under the conforming loan limit." The "juuuuuuust enough" isn't my typo, although I probably got the number of u's wrong. It's Dummies' humor.
As with all mortgage discussions, Mortgages For DummiesTM weighs in on the question of whether 15-year or 30-year mortgages are better. (Tyson and Brown suggest adjustable rate mortgages (ARM's) for people who don't plan to stay in their homes for at least five years. They make a good argument for using an ARM in this case. As the authors note some people are just down right hateful toward ARM's. I'm probably one of those people.)
On the one hand, Tyson and Brown show you pay far more interest with a longer loan period. Tyson and Brown write: "Lenders allow more time to pay back large loans to make the monthly payments more affordable. For example, you'd spend $734 a month to repay a $100,000 loan with an 8-percent interest rate and a 30-year term. The same loan costs $956 a month with a 15-year term. Even though the 15-year loan's payment is $222 per month higher, you'd pay far less interest on it over the life of the loan:
$956/month x 180 months for a $100,000 loan repayment = $72,080 in interest over 15 years
$734/month x 360 months for a $100,000 loan repayment = $164,240 interest over 30 years.
Don't let a low monthly payment fool you into paying a lot more interest over the long haul." (Mortgages For DummiesTM).
Further, Tyson and Brown note that 15-year mortgages usually run about 1/2 percentage point lower than 30-year mortgages, which saves additional money by going with a 15-year mortgage.
On the other hand, Tyson and Brown suggest how you use the money that could be used to prepay your mortgage is also a factor. If you are putting the money into a tax-deferred 401(k), that's probably a far better option than prepaying your mortgage.
(Recall the long-term return on stocks is about 10% and, currently, mortgage rates are at 7-7.5%. My own feeling is that with rates so reasonable, there is little to lose by going with the 30-year mortgage and investing the money you would have prepaid elsewhere.)
If you are investing the money in your own business or other potentially high-return investment, you might also prefer the 30-year mortgage. And, you certainly don't want to take on a larger monthly payment than you really can afford. Meeting the payments of a 30-year mortgage is easier.
Today, Mortgages For DummiesTM Chapter 9, Refinancing Your Mortgage, will be popular. Tyson and Brown provide an example showing how quickly your refinancing will breakeven. They give us "Refinancing's Magic Formula."
Tyson and Brown write: "Just for the fun of it, assume that your present loan payment is $1,500 a month. Your friendly lender offers you a new mortgage with a lower interest rate. Your new payment would be $1,250, which would reduce your loan payment by a sweet $250 a month. However, it would cost you a grand total of $4,000 to refinance the loan."
Tyson and Brown continue: "You won't actually save the full $250 just because your monthly mortgage payment is reduced $250. That's your pre-tax saving. Because you would have less mortgage interest to deduct after refinancing, your tax write-offs would be reduced accordingly. Here's a quick way to estimate the amount you would save on an after-tax basis. Multiply the savings by your federal tax rate as we note in Table 1-1 of Chapter 1 [Table 1-1 is the standard tax rate table for individuals, 15%, 28%, etc...] and then subtract this lost tax savings from your pre-tax savings amount. If you're in the 28-percent tax bracket, for example, the pre-tax $250 slims down to $180 per month on an after-tax basis ($250 x 28% = $70 lost tax savings).
Now comes the important part. Figure the number of months to recover the refi costs.
Here's the magic formula to figure out how long it will take to break even if you refinance:
Refi cost / after-tax monthly savings = months to break-even.
Using the data in our example: $4,000 / $180 = 22.2 months. Simple." (Mortgages For DummiesTM)
Tyson and Brown explain that if you keep your home for more than 22 months, refinancing will save money. Mortgages For DummiesTM goes on to demonstrate a similar refinancing calculation to determine if paying points is a good deal or not.
Mortgages For DummiesTM doesn't formally introduce the annual percentage rate or APR, and I believe this is a critical oversight. (The book does mention APR in its glossary). So, you might be quoted 7.2% and not realize this rate doesn't take into consideration points and fees you will pay. Suppose your current mortgage rate is 8% (APR), you might quickly calculate that you save (neglecting tax effects) 8 - 7.2 = 0.8% on the principal loan amount. This would be incorrect, because your actual APR would likely be higher than 7.2% due to the added fees.
Every few pages, Mortgages For DummiesTM mentions another of Tyson's Dummy Books, Home Buying For Dummies.TM That's another resource you might want to consider.
Overall, I think reading Mortgages For DummiesTM is useful for people who are buying their first home or considering refinancing an existing home. Enough dollars at stake that you should pursue all information on the topic and become an informed consumer, even if you need to tolerate some siiiiily jokes.