If you look down the street, chances are you might see a house that has recently faced foreclosure. The last couple of years have been ripe with poor financial planning and the results have been felt throughout the country. Not only have individuals made poor choices on how to borrow and spend their money, but lenders have as well, lowering standards to a dangerous level, thus making it far too easy to receive a home loan. The result, the mortgage meltdown.

Call me an idealist, but I can’t help but wonder how many of these homes could have been saved, how many bankruptcies could have been avoided, if people had simply done their homework. As I mentioned before in my previous Alphabet Soup post on investing, half the battle in understanding any of these areas is simply learning the language. People often fail to ask questions not just because they don’t want to feel stupid, but because the don’t even know what questions to ask.

With this in mind, and in an effort to keep readers of Schaefer’s Blog well ahead of the financial education bell curve, I have singled out some common real estate terms that everyone should know. Whether you plan on buying, selling, or renting there are some terms and concepts that can benefit anyone as they walk through the process.

In knowing the language, the element of fear is greatly diminished and you will be much more confident in asking the right questions and getting the answers you need to make wise financial decisions.

With that in mind, here are five real estate terms every person should know:

Adjustable Rate Mortgage (ARM) – Yes, this is the three-headed monster that you have been hearing thrown about in the news for quite sometime now. An ARM is a type of loan in which the interest rate that you pay for borrowing the money is periodically adjusted based on what market rates are doing.

The interest rate you pay is tied to an index of some kind (common ones include the Treasury 1-year Constant Maturity series (CMT), and the Cost of Funds Index (COFI)).  On top of this, you pay an additional premium, also called a margin (additional interest on top of the index rate).  The premium is fixed and will not change during the loan, but the interest rate is variable.

There are many different types of ARM’s and many have a fixed interest rate for an initial period, normally anywhere from 1 month to 5 or more years, before they begin adjusting and following the market rates.  If you see numbers in front of an ARM such as 5/1 ARM:

• The first number is how long you will have a fixed interest rate (5 years)
• The second number is how often the rate will adjust after the initial fixed period (annually)

Finally, because an ARM transfers some of the risk from the lender to the borrower you can normally receive a lower initial interest rate (and therefore monthly payment) on an ARM than you can with a traditional fixed-rate mortgage.  So, if you plan on not being in your house for very long, an ARM might be the way to go, but there are several other factors to consider.  Here are some great questions to ask taken straight from the Federal Reserve Board website:

• Is my income enough–or likely to rise enough–to cover higher mortgage payments if interest rates go up?
• Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
• How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)
• Do I plan to make any additional payments or pay the loan off early?

For more great information on ARM’s see here.

Closing Costs – also, known as “settlement costs,” they are the various expenses and fees on top of the price of the property that a buyer must pay during closing (when you sign the papers to purchase the property).  The following are some of the ordinary closing costs courtesy of REMAX of Parker, CO:

1. Loan Organization Fee: This fee is usually equal to 1% of your mortgage.
2. Discount Point(s): Each point is also 1% of your mortgage.
3. Cost of Title Search: Mandatory to ensure you are buying the property from the current owner.
4. Lender’s Title Insurance Fee
5. Survey Fee(if Applicable): The cost of surveying your property if not done already.
6. Transfer Tax: State and/or Local taxes, stamps etc. for property transfer of ownership. This fee is sometimes split among the buyers and sellers.
7. Lender’s Appraisal Fee
8. Recording Fees: Cost of turning closing documents into public records.
9. Prepaid Mortgage Insurance Premium: First payment.
10. Property Tax Escrows
11. Lawyer’s or escrow company’s fee

Earnest Money – money that a buyer gives accompanying an offer on a property to show that they are serious about making the purchase.  The amount varies from state to state (generally 1-3% of purchase price) and is often held in real estate broker’s trust until closing when it is then credited back to the buyer.

Equity – the difference between what a property is worth and how much the buyer still owes on it.  Basically, how much of the property you actually own.  So, if you still owe $150,000 on a $200,000 property, you have $50,000 in equity.  Equity is good…get some!

Escrow – assets (money, property, deed, etc.) put into the safekeeping of a third party until the conditions of an agreement are met.  When buying a house it is common that a,  “mortgage company establishes an escrow account to pay property tax and insurance during the term of the mortgage” (Wikipedia).  The escrow company, in a sense, acts as a savings account for a borrower in that money is deposited and used to pay interest and taxes.

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If you’ve been following my blog for the past few months you know that my family and I have spent the spring going through the process of buying our first house. Since this is a major decision I have tried to share with my readers the lessons we have learned (here and here). Now that we’ve finally found a home I wanted to look at some pitfalls for first-time home buyers. Some we narrowly avoided, others we fell right into, but they are valuable things to think about when facing this milestone. The following are 7 common first-time home buyer mistakes:

1. Don’t Ask Enough Questions – It’s often the case that people avoid asking questions when walking a path they know little about. This seems counterintuitive, but the fear of looking stupid or immature drives many first-time home buyers into making really poor decisions. Smart people ask questions.

When my wife and I decided to start the search for our first home I had my dad get me in touch with a good friend of his who had been a successful real estate agent for several decades. I spent 45 minutes on the phone with him one morning asking him every question I could think of in regards to buying a home. The knowledge I gained through this conversation was immense…not only did it help me avoid potential pitfalls, I acquired in 45 minutes what would have taken me weeks or months of reading and research to discover. ASK QUESTIONS!

2. Underestimate Additional Costs – If only the cost of buying a house was wholly represented by the sticker price, life would be so much easier. Unfortunately the purchase price is just one of many costs included in purchasing a home. Earnest money, lending fees, closing costs and home owner’s insurance are the obvious ones that come to mind, but often people fail to account for other future costs as well.

For example, the landscaping for the backyard was not included in the purchase agreement for our house so we will need additional money to put up a fence, lay sod and plant trees and shrubs. On top of this we will have to buy paint, supplies, window dressings, etc. And then comes utilities, maintenance, the list goes on and on. Because the purchase price is the most visible, first-time home buyers often unconsciously think of this as the single cost that drives their purchase decision rather than one part, albeit significant, of a much larger equation.

3. Overestimate How Much They Can Afford – I wrote a post earlier on determining how much of a house you can afford. Unfortunately, many first-time buyers either don’t take the time to really determine this or they take the largest amount that they qualify for as the amount they can afford…not necessarily true. The lender is simply using a few different formulas to determine what they feel they can safely loan you, but this doesn’t mean you can really afford this much house.

When you find the perfect house that costs a little more than you can really afford, it’s easy to think that you will just suck it up and find the money. Reality is often far less kind. The last thing you want is to be stuck with a house that is a major drain on you and your family, leaving you with the sick, heavy feeling of financial drowning. Be realistic about what you can afford and stick to it.

4. Forget About Resale – As exciting as buying your first home can be, chances are it will not be long before you are ready to sell. According to Realtor.org the average first-time home buyer only stays in their home for 4 years. Characteristics about a house that makes it uniquely perfect for you might not be as attractive to other home buyers.

For example, my wife and I don’t have school aged children, but we realized that finding a house in a great school district will be important, not for us quite yet, but for the majority of other home buyers. Things like school districts, age of house and major features like the roof, plumbing, electrical system, and type of community developing around the house and neighborhood all play important roles in resale.

5. “Tim the Tool Man” Syndrome – Home repair is much like driving…everyone considers themselves above average. The tendency of many first-time home buyers is to look for “fixer-uppers,” partly because of the reduced price and partly out of the naive romanticism of building your house with a hammer, some nails and the sweat off your brow. In home speak, “fixer-upper” normally means “money drain.”

Watch any house flipping show on television and you’ll see that remodeling a home almost always costs more, takes longer and results in far less enjoyment than owners expect. Obviously there are some that have the skills, patience and desire to take on projects like this. But, for the rest of us, put the drill back in it’s case and buy a home that requires only minor improvements.

6. Forget They’re Buying a Neighborhood – Many first-time home buyers are so excited to get into their first house that they become like a horse with blinders, falling in love with a house, but failing to see the terrible neighborhood surrounding it. Location is the number one driver in real estate. Having the best house in the neighborhood can actually be a terrible thing when it comes to the future value of your home.

Look for the least expensive house in a really nice neighborhood. It’s age-old advice, but true. This isn’t always a sure thing, but it definitely will get you on the right track when it comes to buying in a good location. After all, the nicest starter home on the market is worthless if your neighbor likes to keep rusted cars in his front yard and wild hyenas in the back (You laugh, but stuff like this happens, trust me).

7. Buying Before They’re Ready- Sometimes it’s a much better decision to continue renting rather than buying a home. This is hard for some people to swallow being that home ownership is often touted as the greatest single investment one can make. This is true in some cases, but all one has to do is look at the current mortgage mess and see that often times home ownership is actually a financial disaster in the making. Ramit Sethi makes some great points concerning the benefits of the recent meltdown and I must say, I agree completely.

One of the best things to happen from the real-estate bust that we’re undergoing is to make people think twice about real estate as an investment. That’s right — to actually consciously think about why they’re making the biggest purchase of their lives, rather than just buying a house because “it’s the next thing to do.”

Buying a house is exciting, fulfilling and can often times be incredibly rewarding, but it’s a decision that each person must make for themselves. It should be researched and discussed thoroughly, not jumped into because it seems like the next step in the “becoming an adult” process.

What mistakes have you made in this area? What would you differently if you could purchase your first home again? Comment below with your answers.

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For those of you just joining the “Buying a House in 2008″ series, I have recently been going through the process of purchasing a house for my wife, daughter and myself. It is our first house so instead of hoarding all of our newly acquired knowledge it made sense to share the lessons I have learned with the readers of Schaefer’s Blog, many of whom I know are getting ready to purchase their first homes soon as well.

The point of Schaefer’s Blog is to share lessons in skilled living. Since buying a house is the single largest purchase most of us will ever make, knowing how to do it well is a great skill to have. A couple weeks ago I wrote about what I had learned in determining how much of a house you can afford. Today, I present a quick and dirty guide to the most common types of home loans and the pros and cons of each.

A home loan, also called “mortgage” is simply the money you get from a bank or lender to bridge the gap between the amount of money you can pay for the house and the amount the house actually costs. There are endless types of mortgages from the basic to exotic. Much of the current mortgage crisis has to do with people choosing unusual home loans that they didn’t really understand or couldn’t afford. The loans I cover are the basics, by no means a comprehensive guide, but a good starting place for those looking to finance a home purchase.

VA Loan – I throw this in because I’m in the military as are many of my friends. The VA (Veteran’s Affairs) loan is designed for qualified veterans, reservists and active-duty members and their eligible spouses. Many lenders like USAA make this option available and the benefits can be quite helpful. Here’s the official site.

Pros: No down payment needed to qualify and no mortgage insurance premiums. Also, the government limits the closing costs and origination fees lenders can charge.

Cons: VA loans have a funding fee, typically around 2% (can be lower if borrower puts 5% down). The maximum amount guaranteed by a VA loan is $240,000. While this is enough for many, in more expensive parts of the country it may not be enough.

Who Should Consider It: Any military member or spouse that qualifies who does not have money to put down on a house, or wants to use that money elsewhere and will be able to purchase their home without going over the $240,000 maximum.

Fixed Rate – A fixed rate mortgage is one in which the interest rate and monthly payments stay the same for the entire term of the loan. The most common terms are 30 years and 15 years, but many others also exist.

Pros: You never have to worry about your interest rate going up unexpectedly or your monthly payment changing in any way. No matter what the markets are doing your rate is locked in so you have peace of mind.

Cons: Peace of mind has a price. Interest rates on fixed rate mortgages are generally higher than the initial rates on an adjustable rate mortgage. Plus, if interest rates happen to go down significantly after locking in your rate you will lose money, either in opportunity costs or in paying the fees associated with refinancing your mortgage to get a lower interest rate.

Who Should Consider It: Anyone who like stability and is looking at living in their home for a longer period of time like 10 years or more.

Adjustable Rate (ARM) – An adjustable rate mortgage is one where the interest rate is initially fixed for a set term and is then allowed to float (follow the market rate) after the initial term is up. Every ARM has an adjustment margin which is the amount the lender adds to whatever index they follow for the market rate, so the market rate plus the margin is actually what you will end up paying in interest after the initial fixed term is up.

Pros: Lower initial monthly payments than a fixed rate mortgage.

Cons: Once the initial fixed term is up you must either refinance or risk paying higher payments if interest rates go up, both costing more money.

Who Should Consider It: Someone that plans on reselling their home within a short time after purchase. For example, if you are in the military and know that you’ll move every four years, a 5/1 ARM may make sense. The “5″ is the number of years the mortgage is fixed initially and the “1″ is the adjustment interval thereafter. A 5/1 would give you a lower monthly payment than that of a fixed rate.

Resources:
Mortgage New & Advice – Bankrate.com
Pick the Right Mortgage – Kiplinger.com
Mortgages – USAA.com
Which Mortgage is Right for You? – Interest.com
…and before you get too excited about the possibility of making loads of money off real estate check out my man Ramit Sethi’s posts on real estate…I’m not saying don’t buy a house, just don’t be stupid.

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Today marked the beginning of an exciting new adventure for the Schaefer family, buying our first house. We will be moving to Washington this summer where I will be flying C-17’s for the Air Force. We should be stationed there for at least 4 years, just long enough where buying actually makes sense.

For the past several months I have been studying home buying (trying to be one of Ramit’s other friends), reading books, blogs and asking questions to people who have some experience in the area. I’ve learned quite a bit, but realize there’s still much I don’t know. In an effort to share with my readers the info and advice that I pick up along the way, I present a new series of posts called Buying a House in 2008. The goal of this series is to share the lessons I learn as I go through the long and sometimes turbulent process of buying a house.

Figuring Out How Much You Can Afford

Trying to buy a house without knowing how much you can afford reminds me of the episode of Seinfeld where Kramer decides to see how far he can test drive a car on an empty gas tank…neither him nor the car salesman knew how far was too far. So, earlier today I decided to call up my bank and talk to someone about getting pre-approved for a loan. By doing this I would be better equipped to search for prospective properties. This call was absolutely free and did not place me under any obligations to the lender. What I learned was, aside from the basic information (estimated price range, where we’d be buying the house, etc.) the first thing the lender must determine is your debt to income ratio. This ratio shows what percentage of your income is available for a mortgage payment after all other obligations are met.

A commonly used guide is that the total amount you pay toward your mortgage should not exceed 28% of your gross income. This number is simply a rule of thumb and the percentage is often times much higher depending on circumstances. To calculate your debt to income ratio you must know your total income. This includes your salary and any other monthly payments you receive like dividends, interest, alimony or child support payments, etc. If you are married pool your spouse’s income with your own.

After adding up your annual income, divide this amount by 12 to determine your monthly income. Next multiply your monthly income by .28 which will give you the maximum monthly payment allowed for housing expenses (mortgage payment, insurance, taxes…known as PITI). The next number used by many lenders is 36%, the maximum percent of your monthly gross income the lender allows for your housing expenses plus additional recurring debt. To find this divide your monthly income by .36. As you navigate the loan process these amounts should help you understand how much you can afford and what to expect when you talk with your lender. **A note to my fellow USAFA grads that took “the loan” – this debt alone significantly effected this ratio, so be prepared.

Example:

Annual Gross Income = $50,000 / 12 = $4,167 monthly income

$4,167 Monthly Income x .28 = $1,167 allowed for housing expenses

$4,167 Monthly Income x .36 = $1,500 allowed for housing expenses plus recurring debt.

On the phone with my lender I was told that this ratio, along with a few other factors like additional liquid assets, job security and credit score help the lender determine the amount of money they are willing to loan you. This aspect of our conversation took up the first 30 minutes and was extremely informative and beneficial. The second 30 minutes included the various types of loans available to me such as VA, conventional, 5/1 ARM, etc., as well as the actual pre-approval of the loan. More on what I learned on this topic in the next post.

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Anyone who has caught a glimpse of the news over the past year has heard of the black cloud hanging over the American housing market in regard to the sub prime mortgage mess. Record numbers of home buyers defaulting on their loans has had a tremendous ripple effect on everyone from lending companies to major banks, and the U.S. real estate market has shown the strain. Prices have retreated and supply has grown as lenders have tightened down their lending policies and mass foreclosures have become common place. As the saga continues the question is whether 2008 will be the year to buy a house? This question has become personally relevant as my wife and I prepare to purchase our first home sometime next Spring depending on where the Air Force decides to send us after Pilot Training.

After a little research the answer is mixed at best. For one, as real estate agents are often fond of saying, “real estate is local.” Some markets are expected to continue their decline in 2008 at double digit rates while others, mainly those catering to vacation home buyers, may already be close to bottoming out. A recent CNNMoney.com article provided the following table listing those areas predicted to be hit worst by continuing declines in housing prices.

Secondly, the answer to whether or not to buy in ‘08 hinges on how long you plan on keeping your house after the purchase. While opinions on the time frame for a market turnaround are incredibly diverse, almost everyone agrees that in a few years the crisis should be over. Meaning, if you buy a house tomorrow, as long as you’re not trying to flip it in the next year or two, you should be fine.

Keeping these things in mind the best thing for a potential buyer to do is scout the area and put their “House-Flipping for Dummies” book at the back of the shelf for the time being. Barbara Corcoran, the real estate contributor to CNBC, MSNBC and NBC’s TODAY show explains, “Give yourself a crash course on home prices in your area by visiting the open houses of homes similar to the one you’ve got your eye on. Then, get three competitive brokers to give you a cost estimate of what the home is worth. Once you’re armed with information, you can put in an educated offer. A nice place to start is 15 percent below the asking price, if it’s properly priced, or 15 percent below what you believe the value is if it’s not.”

Here are some good sites that can also help you research the local markets by providing tons of great information on the prices of recently sold homes, for sale listing, neighborhood information, trends, etc.:

1) Zillow.com

2) Trulia.com

3) Redfin.com

As Marelize and I go on our own little journey through the world of the first-time home purchase next Spring I will be sure to keep you updated on the process.

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