Buying a Home in the Bay Area With or Without a Six Figure Income

Now that the bloom is off the predatory lending rose for this real estate cycle, it seems impossible for people in the Bay Area without a six-figure income (and challenging even for those with) to purchase their own home. 

After all with a February 2007 median sale price for single-family homes of $790K in Santa Clara County (and $870K in San Mateo County), the amount of the mortgage and its monthly payments seem insurmountable, particularly in the face of all the 1% interest subterfuge that's been going on.

I ran across an article on My Money Blog that outlines the steps Bay Area woman took to buy her own home and discusses the trade-offs she made.  She not only made sure she was in a good position to buy a house, she was also willing to make some hard decisions.

Some of the hardest decisions she had to make were in terms of her goals and financial attitude.  Here are some of the things she did right and some of the questions you should ask yourself, whether you earn six-figures or not.

1.  Setting Goals

Gum is an impulse purchase.  It's there in the checkout aisle just waiting to be pocketed for less than a handful of change.  But if you saw your dream house in the checkout aisle, do you know that you want it?  At this point in your life, is that sort of stability and control important enough where you want to take responsibility for it?

If so, why do you want to buy a house?  Is it a stepping-stone investment, or a place where you plan to live a long time and maybe start a family, or are you looking to make a better life for yourself and your family (in terms of convenience, safety, status, space, etc.)?

Knowing this information will ultimately determine how much you need in available money to buy the house you're looking for.  Based on questions like these, we can come up with a target price range and location for your housing search, figuring out how much it will cost overall and monthly.

By setting your goals upfront, you'll be able to plan ahead; and planning ahead lets you break goal into attainable pieces, then save money by focusing on what's important.

2.  Prioritizing

Should you buy the gum?  It's less than a dollar and it's not going to make a difference, right?  But think of the amount of money that goes into all the wishing wells in the country just from people throwing pennies in. 

Does that cup of Starbucks coffee a day make you as happy as the thought of getting rid of your landlord or neighbors who treat the place they live like... well, a rental?  If the goals we set in the step above are important to you, then those little decisions --- whether to get the tall, grande, venti, or empty --- become much easier! 

3.  Saving Money

The determined woman in the article cut her rent and utility bills by getting a roommate.  Not everyone as that option, especially people with families.  But there are literally millions of ways people can save money with very little effort. 

One of them is, before you buy something, ask yourself if that item is more important than buying a house.  If it is, then ask yourself if you already have a substitute lying around somewhere.  If not, try putting that money away in a savings account or other investment.  Since you were going to spend the money anyway, you're just deferring where you spend it!

There's a wide array of personal finance blogs that will help you save money.  Some of them include (in no particular order) My 1st Million at 33, Lazy Man and Money, The Digerati Life, Get Rich Slowly, and The Simple Dollar.

4.  Understanding and Discovering "Must Haves" vs. her "Nice-to-haves"

Many people know what they need but not how to get it.  Other people know what they want but forget about things so intrinsic to them that they take them for granted.  But either way, everyone has an idea of some of the things they'd like in their new place.

The best way to narrow down your list of requirements to the things you really, truly care about --- the ones you won't give up no matter what --- is to experience a variety of homes with an expert.  I've seen literally hundreds if not thousands of places and the key is not only to choose the ones that meet your list, but to nail down ones that will help differentiate your "musts" from your "nice-to-haves."

A simple story comes from a client who came to me and said, "I want a house built within the last ten years."  We talked for a while and he mentioned that his family has guests over a lot.  He lamented that his old house was noisy and that you could hear the thumping of stairs all the time. 

I setup an initial tour for him that showed him a wide range of options at his price range so that we he could get a lot of exposure without taking a lot of time.  The places included (among others) a brand new townhouse and a 50 year-old ranch.  When he saw the list, he asked, "Why are you showing me this smaller old place?"

We went to the townhouse first and I made a point to march up and down the stairs.  Thump.  Thump.  Thump. 

We then went to the ranch which was recently-renovated, including new plush carpets.  It was smaller but he noticed that the master bedroom and the guest rooms were on opposite sides of the house, a configuration usually seen more commonly in newer homes.  We went through his other criteria and the place just worked, much to his surprise given what he'd said about his requirements.

5.  Putting Money Down 

The days of 100% financing are coming to an end and common sense is returning.  After all, how much do you really value a house if you haven't put anything into it?  If your house goes down in value, but your 100% loan amount doesn't change, then you'll still owe money if you need to sell your house for some reason.  It's called being upside-down.  How much risk are you taking in not giving yourself a financial buffer using a down payment? 

The heroine in our story saved up enough for a 10% down payment, which in this day and age is quite reasonable.  And if you're old-fashioned like I am, you can sometimes get lower interest rates (plus save mortgage insurance or piggy-back interest rates) using larger down payments.

A Requiem for the Loosest Mortgage Terms

"No."  It's a simple word but one that hasn't been heard from a lot of mortgage lenders over the past few years. 

Beginning with a period of historically low interest rates set by the Federal Reserve which dovetailed into the [ed: snark alert] almost artistic creativity in developing high-margin products for people with marginal credit looking to buy a house, lenders haven't had much of a reason to use the word which must not be spoken aloud to a customer.

Altos Research writes about trouble staying in business at subprime lenders New Century Financial and Fremont General.  And another subprime darling, Novastar Financial has seen its stock do the windsheer formation.

Bad credit, no credit, no money, no problem, right?  The tide is turning...

Who Wants to Buy a Time Bomb?

Lenders really haven't had any reason to say "no" to even the riskiest of loans.  After all, most lenders don't keep these high risk loans in their own portfolios; they parlay the expected payments on that loan into cash upfront.  How?

By selling them.  They do a lot of these loans and, with the information they've learned, they know how much money each one makes on the average.  Then they slap a price tag on a bundle of these mortgages, turning them into securities which can be bought and sold.

One huge customer, Freddie Mac, is changing its buying habits starting September 1, 2007.  And that means lenders have to change the products they sell.

"Liar Loans"

Once upon a time, you needed to document your income and assets in order to get a mortgage.  While this was generally a reasonable practice, many self-employed people and folks who were mostly paid in cash had great difficulty getting credit this way.  So, the industry developed "No Income, No Asset" NINA loans (where no documentation required) and "Stated Income, Stated Assets" loans to ease this burden.

Today they're called "liar loans" for good reason and are often used to inflate the amount of a loan over what people can get with their actual incomes.  This also implies that the borrower has targeted a house he can't really afford.

The Difference Between Dangerous and Deadly

That's no problem though because the lender can get you into that house.  The option ARM they use isn't deadly because of the negative amortization or pre-payment penalty which make them only dangerous. 

They're deadly because you can be qualified for the loan based on the lowest monthly payment --- the negative amortization option where you owe more than you did the month before even if you paid the minimum balance.  So you can't actually afford the house even though you successfully receive a loan for it. 

The problem is that the reason why you qualified for the loan goes away after the initial rate expires and the rate resets causing the monthly payments to jump.  The teaser rate is so low that this rate increase is inevitable, making it a ticking time bomb.

Are Loose Mortgage Terms Dead?

That word cannot be spoken, but there is definitely a market shift.  Freddie Mac will no longer purchase NINA loans and is restricting the criteria for stated income loans.  They're developing a hybrid ARM which has a more gradual increase using longer fixed-rate periods and more time for rate resets. 

Their underwriting requirements will be strengthened as well so that these loans can only be approved if the borrower qualifies at the fully-indexed rate, equal to the benchmark rate used to set the price of the loan plus the margin the lender takes.  The bar is higher because being able to make the minimum payment isn't enough to qualify for a loan purchasable by Freddie Mac anymore.

Also, Countrywide, top dog in the U.S. mortgage lending industry, said that their wholesale business channel won't be offering any more 100% loan-to-value (LTV) ratio loans anymore.  Other major lenders like Washington Mutual are requiring at least 5% down and aren't offering piggy-back loans to cover the difference anymore.

Seriously, Are Loose Mortgage Terms Dead?

No, loose mortgage terms aren't completely dead, but then again, I'm old-fashioned.  Even as a real estate agent, I think there are times when you shouldn't buy a house and there are other times when people make it easy to lose their house. 

Folks need to be careful with how much they can afford financially and psychologically so that they're quality of life really is as good as the American Dream makes it out to be!

Mortgage Traps: How People Get Ripped-Off

People shopping around trying to get the lowest monthly payment or the best nominal interest rate often overlook some of the subtleties in mortgage terms which end up costing them a lot of money in both the short and long run. 

Image of Silicon Valley Real Estate Eye

By understanding what to look for up-front, you can not only save a lot of money, but also keep yourself from getting scammed.  Here are five common ways people get ripped-off or scammed when it comes to mortgages on their real estate.

1.  Pre-Payment Penalties

If you pay too much of your mortgage too soon, the lender doesn't make as much profit --- after all, you only pay them interest on the portion you owe.  If you owe less, you pay less.

Lenders often sneak in pre-payment penalties that help guarantee a certain level of profit.  These penalties require you to pay an extra lump sum when you pay off all or a large part of your mortgage within a specified period of time.

Your best defense against getting ripped-off on a mortgage is to avoid signing up for pre-payment penalties.  Why? 

Because even if you make a mistake and get a rate that's too expensive, discover that you need to sell your house in short order, or run into other factors beyond your control, you won't have a boat anchor tied around your legs if you need to take action.  Remember, some loans require the pre-payment penalty for any reason, including selling your house.

2.  Negative Amortization

Let's say that you owe money on your credit card.  You pay the minimum on your credit card every month, and while you know the interest is expensive, you also know that eventually --- if you don't buy anything more using that card --- you'll owe nothing. 

Now let's say that you have a negative amortization mortgage.  You make the minimum payment every month but now you owe more money than you did last month.  You make the same minimum monthly payment the next month, and you owe even more money now. 

What gives?  Well, the monthly payment your lender lets you get away with is less than what your loan actually costs you every month.  The extra money you owe every month is tacked on to the end of your loan. 

It's like owing money on your credit card but racking up more and more charges on it.  You'll never pay off the money you owe because you always owe more money.  On top of that, most negative amortization loans, in the form of "option ARMs," include pre-payment penalties to keep you locked into the loan. 

If you have one of these loans, you have the option to pay the minimum, the interest-only, or a full principal and interest payment.  Treat paying the minimum like charging your monthly mortgage payment on a credit card.

3.  Thinking About Interest Rate Instead of the APR 

The interest rate you get charged on a mortgage is only one component in how much your mortgage actually costs.  There is a list of fees that you pay in addition to the interest rate.  Because these fees are different between lenders, comparison shopping just on the interest rate doesn't accurately reflect how expensive one loan is relative to another.

The annual percentage rate (APR) totals these costs with the interest rate so that you know how much you're going to pay, including lender fees.  If there are no fees, the interest rate equals the APR.

(Speaking of no fees, when a lender advertises a "no fee" loan, it makes even more sense to compare APRs.  The money that would be paid in fees often becomes a higher interest rate.  After all, lenders want to make their money and being able to market "no fees" in their left hand is an easy way to distract people from a higher rate in the right hand.)

4.  Equity Skimming Scams

Sometimes, when people are in financial trouble and their homes are at risk, a white knight approaches with an offer: they will "take responsibility" for your mortgage, paying it while you get back on your feet.  All they ask is for a monthly rent payment and, as security on the mortgage, the deed to the home, which will be returned when the debt is paid off.  The deed is transferred to the white knight using a quitclaim deed.

The kicker is that conveying the deed to the white knight doesn't relieve the former owner of the responsibility to pay back their mortgage.  It just means that the security for the mortgage is now controlled by someone else.

A few things can happen at this point.  The former owner can become a tenant of the property or vacate the property so that it can be rented out.  If the tenant, whoever that is, doesn't pay the rent, the white knight can evict them and take possession of the property.  

If the tenant pays, the white knight can collect the rent but not use it to pay back the mortgage.  This money goes into his pockets and the house eventually goes into foreclosure, which the original owner is still on the hook for.

Equity Skimming 202 

A more advanced angle, described by the Department of Justice, talks about a property management company that approaches the same type of distressed people, folks facing foreclosure or tax liens.  They offer to buy the property at a below-market rate in return for "debt forgiveness."

What happens instead is that the scammers get the property deed in exchange for what is a lot of money to people in financial distress.  The victims are actually relieved because they can continue to live in their house (as renters) and now have a large sum of cash.

Unfortunately, the victims are still responsible for their original mortgage and the lump sum isn't enough to pay it off.  The scammers have no responsibility for that mortgage but control the deed to the house, which they now have considerable equity in because purchased it below market value.

5.  Straw Scams

You and your fiance find your dream house, but since you're just getting started on the rest life, you can't get a reasonably-priced mortgage.  But your parents have pretty good credit and a strong income, so you ask them to buy the house for you and then transfer ownership to you using a trust deed.  You promise to pay them on the mortgage that you couldn't qualify for yourselves.

That's a relatively innocent version of a straw scam.  A more sophisticated version of the straw scam requires an unethical team comprised of an agent, a knowing straw buyer, loan officer, and appraiser to attack an unknowing seller.  If you get offered well above asking price so that you can rebate it to the buyer, something's up.

Negative Equity: Heartache for Home Owners

Kenneth Harney laments in his piece published in the San Jose Mercury News that, once upon a time, people actually made "sizable" down payments on houses they bought.  The statistics he quotes are downright scary: almost 50% of all first-time home buyers financed 100% of the transaction.

That's right, half of all new home buyers put zero percent down.

How much should they have allocated as a down payment?  In a period where there seemed to be no limit to the price of single-family homes, or bounds to lending practices, it's easy to understand how people got carried away.

After all, every infomercial personality worth his salt was talking about cash-on-cash return and buying properties with no money down.

Now that we've seen the sequel to the movie "Buying on Margin" which bankrupted more than a few daytraders at the turn of the century, we need to talk about the concept of "negative equity."

Upside-Down Is Not a Fun Place to Be

Imagine selling your house and still owing money on your mortgage.  That is what it means to have negative equity: the debt you own on your property exceeds your property's value.  In industry parlance, it's called being "upside-down" and Liz Pulliam Weston at MSN Money says 1 in 10 homeowners may be in this situation!

When this happens, the normal thing to do is wait.  If you don't have to sell the property and you're still using it, then the equity value you have in the house isn't as important as your ability to live in it.

Dealing With the Short Squeeze

But if you've purchased a house with an adjustable rate mortgage (ARM), you may have a rate reset coming up that will cause your payments to increase.  If you believe they'll increase to levels you can't afford, then you can always refinance, right?

Maybe. 

There are prepayment penalties to consider which may put you in more debt if you decide to refinance.  Also, since refinancing is another test of your credit's ability to secure you a loan, your FICO score and debt-to-income ratio come back into play just as if you were figuring out how much house you could afford to begin with.

Take Action If You're There

You don't have to lose your house, but you will need to take the important steps of decreasing your debt and spending.  Get your credit back on track and read important tips on becoming more frugal.  This will allow you to save money and buy you time to get out of a bad situation.

Try reading these great sites on personal finance:

• The Digerati Life and Curly Tree's FAQ on Saving Money
• Lazy Man and Money with his links on being frugal
• The Simple Dollar
• Wise Bread, recently featured on the Carnival of Improvement

How Home Buyers and Sellers Get Trapped in Straw Scams

Let's say that you've just gotten engaged and that you and your fiancee find your dream house.  But since you're just getting started on the rest life, you can't get a reasonably-priced mortgage. 

Your parents have a pretty good credit score and a strong income, so you ask them to buy the house for you and then transfer ownership to you using a trust deed.  You promise to pay them on the mortgage that you couldn't qualify for yourselves.

Your parents are acting as a "straw" through which you are getting ownership of a house.  This scenario seems relatively innocent, but it's illegal and leaves your parents on the hook for mortgage payment responsibilities on the house you now own.  You are now a straw scammer.

There's another class of straw scammers that causes real estate bubbles all over the country and you can stop them dead in their tracks.

"They Want to Offer Me W-a-a-a-y Over Asking Price!" 

More sophisticated straw scams require a different kind of team work and at least one unknowing participant. 

I was reminded by a posting on Craigslist (no direct link because posts are only valid for a week) where a "for-sale-by-owner" home seller had been offered well over asking price if he would refund part of the difference back to the buyer.

Above-asking price offers aren't uncommon in Northern California, particularly with Bay Area and Silicon Valley real estate, but this one was more than anyone would have reasonably expected.

Taking the Deal Makes Him an Accomplice

This scenario requires an unethical team comprised of an agent, a knowing straw buyer, loan officer, and appraiser to attack an unknowing seller.

The seller is made an above-market offer which is accepted.  The difference between the market value of the property and the price agreed to is the bounty that the seller, buyer agent, buyer, loan officer and appraiser split.

The lynchpins in the deal are the knowing straw buyer and the appraiser.  The straw buyer must have credit good enough to not look suspicious purchasing --- or even applying for a mortgage on --- a house of that value.

The appraiser is critical because the appraisal report is what is used to get the deal past the lender's underwriting department.  Once the risk management folks sign off on the deal, the mortgage can fund so that all parties get paid.  The agent, buyer and loan officer obviously know what's going on and cooperate in telling a story to the seller.

For-sale-by-owner properties are good targets for this type of scam because the seller's priority is more often maximizing the value of the property than being a student of the details of real estate transactions.  An ethical listing agent will alert the seller about a possible scam.

Straw Scams Hurt Regular Folks: The Bubble

Sounds like a win for all parties, right?  Everyone in the deal gets paid and the only loser is the investor in the secondary market who bought the mortgage the straw scammer took on, and even they knew the risk in buying mortgage-backed securities.

Unfortunately, the market comparables are now skewed because of a house that sold ostensibly for a much greater amount than the market would usually bear.  Market values for houses rise artificially because preceding houses sold for so much.  And as people in the neighborhood refinance, they do so against inflated property values, often cashing-out this artificially built equity.

What Causes the House of Cards to Come Down?

Being the straw buyer often works during up-markets because they can refinance against the appreciated value of the house and take cash out of the loan.  But if they can't refinance,  the straw buyer has to walk away from the mortgage, or flee, leaving the mortgage unpaid and the house in foreclosure. 

You know from all those real estate infomercials that many foreclosed houses don't sell for at or above market value, so people banking on the equity in their homes --- or folks who cashed out on the equity --- are now in a lot of trouble.

Identity Theft Makes for Unknowing Straw Buyers

There are criminal straw buyers who know what the deal is going in. Other times the buyer is just a sucker and agrees to this deal voluntarily and may even agree to deed the house to a third party after the transaction is complete, similar to the parents in the example above.

But identity theft plays a critical role in this type of scam because it eliminates the need to meet and convince a straw buyer to take the risk of applying for and then leaving a mortgage.  It's not uncommon for mortgages to be done sight-unseen and by the time an unknowing identity-theft victim finds out about their "application," the mortgage might have already been funded.

While most of these cases are eventually resolved so that the identity theft victim is not responsible for the mortgage, please don't underestimate the amount of time and inconvenience this causes.  An event like this is a major life disruption. 

One small way you can help yourself is to slow the proliferation of your information by opting-out of pre-screened credit card offers.  It alone won't keep your identity from being stolen, but it does keep create a bottleneck for sharing your information or selling it to third-parties.

How to Lose Your House

Between the speculation and pricing madness during real estate booms, people actually buy houses so they can live long, happy lives there.  

Image of Foreclosure Life Preserver

But home buyers should know --- particularly if one of your goals in buying a house is achieving a more stable lifestyle for yourself and your family --- that losing a house is a fairly easy thing to do.  Here are five common ways people lose their houses.

1.  Start Off With Bad Mortgage Terms

Most people focus on the price they pay when they buy a house, but the reality is that the most expensive part of buying a house is the interest on the mortgage.  Even a fraction of a percentage makes a big difference on your monthly payments, and could mean tens of thousands of dollars over the life of the loan.

But just as it's easy to focus on the price of the house, it's also easy to get caught up with the interest rate on the mortgage.  The terms of the loan are what really determine how much your mortgage ends up costing you.

The interest rate isn't the rate you pay; it's one of many charges that get rolled into your Annual Percentage Rate (APR), the actual rate you pay per year.  The APR will almost always be higher than your interest rate because of added fees.

Your lender is required by the Truth-in-Lending Act to breakdown the fees and tell you what the APR is.  Please don't ignore the Truth-in-Lending disclosure --- you do so at your peril.

Key phrases you should ask about that signal potentially dangerous mortgage terms include: pre-payment penalty, partial amortization, negative amortization, option ARM, and sub-prime. 

Phrases that signal mortgages that require extra care include: teaser rate, adjustable rate mortgage (ARM as opposed to option ARM) and interest-only payments.  These are not inherently bad, but require vigilance because the rate you locked-in will change, and possibly increase significantly.

2.  "Keeping Up With The Joneses"

Sometimes people who live in expensive neighborhoods and have fancy cars aren't the ones with the most money --- they're just the ones who spend the most.  This material arms race has caused more than one person to become so riddled with debt that they hurt the successful lifestyle they were originally trying to achieve.

Buying too big a house is a fast way of digging yourself into unmaintainable debt and causing unnecessary stress on you and your family.  Financial strain leads to emotional strain and large houses often require a lot of furniture, all of which has to match the level of the house.  This leads to expensive credit card debt, which hurts your ability to pay your mortgage debt.   

And, also, while some people are tempted to buy a more expensive house than they need because of a good school district, you may be able to save money by getting a home in a less expensive neighborhood and sending your kids to quality private schools.

3.  Failing to Communicate with Your Lenders

Even if you have fallen into a bad situation and cannot pay your mortgage, you still have the opportunity to save your house.  According to John Karevoll of DataQuick, only 10% of Bay Area homeowners lose their homes in a foreclosure sale after a Notice of Default (i.e. after mortgage payments have been missed).  Most make other arrangements.

But you can't make those arrangements if you don't tell your lender what's going on.  Maybe you've had unforeseen circumstances at your job or have had large medical payments recently.  Or maybe you're having trouble making your payments because of too much debt.

While lenders might not be described as "understanding," you can negotiate with them by understanding their goals.  Lenders aren't in the business of buying and selling real estate.  If they foreclose on your property, they will probably lose money on the deal and go through a lot of inconvenience as a bonus.

Knowing this and assuming you are dealing in good faith, your lender may offer you debt consolidation, a deferred payment plan, or another solution to avoid a larger loss for them.

If you run into a situation where you cannot pay your mortgage, for any reason, do not abandon the house: read The Department of Housing and Urban Development (HUD) advice on the topic, tell your lender immediately, and enlist the advice of a reputable, non-profit credit counseling service.  Using a non-profit is organization is key because you run a very high risk of being scammed at this stage.

4.  Mess With the Government and Its Money

There's probably no more efficient way to lose your house than to fail to pay your property taxes.  The government doesn't kid around and they make sure your debt to the government takes precedence over any other debt you have.  If you cannot pay your property taxes, you need to notify the government immediately. 

Even if you think the tax bill is incorrect, The Los Angeles Times advises "Pay Property Taxes First, Dispute Later."  Separately, the San Jose Mercury News suggests keeping an impound account as a discipline to help you save money for taxes and insurance. The bottom line is that as serious as lenders may seem about getting their money, the government will almost always get its way first.

5.  Buy Too Little Insurance

Nothing causes dire financial consequences like the unexpected.  Fortunately, insurance companies make their living off preparing for unexpected financial consequences.  The challenge is that insurance is one of those services people don't want to think about because they don't want to have to use it --- which defeats its purpose.  After all, it's insurance.

But if you have a fire, or a burglary, or a flood, or an earthquake, and you are on the high-end of your debt-to-income ratio, you run the great risk of losing your house altogether because of the financial ramifications. 

Some lenders will require you to get homeowners insurance but, often, standard insurance does not cover acts of God like floods and earthquakes.  Moreover, while most policies cover your personal property (like your furniture, etc.), you need to take a strong home inventory including detailed lists and pictures, then store that inventory in a safe place or remote location. 

The Three Traps of Exotic Mortgages

Can you imagine a world where everyone had to buy a house using only cash on hand?  Very few people would own a home if the world were like that.

Lenders know this and have come up with a number of loan types (they call them products) that ostensibly help people get into their dream houses.  Some of these products, however, carry more risk to you than others.

The most notorious of these loans is the option ARM, sometimes called a "pick a payment" mortgage and it is as dangerous as it is powerful. 

Introducing the Option ARM

It's called that because the option lets you choose between three payments: (1) an obscenely low payment with a 1% interest rate, (2) a low interest-only, or no deferred-interest, payment, and (3) a standard principal and interest payment.

The ARM stands for "adjustable rate mortgage" where the interest rate is fixed for a certain period of time, say five years, and the adjusts based the on what the interest rate is at that time. 

There are three potential traps in this type of exotic mortgage. 

Trap 1: Low, Low Monthly Payment!!!

The first is the "obscenely low payment" option.  When you use this option, you pay less than the interest you owe every month. 

This difference is new debt added to the end of your loan, which you pay interest on. This is called negative amortization and it means you pay less that month but end up owning less of your house every time you use this option.

Trap 2: Don't Steal Our Profits

The second trap is the pre-payment penalty usually included in these loans.  The pre-payment penalty is the fee you pay if you want to payoff your mortgage within a certain period. 

The pre-payment penalty ensures lenders make a certain amount of money on the loan.  Most often this penalty kicks in to keep you from refinancing the loan but sometimes this penalty is enforced when you go to sell your house.

Trap 3: Surprise!  Your Monthly Payment Is Now...

The third trap is the rate reset.  Because the interest rate on ARMs is only fixed for a certain period, the rate will eventually change to the prevailing rate, which may be much higher than the previously fixed rate. 

Many unsophisticated borrowers don't negotiate a cap in the amount the rate can change and have recently been hit with large increases.

While this applies to both regular ARMs and option ARMs, the triple play of a large pre-payment penalty, negative amortization plus this costly rate reset makes it a perfect storm for financial disaster if you're not careful.

Tread Lightly

There is nothing inherently evil with this powerful tool if you know the dangers involved in using it, but these loans may significantly restrict your flexibility if you run into unforeseen events and can increase the amount of debt you owe even as you make regular monthly payments.

California Mortgage Defaults Hit 8-Year High

That's the headline from the Silicon Valley Business Journal.  The San Jose Mercury News states it more plainly as "More Californians fall behind on their mortgages."

Impact on Silicon Valley Real Estate: There's a Moral Below...

So what's the impact here in Silicon Valley?  According to John Karevoll, who works at DataQuick, the company that compiled these statistics, "None right now.  Literally none."

Why? 

Mortgages are in default when a "Notice of Default" is recorded with the county by the lender.  This usually happens after falling behind a few months on mortgage payments.

According to Karevoll, only 10% of Bay Area homeowners lose their homes in a foreclosure sale after a Notice of Default.  Most make other arrangements.

Because the number of additional homes put on the market due to foreclosure is relatively low, overall supply has remained steady and prices have remained stable. 

In fact, the homes in California least likely to go into foreclosure are in Marin, Santa Clara, and San Francisco counties.  San Mateo has good numbers as well. 

Not surprisingly, Northern California has many high-paying jobs that help account for the health of the real estate market as well as the smaller number of foreclosures.

Be Alert During the First 18 Months of Home Ownership

The moral of this story is that home owners need to be extra careful with their finances during two periods.  The first 18 months of home ownership is an especially high-risk period.

There are a lot of defaults during the first year-and-a-half because home owners often incur costs that are unexpected or not budgeted. 

• How much house can you afford financially?
• How much house can you afford psychologically?

Property taxes, maintenance, added utility bills, and the extra furniture needed to fill out a larger space often stretch finances more than planned, especially compared to renting where these bills are smaller or don't exist at all!

Be Very Alert When Your Before Your Interest Rate Resets

If you've taken out an adjustable rate mortgage (ARM), you'll need to be vigilant well before the period of your initial rate expires. 

There is nothing wrong with taking an adjustable rate mortgage, but you need to be aware that the initial rate will change, and possibly increase. 

The interest rate reset on adjustable rate mortgages can cause monthly payments to shoot up hundreds or even thousands of dollars in some cases so it's very important to estimate what that number is and speak to a mortgage professional about the advantages of refinancing at that point.

Don't Assume Your Mortgage Broker Is Out To Get You

Sometimes they may not know what they're doing either.  There's a story in the Wall Street Journal about a mortgage loan officer (and landscape designer) whose family invested in a single-family house they wanted to flip.

Image of Bear Trap

Based on the assumption they'd flip the house quickly, they put no money down and took out an 80% mortgage priced well-above market at the time (almost 7%) and a double-digit interest piggy-back loan. 

The article mentions that the market in their area has shifted towards buyers, but that's not the half of it.  My parents retired to that city and it's bleaker than it reads.

Silicon Valley North 

Home to Nike, Intel, and a new Google facility, Beaverton, Oregon (just outside Portland) is a meant to be a suburban copy of Silicon Valley with more rain and better public transportation.

A few years ago, my folks and I looked at houses where there are actually streets named after Silicon Valley cities to make their prospects feel at home.  Now, you can't throw a football around that neighborhood without hitting a "for sale" sign.

If You Fail to Plan, Plan To...

The Catch-22 situation in the Wall Street Journal article was brought about by not considering alternate exit strategies if your primary out falls through.

But the real kicker here is that this was a mortgage loan officer who got herself into the situation of taking out loans that were above market: now they can't rent the place without losing money.  (This is actually abnormal in many parts of the country!)

What to Do, What to Do?

They can't afford an agent now, so they've listed their property for sale by owner (FSBO).  To better communicate the pros and cons of FSBO, I just finished reading The For Sale by Owner Kit by Robert Irwin --- a quality book --- and will be posting a summary shortly.

The Trap: They Fell In Twice

But Robert explicitly says in his book that most FSBO's are priced too high because the owner sets the price based on what they want to get back, not what the market will bear.

The couple in the story fell into this trap by trying to sell their house at an above market price.  In the meantime, the they're trying to rent their house with a lease-option. 

A lease-option is like "renting to own" and is usually structured where a portion of the rent payments can be applied to purchasing the house at a set price. 

The couple has set the lock-in price at 5% higher than the price they can't sell the house attoday!  And on top of that, they're asking for a deposit for the privilege.  That's both legs in the bear trap.

The Moral: Plan for Contingencies

If this couple would have gotten a set of market price loans, they would have avoided this situation completely. 

The reason why they didn't plan is because they made assumptions about the market direction instead of using solid financial numbers and analysis of their goals.

You may have feelings and even some assumptions based on data about whether the market will go up or down, but when you understand your goals and your exit strategies, you can make good decisions no matter what may be going on around you. 

Also, your mortgage broker or real estate agent may be family or a friend of a friend, but you still need to look out for your best interests.

How Much House Can I Afford? (Part 2 of 2)

In Part 1, we talked about the financial half of deciding how much house you can afford.  But how happy you are after buying the house depends on how well you balance the financial of your decision with the psychological ones.

Is More Really Better?

Hugh Chou writes an excellent article, "How Much Do You Really Need to Buy?" based on the book The Millionaire Next Door, disputing the contention that more is better. 

He contends that sometimes people who live in expensive neighborhoods aren't always the ones with the most money --- they're just the ones who spend the most. 

Sometimes More is Just More

In fact, larger homes in better neighborhoods take more furniture to fill, and the level of furniture you get needs to fit the house.  And so does the landscaping, and then the car, and the clothing, and... no?

There is nothing wrong with consciously making material status your goal and understanding the ramifications, but it's a slippery slope for those who max out their credit and get a larger mortgage than they'd normally be able to afford.  

But Don't More Expensive Houses Come With Better Schools? 

The most surprising, though logical, argument Hugh makes is that people fall into the trap of buying a house more expensive than they need because they want better schools. 

While ensuring a good education for your children is both important and honorable, he suggests that you may be able to save money by getting a home in a less expensive neighborhood and sending your kids to private schools.

Financial Strain Leads to Emotional Strain 

Buying a home can be an investment decision with significant benefits but most of the times it's about your lifestyle: having a space to call your own, ensuring a stable home for you and your family, making a life.  

But your home needs to support and enhance your lifestyle, not stretch your finances and cause emotional stress.  The fact is that most couples argue over money and I've seen what buying more home than you need can do first hand when I was young.

Bottom line: Just because you can afford it doesn't mean you need to buy the biggest house your lender thinks you can afford.