Written by Mike Summey –
For millions of people, the American Dream of owning a home became the American Nightmare when the real estate market crashed in 2007. As an investor who has since purchased many of the homes that were lost in foreclosure actions, I have had a front row seat in witnessing the problems that caused the crash and the resulting misery experienced by many of my former and now current tenants. When the market was red hot in 2005-2006 and mortgage money was available to anyone who could fog a mirror, many of my better tenants purchased homes and left the rental market. As a result, while the sales market was experiencing a boom, the rental market experienced a mini bust. I experienced the highest vacancy rates in over 40 years during that time. Following the boom, millions of people discovered that there is much more to owning a home than being able to make the payments. This is an opportune time to discuss a few of the things to consider when buying a home.
The first is how long do you plan to live in this home? Unless you plan to live there for at least five years, you might want to consider renting. The cost of selling can be quite expensive when you consider real estate commissions, closing costs and other expenses a purchaser may want the seller to cover. If you purchase a home knowing that your job or other factors may require you to move within a couple of years, it’s doubtful that the value of the property will appreciate enough to cover your cost of selling, which can leave you coming up short of what you have in the property when you sell. If you’re like most people, once you buy a home, you will spend additional money on making it have the look and feel you want. This could be replacing carpets, painting, landscaping, etc. All of which are items that add to your cost, but are not necessarily things that will increase the value of the property.
If you have been renting, you’ve only had to worry about having the income to cover your rent. Many people got in trouble when they purchased a home and got a mortgage that was equal to or very close to what they had been paying in rent. Then, when taxes, insurance, maintenance and other expenses associated with ownership kicked in, they lacked the income to pay these additional expenses. They didn’t consider the fact that the rent they were paying had these expenses factored into it. This added cost of ownership probably got as many people in trouble as any other single factor. I currently have several tenants who rented from me before buying a home only to get in over their heads financially and lose the home in foreclosure. Now they are back as tenants with their credit destroyed and the attitude, “I’m not ever going to do that again!”
Not only did tenants learn valuable lessons; financial institutions did as well. During the boom years of easy money and subprime mortgages lenders often loaned more than 100% of the appraised value of homes. Then when the market crashed and values fell, they were left holding the bag by people who either defaulted on their mortgages or simply walked away from properties on which they owed more than the properties were worth. The easy money that caused prices to escalate rapidly, coupled with the huge influx of uneducated buyers, created a perfect storm that nearly wrecked the economy. But, unless you’ve been living in a cave, you already know all this. The question is how do we prevent it from happening again?
The answer to this question may be as simple as having a little common sense, but it has often been said that common sense is a very uncommon thing. Allow me to elaborate on a few points that fall into this category. Most people are aware of the difference between wholesale and retail prices. This difference is the profit that fuels the economy and creates wealth. Many buyers never think about the fact that real estate also has a wholesale and retail value. The wholesale value of real estate is the price at which investors are willing to pay for properties in order to make a profit. I discuss in detail how investors calculate wholesale values in my Weekend Millionaire books and audio programs. Retail, on the other hand, is the price buyers are willing to pay in order to get what they WANT. The real difference between wholesale and retail in real estate comes down to emotion.
There’s certainly nothing wrong with paying retail for a home, especially if it makes you happy and you get enjoyment from the additional price you pay by living in it for years to come. If people weren’t willing to do this, there would be no need for real estate agents. What buyers need to think about is the reason why lenders want a substantial down payment from buyers who pay retail. Twenty percent down based on the appraised value was the standard for conventional mortgages for many years. Any idea where this amount came from? Think about it! It’s common sense! Putting twenty percent down on a retail purchase allowed lenders to finance an amount closer to the wholesale price of the property. By doing this, they felt comfortable because they knew that if the loan went bad and they had to foreclose, they could probably get their money back when the property sold. They were protecting themselves.
As a buyer, the twenty percent down rule is also important to you for a number of reasons. First, it requires you to be disciplined enough to save the down payment. Second, when you are invested, or as lenders like to say, you have some skin in the game, you are not likely to walk away and leave them holding the bag. But the most important reason is that in an emergency or in a real estate crash like we had in 2007, if you truly have to sell, you can probably do so for at least enough to pay off the mortgage and possibly have a few dollars left. Also, even though you may lose some or all of your equity, it can enable you to salvage your credit and keep yourself in a position to be able to buy again in the near future.
The biggest common sense item, and the one most often overlooked is the importance of maintaining adequate cash reserves. I’ve seen people put virtually all of their cash into a down payment thinking that was best because it resulted in a slightly lower payment. I’ve seen others pay extra principal each month before building up a substantial cash reserve. For those who do this, I have one simple question, have you ever tried to pay bills with dirt? Home equity is an asset that should not be escalated until the funds to do so come from excess money after you have built up adequate reserves. Keep in mind, any cash you accumulate can be paid on the mortgage at any time, but once that is done, getting the money back to cover an emergency requires remortgaging the property and this may or may not be possible and can be quite expensive.
One of the biggest arguments some people make against keeping cash reserves is the fact that the interest they earn is much lower than the interest they pay on their loan. For those people who figure it must be a good idea because they are saving more than they are earning, let me give you another way of looking at it. When you maintain enough money in liquid assets to cover three to six months of your total obligations, instead of viewing the difference between the interest you earn and the rate you pay on your mortgage as a loss, why not look at it as the premium on insurance that guarantees you will be able to pay your bills on time and cover any emergencies that may arise?
Thousands of books have been written and hundreds of audio programs have been produced on real estate investing, money management, financial planning and other money related topics, but few focus on simple common sense techniques to help ordinary people navigate the financial highway. My space here is limited, but while the few common sense suggestions I’ve included in this article may not make you rich, I hope they keep you out of trouble in the future. Many times, knowing what not to do is more important than knowing what to do.
Mike Summey is an entrepreneur, the author of several books on real estate, and is also an avid pilot and philanthropist.