Amortization - Regular payments over a specified period of time to repay a debt like a mortgage. The payments cover both principal and interest. You can request an amortization schedule from your mortgage lender or calculate your own with an online amortization calculator.
The photo in the comic was taken by Marcin Wichary.
This article was featured in the Carnival of Personal Finance hosted by Lazy Man & Money.
Photo by Stefan
Q: With housing prices dropping, we’re hoping to buying our first house. Is now a good time to buy? What do we need to do to avoid the housing crisis?
A: There are two issues here. Is it a good time for anyone to buy a house? And, is it a good time for you to buy a new house.
Generally, any time is a good time if you have the money and you plan to stick around for 5-7 years. The longer you plan to stay, the better.
Although the “housing crisis” may cause some homes to depreciate, these foreclosures are different from a natural disaster which would actually destroy homes. Instead, for every foreclosed home, “one family moves out, and another moves in,” according to economist Steven Landsburg.
Multiple foreclosures nearby could significantly affect your house’s value, so you shouldn’t count on appreciation or buy a house without a full down payment. A home should be a shelter first and an investment a distant second.
You’re buying for the right reasons. Although a house might turn out to be a good investment and some people do invest in real estate, for most of us, a house is a place to rest our head. You are much likelier to be happy if you buy a house for the purpose of shelter and you stay in it at least five years.
You can afford the house. Houses are expensive. They cost a lot up front, they cost a lot to maintain, and your mortgage payments are very much like rent payments to the bank.
Opinions differ on mortgages, but homeowners are better off when they have the full 20% down payment and the cash on hand for closing costs. A down payment reduces interest expenses and protects home owners from dropping valuations.
Taking a 15-year fixed rate mortgage will keep your true costs down, protect you from spending too much, and will give you the freedom pursue other financial dreams sooner. Unfortunately, many mortgages haunt people up to–and even beyond–retirement.
You can get a reasonable mortgage rate. Most of the housing crisis is due to “homeowners” buying houses before they were ready. If your credit score is damaged or you are carrying other debts, you should take a couple of years to aggressively pay down your debts and make a habit of paying your bills on time.
The American dream is a wonderful goal, but one that can quickly become a burden if you are trapped by debt or an aggressively rising interest rate.
You have an emergency fund. Although many people skip this step, many disasters could be avoided if people had a rainy day fund equal to 3-6 months of income. Home owners face all kinds of small to large disasters. When something breaks (and something will break), you’ll be thankful you were prepared.
Would you rent a house if you had to compensate the landlord for any depreciation during your stay? What if there was also a hefty move-in and moving-out fee?
What if the house was situated in a desirable neighborhood, contained the right amenities, and you could swing the monthly payment? Thousands of home buyers unknowingly enter this scenario when they take on a mortgage.
So how is this similar to the example? When a house is purchased, the home owner assumes new risks and responsibilities. When a mortgage is required, the risks and responsibilities are compounded. And even though we all think of the house as ours, the house really belongs to the bank until the last dollar is repaid.
So when does buying a house go from being a good decision to simply renting from the bank? This depends on three factors:
So why would anyone want to rush into a house if home ownership isn’t currently in their best interest? Home ownership has long been part of the American dream and for most people, buying a house is a highly emotional decision. Also, the mortgage industry has been very successful promoting the idea that almost anyone can afford a house right now and those who rent are throwing their money down the drain.
This ploy appeals to our emotions. No one enjoys throwing money away. Fortunately, this is not the case. Renters receive valuable benefits in exchange for rent. In addition to shelter, renters avoid: mortgages, maintenance, sharp property tax increases, and long-term commitments. These are important advantages in this age of skyrocketing property tax increases, a slowing housing market, and a mobile workforce.
Photo by Jordan
Many first time home buyers unknowingly commit themselves to excessive interest expenses by starting with their dream house. Starting with your dream house holds a lot of appeal: you get to enjoy the house now rather than later and you save on real estate agent fees on the purchase and sale of your first home. Additionally, one skirts all of the stressful unpleasantness that comes with moving and selling your home.
Unfortunately, many home owners trade thousands of dollars for this convenience. Understanding the behavior of interest on large balances will help you weigh the benefits of starting with a modest home.
Interest is a powerful force. Interest’s impact is determined by three things: time, rate, and balance. Unfortunately, at least two factors are usually against the home buyer. The amount borrowed usually is substantial, so the borrower has to stretch the loan out over many years. Often, the rate is high as well, so the borrower may need to reduce the amount borrowed or shorten the length of the loan.
Sadly, an understanding of this process is often lacking or just forgotten due to the excitement of buying a house. To make matters worse, house shoppers often increase the amount they’re willing to borrow as they encounter houses priced just above their price range. That decision will cost them dearly over the long haul.
When discussing large amounts over long periods, interest’s effects become correspondingly large. Consider the purchase of a four hundred thousand dollar home—not an uncommon occurrence along the coasts. There are three strategies a home buyer could employ to finance the purchase amount. (The example below ignores the impact of taxes and inflation.)
First, finance the entire amount. Second, purchase and pay off a starter home over fifteen years before buying the dream house. Third, purchase a starter home but make payments equal to the first option before buying the dream house.
The first option will burden the new home owners with a $2,528 mortgage payment (@ 6.5%) to the bank—totaling more than half a million dollars in interest over the life of the loan! While some buyers may be able to handle the payment, the $400,000 house will cost over $900,000 by the end of a 30 year mortgage.
Most people find these numbers truly disturbing. Fortunately, starting with a more affordable house can cut interest expenses in half.
The second option involves two changes: the amount financed and the length of the loan. When a $200,000 house is repaid over fifteen years, the payment drops by $786. After fifteen years, the more expensive house only requires another $200,000 loan. Borrowing smaller amounts has a big impact on the total interest costs—$227,000—less than half of the interest and at a lower monthly payment to boot.
For the home buyer who can handle a twenty-five hundred dollar payment, the more expensive house might still be a mistake. If a starter house is purchased, but paid off at the higher $2,528 payment, the house will be paid off in eight years and nine months, resulting in just under $62,000 paid to the bank. If the more expensive house is then bought and paid off at the same rate, the home buyer will be mortgage free after 17 1/2 years and $123,698 in interest.
This leaves the savvy homeowner in an enviable position with an extra $2,528 a month to invest. Placed in a savings account earning just 1.5% more than inflation, the balance will grow to $417,315 at the end of thirty years—just as the first home buyer is paying off his $400,000 house.
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