This is Mortgage Secrets Episode 5

In this episode of Mortgage Secrets, we’re going to talk to you about how to buy your first house and, specifically, how to choose what kind of property to buy. This is Mortgage Secrets episode 4, and I’m John Downs.

You know, when you’re starting the process, and you’re trying to figure out what to buy or how much to spend, it can get complicated because there’s no real right answer. You can’t just say, “You make X, and therefore, you can borrow Y, so go look here.” We find, a lot of times, you have to start with… Again, it’s all about you, your goals, your ambitions, how long you’re going to be on the property, why you’re buying in the first place. Then, once you have that plan identified, you can kind of go from there.

Unfortunately, it’s not as easy to just say, “The lender said I can go up to this price point.” What I mean by that is lenders use very specific percentages of income. Usually, it makes sense or can be a little restrictive if you’re kind of in that middle America tier of the family of four making $80,000 a year with a couple of car loans and some credit card debt and student loans and things like that. Our rules become a little restrictive, right? We start and say, “Well, based on everything you told me, you can only go here,” and the conversation, actually, is a lot easier because then you just focus on what that is, and is that good enough?

But if you’re in that range where, let’s say, your income is higher or your debt is lower, it’s all about you, and that actually makes it harder. Generally speaking, lenders will say (and you can find many different investor guidelines) that your mortgage payment shouldn’t exceed 28% to 33% of your monthly income, and your total debt should not exceed, say, 43% to 45%. But again, every situation is different, so it’s not quite that easy.

So, if you’re sitting there, trying to figure out yourself and what you can afford, it’s pretty simple—figure out what you make.

Let’s just say you make $120,000, a household income of $10,000 a month to keep numbers easy. We would say that, on a conservative basis, 43% of that can be debt. Debt is future mortgage, car loans, student loans, credit cards, all that other stuff that you have to pay every month. If we take $4,300, and let’s say you have a couple of credit cards, and you pay minimum payments ($250), and you’ve got a car payment of $400, and then you’ve got another couple hundred dollars of student loan debt, well, you can comfortably go up to low $3,000-ish range in a mortgage payment. And if you start stripping out the other parts of the mortgage payment that we just went over in the prior podcast, that’s probably financing somewhere around $500,000 to $550,000 if you include taxes and insurance. That’s kind of how you would go about just doing it yourself.

Now, just because you can go to $500,000 doesn’t mean you should just go out there and spend $500,000.

It gets even more complicated when, let’s say, your income is $150,000 or $200,000, and let’s say you had no debt, no car payment, no credit cards. Does that mean you’ll go out and buy a $1.4 million house? You have to sit back and take all these other factors that we’ll get into and discuss to help you figure out what you should buy.

At least a few times a week, I’ll get this type of phone call:

“Hey, John, I’m trying to figure out what I should look at. I met with XYZ realtor, and they said you can help unpack all of this stuff. I know I want to buy a house. Everyone tells me I shouldn’t keep throwing money away and renting forever, so I want to do it. Here’s my financial situation—what should I buy?”

It takes a good, solid 20 or 30 minutes of just dialog back and forth to really figure out, well…

Why are you buying?
Is it investment-minded? Is there a strategic purpose of “I’m buying now, and I will be in this place for X number of years, in which case, I will be moving and going here?” Is it “We’re getting married and having kids, and we’re only going to be in this house until our kid is 4 because then we’re going to have a second kid, and we know we need a bigger house?” Or is it “Maybe we should plan for that bigger house right now because we want to have multiple kids in the future?”

So, you really need to take a step back and talk about life and goals, and without life and goals, you really can’t make a good decision, in my opinion. The conversations that we have with people go in so many different directions. If you talk about that person that’s thinking of raising a family, everything to the type of mortgage you choose, the duration of the fixed-rate period, whether it’s a fixer-upper or not, all of that has to speak to that plan.

The clients that are looking more at short term… “Short term” means “I’m in this house, and I will be selling it in X period of time.” “Short term” also means “I will only be living in it personally for a short-term period of time, in which case, I will want to keep it as a rental and go buy something else.

With all those scenarios, there are different thoughts and options to consider. So, if you’re going to sell the property quickly (call it 3 to 5 years), ideally, you would maybe want to look at an adjustable-rate product. If you knew for sure you were leaving, then the structure of that changes. The area in which you purchase might also change. Maybe you really need to be in that up-and-coming transitional market, where equity and values are more likely than not going to rise versus the one that’s kind just short and stable.

If you’re the person that’s thinking about living in that property short term and, in the future, trying to keep it as a rental, will you have enough money to buy the new house? A lot of people start the process, they buy it perfectly, and they totally intend on renting it, and it’s a great area for rentals, but then they don’t have any cash for the house they want to buy in the future because they put too much down on the investment. Lots of thought goes into all of this. The type of property, ultimately, needs to speak to your plan.

During some of these conversations, I’ll actually hear people revert back to the “I don’t know. I should maybe just rent.”

I couldn’t be more clear in saying that I think everyone out there should absolutely buy a house as soon as they humanly, possibly can. And even if you’re not thinking of buying a place and living in it forever, look at it from an investment standpoint.

I interviewed someone recently, a young guy thinking about getting into the mortgage business. Just through casual conversation, I said, “Tell me about life. What does it look like for you?”

He said, “Well, I live with two other roommates.”

We got to talking about how much he spends in rent, and it was kind of crazy. Think of a three-bedroom condo (of course, this is D.C., so it is a fairly expensive area). Three people renting for $1600 each.

It just made me think, “Wow, have you ever thought of maybe trying to buy a place and yet still keep those two tenants instead of everyone making your landlord rich? Maybe those two people could kind of help you out.”

In the end, he wound up speaking with family, bought a property, rented the other two bedrooms to his friends, lived virtually rent-free. It doesn’t always just have to be “I’m buying a house and living here forever” mentality. It is “I have money that could be doing something for me somewhere.” I think housing is, by far, one of the easiest and best places for people to look.

So, now that you’re at the point where you say, “OK, I get it—I want to buy, but again, I’m still confused on where, how much, and what.”

I think we always have to try to take a step back and look at life today and unpack:

Why are you buying?
Where do you want to live?
What does that area look like?
What about those areas are appealing to you? Is it the nightlife? Is it the restaurants? Is it the ease to whatever? Is it the dog walking parks?

All those things go into trying to find what to buy, but I think area is where you start—the neighborhood. In checking out neighborhoods, I think you have to check out neighborhoods at all times of day. Don’t just swing by at lunchtime and check it out and say, “It looks pretty awesome!” because I’ve had plenty of people go under contract and eventually back out, saying, “You know, I went there Friday night, and it wasn’t so sweet.” Neighborhood is important.

Once you know the neighborhood or the specific area, then you can look at the housing stock within that area. You can’t just start and say, “Condo/townhouse, single-family” because there are many areas where you’re just not going to find a townhouse, or the townhouses might be too crazy expensive, or there might just not be any condos. Everything might be single-family. Maybe it’s the structure of single-family, the age. Is it a colonial? A rambler? A one-style house? A split-foyer? There are many, many different types of houses that you could look at.

From a mortgage lender’s standpoint, we really don’t care where you buy.

We’re loaning money against a certain sale price, and that sale price happens to be a certain property. I think, with some properties, you will get unique situations. Condominiums are an example. Of course, you’re buying, basically, what’s in the walls. You open that door to the unit, and everything you see, you own. But everything outside those walls, the Homeowners Association, they own that. That’s why you pay those condo dues. Some condominiums are not well run. Some have delinquency issues. Some might have some structural issues. There are things that lenders will look at that could actually change and adjust your mortgage.

Another little side bar is, depending on the property type, that might actually affect the interest rate that you’re looking at. You won’t always find the same interest rate on, let’s say, a condominium that you would, say, on a single-family home.

Other conversations that we have would include “Do I buy something that’s brand new, or do I find some fixer-upper that I can renovate myself, or do I find something that’s really, really nasty and maybe hire a contractor to try to rebuild?”

I think each of those situations, again, goes back to the individual. As a case in point, if you went to get a construction loan, and you said to the lender, “I am going to do the work myself and be my own general contractor,” you’ll find most of them say, “Not with us!” The reason is they realize that it is so disruptive to do work on your own house because you actually have a life, and you work, and you have a day job, and to think that you’re going to go in and renovate your own house part time? It’s a challenge.

I’ve seen many people go in and say, “I’m going to buy this place. I’m going to put some sweat equity into it. I’m going to build in my own equity.” And 18 months later, we talk to those people, and they’ll say, “I just don’t have time to do it. I just wish I bought that house that was buttoned up a little better.”

I’ve had others that settled on a price and actually closed and then went out and hired general contractors and builders to do some work just to realize that the amount of money it would cost would then lead to massive appraisal issues. People that would buy a place for $500,000, maybe try to put $250,000 in it to make it a little McMansion or something, and the next thing you know, the appraiser comes in and says, “Well, you can only put in $150,000 of upgrades, not $200,000 or $300,000.”

Generally speaking, I think people need to look at their personal situation and realize “What exactly are you capable of really doing with life? And do you want to just jump in, buy something right away, be happy? Or do you want to jump in, buy something, know that you’re going to have to do some work, but plan that work out and actually do it?

Now, in the case of someone trying to do a real construction project, I will say it changes from market to market.

If you’re in a really, really hot market, the problem is, you seem to pay top dollar for almost everything. If the house is really junky, some developer is going to swoop in and use some hard money and gobble it up quick, so in order for you to win and get a construction loan, you’re kind of outbidding those people, or maybe the house is livable enough for someone else, just not for you, and they’re willing to pay a little top dollar.

I’ll tell you how construction loans work because a lot of people don’t really understand this.

Lenders always look at the equity in the completed product. If you buy a place for $500,000, and you need $300,000 to put into the house to make it right (a developer builder says you need $300,000 to put in here), that’s $800,000. The bank is actually going to take the plans and specs of that property, of what that completed thing looks like, and give it to an appraiser.

The appraiser builds a digital house and says, “If this thing was done today with all of this stuff, the exact same specifications and materials, what would it be worth?” In order for them to lend on that property, it needs to be worth at least the sum of that total, that $800,000. That’s where there’s just a lot of complication. People buy these places, and they really think, “I’m going to make it beautiful and perfect,” but that appraisal doesn’t come in, and if that appraisal doesn’t come in, that whole transaction unwinds.

Now, trying to figure out how much you should spend is hard, and it takes a lot of thought.

There are many ways that we can unpack this for people, and I’ll give you a couple. In one sense, we just sort of look at what you’re paying today, how you’re living today—meaning you’re renting somewhere, you’re paying a certain amount of money, and how does that feel? Are you saving enough money? Are you putting enough away in your 401K? Are you able to have some freedom and going out there—restaurants, vacations, all that stuff that’s important to you? How does it feel?

Some people say, “It’s a struggle!” Luckily, I say, “Well, the good thing is, even if you have the same payment on a mortgage, the tax savings alone will give you a buffer,” and again, that’s a conversation for a later point. That’s one way of doing it. “I’m living like this today; therefore, how could I live if I own this place?” That’s one good way to do it.

Another way to go about it is to try to forecast life and say, “OK, 2 years from now (or 3 or 5—whatever these numbers are), my income is going to be here. I will incur extra expenses of…” Childcare is a big one.

I have some people that will call and say, “You know, I want to buy a place, and I want a $3,000 mortgage,” and our calculation shows that they could go up to $6,000. Obviously, they don’t want a $1 million mortgage, but they have a hard time finding property at that $3,000, and when you really unpack it and say, “Where did that $3,000 come from?” For some people, it’s not well thought out.

For some people, it’s extremely thought out. The extremely though-out is someone that says, “We’re getting married. We will be having a kid. I’ve already checked into childcare, and it’s going to cost me about $1,750 a month up until the point where they get into elementary school, and it’s going to drop to $1,200. Now, of course, costs may rise over time, but I really want to buy something today and properly budget for that time.”

Of course, those same people would not want to use wage increases and things like that because that, too, is not overly predictable, but I think that’s kind of how you would have to do it. Through looking at how you live today, through forecasting life 2 to 4 years out, you can kind of back into this payment.

Once we know the payment, we then can talk about your cash.

How much cash do you have, and how much should you put down? That, ultimately, yields somewhat of a range of what this price point should look like for you. Now, I have a good video on our website, which is called “My Top Two First-Time Homebuyer Mistakes,” and I always take time to talk about these two.

One is that people just put too much cash down. They have X percent. We talked about this in the prior podcast, but “I’ve got this much money. I’m going to buy a house and use this.” We always want to make sure you have some what-if money left over and that you understand time-value of money and all that stuff, but then the other part is not buying enough house.

What we mean by that is not forecasting life. Not forecasting life means not understanding the tax saving that is going to come your way, not understanding your income situation, not understanding that some of your debts that you currently have will be gone, car payments that will go away that you’re not replacing, or credit cards that are decreasing, or student loans that are set to fold in a few years. Maybe a second income where people might be moving in together, or maybe you’re going to rent out that second bedroom.

Routinely, a few years after someone buys a place where they don’t think about all those things, they call back, and they say, “You know what? I should have bought that bigger place.” When we go back into the current market, and we talk about current rates, which are higher, and we talk about property prices that are anywhere from 15% to 25% higher, they then realize that they can’t even buy their own house today based on where their income is, so they’re kind of stuck. You really do need to think about this! Forecast life. Look 2 to 4 years out, and things will make a lot more sense.

I have a lot of clients that pick an actual payment. Again, price point is always a product of the payment you’re trying to get mixed with the cash you have to put down. You’ll hear lenders always go back to the payment because that is, ultimately, what leads to that final sale price. I have a lot of people that just look at “I’m paying rent at this right now, and therefore, I want a mortgage payment at that same amount.” Lenders will always joke, “Oh, it’s pretty cool because you’ll actually be saving money even if the payment stays the same.” I’ll explain what that means.

When you rent, you write a check, you live for 30 days. At the end of 30 days, you have to do it all over again, or you have to move. On a mortgage, you write that same check, but all the mortgage interest and the property taxes become a deduction on your tax return. It’s not quite as easy as just adding up all the interest and all the taxes, and multiplying that by your tax rate, but it’s pretty close.

So, let’s say you have a mortgage payment, and it’s $2,500 a month, and of that, $2,000 a month winds up being tax savings. That’s $24,000 a year of write-offs. If you’re in the 30% tax bracket, that’s an $8,000 refund, so it’s a lot of money. So, the question is always, “Do you take that $700 a month, and do you factor that extra money into the final payment that then, ultimately, could adjust the sale price that you look for? Or do you just take that as extra money and gravy in a cushion?” It’s totally up to you, but at least understanding that is very important.

Remember: In order to pick this price point that you should shoot for, we all, ultimately, go back to the payment.

Once we have this idea of what your monthly budget, we can then kind of figure out, with rates today mixed with your down payment, “What is that price point?”

Now, a lot of clients wind up choosing that monthly payment based on their current rental situation. I think it’s important for people to know that when you rent, you write a check, and you get to live for 30 days. At the end of 30 days, you’ve got to move, or you’ve just got to write that check again, but you walk away with nothing.

On a mortgage, you write that same check, but there are portions of that that wind up being an offset from your income on taxes. So, what I mean by that is, if you borrowed $400,000, and your mortgage rate was, say, 4%, that’s $16,000 a year of mortgage interest that becomes a write-off. That means you don’t pay taxes on that $16,000. Let’s say your property taxes were another $4,000. Well, again, that’s $20,000 total that you don’t pay taxes on. If we assume just a 25% tax rate, it’s a $5,000 refund that you would get. Again, same payment as rent, but as a homeowner, you’re actually going to get that extra $5,000 when you file taxes.

Now, of course, you could take that same $5,000 and adjust your paycheck exemptions and, ultimately, get more money back on your paychecks ($400 more per month). So, the question is, do you use that extra money to help increase, potentially, the price point that you set for yourself? Or do you just take that money, know that it’s there, and use that for some other budget purpose?

The key takeaway about trying to figure out what you should buy is you really need to look at many different factors.

You need to understand what your budget is, not just today but what it looks like in the future. Where is your income today? Where is your income in the future? How do tax savings play a role in my budget as I buy this place? It’s a deep conversation, and it takes time. It’s a conversation that we have with all of our clients, and I can’t imagine moving forward without slowing down and thinking about all of these things.

As always, if you have any questions, feel free to email us at DownsGroup@VellumMorgage or check our website at www.DownsMortgageGroup.com, and be sure to listen to Episode 6—it is about the right way to shop mortgages. I’ll even give you a big hint: getting the right mortgage is about way more than rates. See you then!

If you want to learn more about shopping for mortgage, be sure to download my companion e-book to this podcast at DownsMortgageGroup.com/shop. Or, as always, you can email me at info@DownsMortgageGroup.com. Thanks so much for joining us!