Volume 15, Issue 10
The Basics of Financing Your New Home
If you’re in the market for your first home or are looking to buy again after not owning for three years, Congress is providing an incentive—the $8,000 first-time homebuyer credit. If you qualify and buy a home after January 1, 2009 and before December 1, 2009, you could receive up to $8,000 that does not need to repaid if you remain in the home for three years. What’s more, interest rates are favorable, and good deals are available in many areas of the country.
Buying a home is the single largest purchase most people will ever make, and for first-time homebuyers, the financing process can seem especially confusing and complex. Here is a brief guide to help you find a mortgage that best suits your needs and financial goals.
The two basic mortgage types are fixed rate mortgages and adjustable rate mortgages (ARMs). Deciding which is right for you depends on a number of factors, including the spread between the prevailing fixed and variable mortgage rates, the length of time you expect to own your home, the current inflation rate, and the tax savings you expect to receive from the home mortgage interest deduction.
Fixed Rate Mortgages
A fixed rate mortgage is characterized by an interest rate that remains the same for the life of the loan, consistent monthly payments, and a principal that will be fully repaid at the end of the loan. The total amount of interest you will pay on a fixed rate mortgage increases with the term, which generally ranges from 15 to 30 years.
One major benefit of a fixed rate mortgage is the certainty of knowing your monthly payments will not increase over the life of the loan, even if interest rates rise. On the other hand, the chief disadvantage is that if interest rates drop, your monthly payment will not decrease. The only way you will be able to take advantage of a drop in interest rates is to refinance the loan, which may be costly.
Adjustable Rate Mortgages (ARMs)
An adjustable rate mortgage carries an interest rate that a lender can vary during the loan term. ARMs are designed to shift the risk of rising interest rates from the lender one to the borrower. To offset the increased interest rate risk, ARMs usually offer borrowers a lower rate—compared to a fixed rate mortgage—during the first year. If you are considering an ARM, you will probably encounter the following terms:
Index. An index is a benchmark used by a lender to adjust an ARM’s interest rate. Commonly used indexes include the rate on U.S. Treasury securities and the average cost of Federally-insured savings and loan funds.
Margin. Also called the “spread,” this is the amount a lender can add to the value of the index specified in the loan agreement.
Initial Rate and Adjusted Effective Rate. The initial rate is the interest rate at the start of the mortgage. It is typically lower than the amount you would owe on a fixed rate mortgage. Very low initial rates, called “teasers,” are designed to persuade you to enter into the loan.
The adjusted effective rate is the rate you pay when the adjustment kicks in. It is calculated as the value of the index specified in the loan agreement plus the margin. For example, if the index value rises to 8% and the margin is 2%, the adjusted effective rate is 10%. (The adjusted effective rate is not the same as the annual percentage rate (APR), which includes the points levied on the mortgage.)
Adjustment Period. Mortgage payments or interest rates may change every six months, annually, or every three years—according to the length of the adjustment period.
Caps. ARMs may include several kinds of caps. A payment cap limits the increase in monthly payments at each adjustment period. An interest adjustment cap limits the amount by which the interest rate can rise or fall at each adjustment period. A lifetime interest cap limits the maximum interest the lender can charge during the loan term. A lifetime payment cap limits the percentage by which principal and interest payments can increase during the loan term.
Negative Amortization. Negative amortization occurs when your mortgage payment is less than the amount necessary to cover the interest on the loan. As a result, the unpaid interest is added to the loan principal. The loan agreement may cap the amount of negative amortization allowable.
Understand Your Options
There is no “right” way to finance a home. All financing arrangements involve trade-offs. The more you know about your options, the better equipped you will be to find a mortgage that suits your needs.
Making Life’s Transitions More Manageable
Some life transitions, such as a career change or wedding, are planned. Others, such as a job loss or divorce, can be sudden and unexpected. One common thread that accompanies all transitions, however, is the concern about whether you will have enough money to maintain your lifestyle. This concern may be exacerbated by not knowing exactly when the transitional period will be complete. While the goal of finding a new job (in the case of job loss) or landing a first job in a new field (in the case of a career change) is clearly defined, it is the timing of achieving the goal that can cause a great deal of financial anxiety.
One way of dealing with this problem is to determine your financial staying power. This exercise allows you to project how far your financial resources will carry you. While there may always be some financial concerns, by knowing how much time you have before additional resources will be needed, you can better concentrate on accomplishing your goal.
The process begins by examining how much it costs to sustain your current lifestyle. To do this, you will need to review your check book and credit card receipts to find out where your money has been going. Don’t forget those cash expenditures and frequent ATM stops.
Once you have an idea of your average monthly expenses, you can compare them to the financial resources you have committed to the transition. This will include cash on hand; any reliable cash inflows, such as a spouse’s salary; investment income or rental income; alimony or child support; a severance package or unemployment compensation, if applicable; and any investment assets you can liquidate in the event of a shortfall.
After recording your current lifestyle expenses, you may project a modified spending plan. You can modify your current spending by noting areas where you can cut your budget without seriously compromising your lifestyle. Such modifications might include doing some things on a less frequent basis or seeking less expensive alternatives for some of your current habits.
Now that you have recorded the expenses of your modified spending plan, you are ready to hone your plan into a “bare bones” budget. This third level of spending reduces your cash outflows to necessities only, such as housing, food, transportation, etc.
At this point in the process, you have the information you need to decide how you will allocate your resources. You may choose to customize your plan, allowing you to continue funding your current lifestyle for a certain number of months, switch to a modified spending plan if you find that you need more time, and implement your survival budget if an unexpected obstacle prevents you from achieving your transition objective within the planned time frame.
Life changes can be challenging, but you can ease the financial pressure by planning at the outset how you will allocate your resources during the time of transition. By determining how much it will cost to get from point A to point B, you can decide whether your transition plan is financially feasible or if modifications are necessary.
Inflation and Your Insurance Coverage
When Brenda and Jake purchased their life insurance policies 20 years ago, they thought they did things the right way. They assessed their insurance needs, accounting for their home mortgage, the projected college education costs of their children, and their living expenses. Well, that was then. . . and this is now.
Recently, as they contemplated retirement, the couple reevaluated their insurance needs. They were surprised to discover that their insurance coverage was inadequate. How could this be? The answer, in a word, is inflation.
Because inflation affects purchasing power, it may also affect life insurance needs. For couples like Brenda and Jake, inflation means that life insurance coverage that was adequate years ago may now be insufficient. With this in mind, consider three of the more common uses for life insurance proceeds that may be affected by inflation:
Paying Off Your Mortgage. Like all markets, the housing market may experience upturns and downturns, but in general, home values tend to rise over time. In addition, greater employment opportunities, dual income households, and changing family dynamics have prompted many families to move or upgrade their homes. If you have recently moved, purchased a larger home, or remodeled your home, you may consider increasing your life insurance to help cover larger mortgage obligations in the event of an untimely death.
Funding Future College Expenses. If you are planning on sending your children to college, you may be concerned about the rising costs of higher education. Compared to the previous year, the average annual cost of tuition, fees, room, and board for the 2008–09 academic year increased over 5% at private and public four-year colleges (The College Board, 2009). To be prepared for these increases, be sure to factor inflation into your college savings strategies. In addition, have a contingency plan in the form of adequate life insurance to help provide protection in the event of your death. Review your plan periodically, and consider increasing your coverage to reflect the anticipated future cost of higher education.
Maintaining Your Family’s Standard of Living. Everyday costs associated with maintaining your family’s lifestyle, such as groceries, clothing, gas, family vacations, and medical expenses, are greatly affected by inflation. If your life insurance needs calculations are based on your current income and today’s cost of goods and services, your family may not have enough to cover the future costs of these expenses in the event of your death. For a comprehensive insurance strategy, include an assessment of both your current and future needs, as well as objectives, to help your family maintain their standard of living.
Determining current life insurance needs is important, but projecting how much coverage you may need in the future requires you to pay careful attention to inflation and how it can affect your lifestyle. Plan to set aside time annually to help ensure that your life insurance program is keeping up with inflation.
Updated Wills Can Contribute to a Relaxing Retirement
Whether you’re decades or months away from retirement, it’s prudent to review your will whenever there is a significant change in your family circumstances or finances. To stay current, revisit your will at least once every five years to help ensure your estate tax strategies are appropriate and your assets are distributed according to your wishes.
With a comprehensive estate plan, you can relax during retirement, knowing your financial house is in order.
Legally, you could draft a will on your own. However, it is recommended that a will be drawn up by a lawyer. Besides the inherent complexity of estate planning, states have different standards and often require specific language in order for the document to be deemed valid. At least, have your will reviewed by a lawyer so you can be assured that all statutory requirements are met.
Husbands and wives may draft their wills jointly or separately. Separate wills may help specify who owns what property. The portion of your estate covered by a will includes tangible assets, such as your home or car, and intangible assets, such as savings accounts held in your name. (Property owned jointly with right of survivorship will pass directly to the surviving owner, while other assets, such as life insurance death benefits, will automatically pass to your designated beneficiaries.)
Whenever you update your will, the new document should include the date, a statement revoking all previous wills, provisions for trusts (if any), names of guardians and alternates for minor children (if necessary), and specific bequests. A specific bequest calls for the transfer of a particular piece of property to a named beneficiary, while a general bequest does not specify from which part of an estate the property is to be taken. Be sure that the updated and signed document includes your full name, a statement that the document is a will, and the names of the executor and alternate executor.
Once you have reviewed and updated your will, you can make photocopies for yourself, members of your family, or others who may need the information. Be sure the original is kept in a secure place, such as a bank safe-deposit box or lawyer’s office. Also, make sure your family and friends know where the will is located. Once these tasks are completed, you may relax, knowing that your wishes will ultimately be fulfilled.