August 29, 2015
How to Buy A Home, Step 6 – Funding
There are three main ways to buy a home:
- Credit (mortgage)
Most homes are purchased with a mortgage. A mortgage is a note to the bank promising to repay the loan in exchange for title to the property (in case you don’t fully repay, they’ll take your property and you’ll forfeit all payments made).
In many states, a third-party trustee is appointed to hold the title to the property, keeping it protected until all parties agree on who will receive it, and when, and under what terms. Alternatively, some states allow the mortgagee (borrower) to hold the title unless he fails to repay the mortgage, when it defaults to the bank (mortgagor).
Mortgages come in many varieties. Adjustable Rate Mortgages (ARMs) allow for variation in the annual percentage rate (APR) of the mortgage, up to a preset maximum per year and a maximum variation over the life of the loan. An ARM is great if you plan on making a sizable down payment greater than 20% and only plan on being in the home for a few years, less than 5, usually. Most ARMs are able to be refinanced, in case mortgage rates drop enough to make a lower payment part of your permanent financial picture.
Typically, a drop in mortgage rates of 1% or more make for great refinancing terms, unless you have a ton of equity in the home, in which case you will want to be careful: refinancing could begin another 30-year term.
If you refinance with more than 20% equity in your home, make sure your mortgage does not include PMI (Private Mortgage Insurance), a premium assessed to lower-equity borrowers to cover the increased risk the bank is assuming when lending to a borrower with a lower down payment. Also, refinancing from a 30-year mortgage to a 15-year mortgage when you have a large chunk of equity makes the most sense, as long as you can still make the payments as required.
Fixed Rate Mortgages (FRMs) are the most commonly used mortgage. A fixed APR is set for the life of the loan, making payments the same over the life of the loan. Even though the interest rate is set on this type of mortgage, several factors can cause the payment to increase:
- Increased property taxes
- Increased insurance premiums
- Escrow shortage
Escrow is an account opened by the mortgage company to collect and pay for items like property taxes and property insurance. They typically require two full months’ reserves, and are reviewed for shortage/surplus once a year. Adjustments are usually required to be corrected within 30 days, and can be corrected by making an additional payment to cover the shortage or by allowing your monthly payment to increase.
When possible, I recommend making up the difference immediately to keep your monthly payments the same, allowing you to continue executing your financial plan with minimal long-term disruption. This payment is usually not more than $100, so making up the difference is pretty easy for most people.
Deals financed with a mortgage require about three times the amount of paperwork, but only add about 30 minutes to the closing process (next post).
You can also buy a home with cash. The cash used to purchase real estate can be sourced from long-term investments such as 401(k) funds (though I don’t recommend cashing your retirement for a home), savings and CD accounts, stock and other equity holdings, or by selling other real estate or goods.
Part of the cash can be a gift as defined by the IRS, which makes for more paperwork but in the case your family wants to help you with your purchase, it’s worth a few extra signatures to receive the help (assuming it is actually a gift and you don’t have to repay the amount).
In the event you are buying a property with no liens or encumbrances (such as mortgages, second mortgages, etc), you may be able to trade goods and or services for the real estate.
Imagine you just sold your boat dealership in Miami and are ready to retire. The buyer of your business wanted the property where your business was located but not the inventory, and all your “going out of business” sales didn’t fully liquidate your inventory and you’re left with a couple dozen boats. If the seller is willing to trade (and there aren’t any banks involved- they tend to make things more muddy than necessary) the real estate for your boats, all is good. What’s to stop two reasonable people from making a trade of like value? As long as you are following the law, everything is good to go.
Deals can be made in much more creative ways, but these are the three most common ways of funding a real estate purchase.
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Up Next: Closing the deal on your next home purchase
Catch the whole series here.
(image courtesy of flickr user gotcredit)