Borrowing Money from your 401K when Buying a Home

The days of borrowing 100% when buying a home may be gone.  At least, if the mortgage companies have learned their lessons from the 2008 crash, they should be gone.  Many companies learned that asking for a substantial down-payment is needed to provide some incentive for the home buyers to not just turn in the keys if housing prices decline.

Borrowing 100% of home value has also proven problematic for home buyers because even a minor 5% drop in the value of a house has caused owners to be trapped in the house.  Throw in the loss of a job and a bad situation gets far worse as individuals are unable to move to a location with better employment because they cannot sell their homes in the distressed area.

While it is unpleasant to lose several thousand dollars of a down payment when real estate prices drop, at least if you’ve made a good down payment and have some equity you can sell the house and move if needed.  You can also  buy something else in the new location at a good price, possibly recovering your losses as the real estate market recovers.

Few individuals have the patience and discipline, however, to save up a big down payment, especially 20%.  (Note that a 20% down-payment should be the goal since that allows one to avoid paying PMI on top of the loan interest.)

While most people have little money in the bank, if they have been contributing regularly to their 401K accounts they may have tens of thousands of dollars stored away.   For many people, that money which has built up in their 401K accounts is tempting.   Why not take out $40,000 or so in a loan from the 401k to make a down-payment?

The issue is twofold.  First of all, one loses investment earnings from the 401K while the money is borrowed and not invested.  While this may not seem like much of a concern, given that the market has been flat for the last 10 years, one never knows when the next big bull market will begin.  If you had borrowed money for your down-payment in 1980, thinking that the economy looked sour anyway, you would have missed out on the biggest bull market of the 20th century.

The second issue is that if you lose your job or decide to quit, you must pay back the loan immediately or the loan will be counted as a withdraw, causing taxes and penalties to be due.  On a large loan this could be a significant amount.  One might therefore end up with a huge tax burden or being trapped in a bad job because it would be too costly to quit.

So, while it will take dedication and stamina, it is worth saving up the money for a down-payment.  Remember that your retirement funds are for just that – retirement.  And if you are not able to save up a down-payment, maybe the house you are looking at is out of your price range because it will be difficult to make the payments anyway.  Think about buying a smaller house and moving up in increments or cutting back your lifestyle for a while to save up the needed funds.

Have an Investing question?  Please send to vtsioriginal@yahoo.com or leave a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Right Way to Buy a House

The right way to buy a house is as follows:

1) Save up at least a 20% down payment.

2)  Take out a fixed loan with a term of no more than 15 years.

3)  Select a house with a payment of no more than 25% of your take-home pay.

Now I know that many will comments that this is not practical.  That there is no way to pay off a house in 15 years.  That no one could possibly save up a 20% down payment.  There are no nice houses that one could afford for no more than 25% of take-home pay. 

Part of the problem is expectations.  Individuals are leaving their parent’s homes, getting their first jobs, and expecting to instantly have the lifestyle that their parents enjoy.  Remember that your parents worked for many years and worked their way up the pay scale before getting that four bedroom with the bonus room in which you grew up.

Before readers start grousing and making excuses, let me say that the last few years have proven that buying a house the other way just doesn’t work.  Individuals are now trapped in houses, maybe in towns where there is no work, because they owe more on a house than it is worth and they don’t have the tens of thousands that would be required to get out of the loan.  Maybe it is time to try something different.  Let’s look at two different buyers, Doug and Dave, and see where they end up:

Doug goes out and buys the biggest house he can.  He gets a thirty-year, 80-20 loan and puts $2000 of his own money down.  The payments for the two mortgages are about 40% of his take-home pay, but he figures it is worth it. 

After getting his first job, Dave gets interested in buying a home.  Deciding it is a priority, Dave finds the cheapest apartment that is livable (maybe just renting a room in a home).  He decides to seldom eat out, keeps the electronic gadget subscriptions to a minimum, and spends some extra time at work or doing free things like hiking rather than getting the premium television channels.   After a year he takes the savings and piles up a 20% down payment for a small two bedroom place in a safe but older neighborhood.  He takes out a 15 year fixed loan with payments of 25% of his take-home pay.

Ten years pass by.  Doug has been making the big payments for a number of years, but has only paid off about 10% of the principle.  He has also started paying some larger maintenance bills (to maintain the big place) and has spent quite a bit on furnishings, yard upkeep, and other trappings to impress the neighbors.  The house has also appreciated by 20%, so he has a little bit of equity.  The air conditioner and roof are starting to wear out, so he decides to take out a home equity loan to pay for them, whiping out much of his equity.

Dave has found that his low payments let him put some extra money towards principle and also save up cash in a repair fund.  He has had to make a few repairs, but he has easily saved up enough money to pay cash for them as his salary increased and his house payment became a smaller portion of his paycheck.  He has also invested a portion of the excess and his investments have grown.  After ten years he decides to pay off the place early.  He continues to save up and invest the money he was using for making for payments.  Because he has savings and investments, he is able to pay cash for vacations and car repairs.

Ten more years pass.  Twenty years into his loan, Doug has paid off about 40% of his original loan.  He also still has the home equity loan that he seems to need to keep refinancing, taking out more cash each time to pay off credit cards, make home repairs, and take vacations.   Because of his large house payment, he never has any extra money to pay for anything that comes up.  Because of this he only has about 20% equity in the house even though he has already sent in much more than the original loan amount to the bank.  Doug also gets married and takes out a HELOC to finance the wedding and honeymoon.

Dave has also gotten married.  He used some of his savings to pay cash for the wedding and a nice honeymoon trip.  After saving the house payments for about five years after paying off his house and investing the money, he has been able to save up, including the equity in his smaller house,  enough to put a 70% down payment on a house equivalent to Doug’s house.  The extra time he was able to put in at work has also lead to his career taking off.  He is therefore able to finance the remainder on the house with a ten-year loan at only 20% of his take-home pay.

Ten more years pass.  After thirty years Doug has refinanced the original loan, rolling his home equity loan into another first loan, but still has the HELOC that he seems to keep needing to tap to pay for the various events that come up.  He has paid more than two-times the original price of his house for the original loan and the value of his house again between the home equity loan and the HELOC.  With the new loan, he has another 15 years remaining before the home will be paid off.  He has been able to save little for retirement and plans to keep on working as long as possible.  He also expects to still have the house payment in retirement.

Dave has paid off his remaining loan a few years early.  He is now putting the larger house payment and additional savings into investments.  He finds that he is able to take a nice vacation each year using the profits from his investments and expects to have about $15M in investments at retirement.

By delaying the large buy and building up from a small house, Dave is able to get the same house Doug had but pay a lot less for it.  He has also gotten the security that comes from having savings and an easily affordable house payment.  Remember that while you’re making payments, you’re paying more for something than the sticker price – often a lot more.  If you pay cash you will be paying far less because you will not be paying any money to interest – that is money you can then spend on second homes, vacations, or retirement.  Best of all, if you are able to save and you also invest as you go, you are actually paying less than sticker price out of your sweat (wages) since your investments will provide some of the cash.  If you can resist the “have it now” attitude, things will turn out far better.

An Easy Way to Save Thousands on a Mortgage

Perhaps one of the hardest things to understand is an amortization schedule.  In setting up a mortgage people talk about things like points, prepaid interest, principle payments, and other aspects.  There are companies out there that claim they can switch you to a 26 week mortgage payment (for a fee) and save you thousands.  Unfortunately, this lack of understanding makes people pay thousands more than they need to on a mortgage.

Perhaps the worst mortgage is a 30-year mortgage.  If one faithfully pays the monthly payments it will take about 20 years to reduce the balance of the mortgage by half.  The reason is that in the beginning the whole value of the house is owed, so the amount of interest that builds up each month is large – most of the payment.  As the mortgage is paid off the interest that builds up is less and less, meaning that the payment includes more and more principle – you’re paying off the house and reducing the loan balance faster.

The trick to saving thousands is to pay more at the beginning.  Making extra payments during the first few years of a mortgage will takes years off of the schedule.  Given that each year’s payments will be $10,000 or more, this would mean saving tens of thousands of dollars.  Making extra payments at the end will make little difference.

A good way to do this without a lot of math is to look at your mortgage statement and study the principal and interest that was paid during the previous month.  The amount of principal that is paid during the current month will be slightly more than the previous month.  Likewise, the amount of interest paid will be slightly less (since the total of principal and interest adds up to the payment, which is constant).  For example, assume a $1000 payment was made, of which $50 was principal and $950 was interest.  The next month the balance due would be reduced by just $50, despite the $1000 payment.  During the next month, $55 might be principal and $945 interest.

So how do you put this information to use?  If you pay an additional amount the next month equal to the principal amount from the previous month, you will be reducing your payment schedule by one month.  In our example, instead of sending in $1000, send in $1050.  By adding just $50 to your payment, you have avoided one $1000 payment.  That $50 has just saved you $1000!  When looking at things that way, it gets a lot easier to pay extra.   If you could pay an extra $1000, you would take almost 20 payments, or almost two years off of your mortgage.  This would be a savings of about $20,000!

As the mortgage starts dwindling the amount of principal paid off with each payment will increase and the interest decrease.  During the last few years your payment may be $950 in principal and just $50 in interest.  At that point extra payments make little sense since paying an extra $950 will just save you $50.  Sending extra cash to a mutual fund or stock account may make more sense when the mortagge is only a few years from being paid off.

Sadly, as with all things, you’ll probably have a bigger income near the end of your mortgage and be more able to make extra payments than at the beginning.  The same holds true with savings where the amount you invest when you are young with a low income makes a lot more of a difference than what you invest when you are old with a high income.  Luckily though, even if you are only able to send in an extra $50 per month at the start of a mortgage, it will make a big difference.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Ways to Pay off Your House Early – Part 2: How To

In the last post I talked about why it is an important part of your financial plan to pay off your house as soon as possible.  Link to Part 1:  http://smallivy.wordpress.com/2010/10/06/ways-pay-off-your-house-early-part-1-why-you-should/

Once you have paid for you house, you can direct the monthly house payment to investments, retirement, college savings, or other areas.  You can even start purchasing a vacation home that could serve as a retirement home later down the road.  There is also nothing like the security of truly owning your home since you’ll not need to worry about being foreclosed upon if you lose your job.  Remember that almost 100% of homes that are foreclosed upon have a mortgage (the others had unpaid property taxes, but that is a discussion for another day).

So how can you pay off your home in 10-15 years while everyone else is resigned to the 30-year mortgage, with multiple refinances for upgrades?  Here are some secrets:

1.  Start out with a 15 year mortgage.  Consider buying only as much house as you can afford with no more that 25% of your take-home pay going towards house payments in a 15 year fixed rate mortgage.  By doing so, you’ll get a better interest rate and save a great deal of interest.

2.  Pay an extra payment each year. Because most people are paid bi-weekly, and there are 26 2-week periods in the year, there are two months where one receives 3 checks instead of two.  In those months, one also tends to get a greater take-home amount than normal because payments for benefits are typically not removed from those checks.  If you are able to make an extra payment during those months, you can reduce the number of years to pay off a 30-year mortgage from 30 years to about 22.5 years. 

Note that because you are paying about 90% interest and only 10% principal during the first several years of a 30-year mortgage, making extra payments early makes a big difference.  Each extra payment at the beginning will remove about 10 payments from your loan.  Think about it–two extra payments in the first year will remove almost two year’s worth of payments.  Even if you can’t make a full payment, $100 extra may take off a payment or two.

3.  Save some extra payments in a separate account.  While making extra payments is great, the bank will still start foreclosure proceedings after about 3 missed payments and you’ll get a bad mark on your credit report after just one missed payment, even if you are several payments ahead.  One option to consider is to pay some extra payments, but also save some money for the mortgage in a separate savings account.  Perhaps pay one extra payment a year with the first “extra” paycheck and then save a payment from the second “extra” paycheck.

Because the time horizon is greater than five years, this money can be invested in stocks (probably mutual funds) which will provide a greater return than the interest rate on the house.  If you are more conservative, there is also nothing wrong with a one-year CD  (or five-year CD if interest rates ever pick up again).  When the amount in the account equals the remaining loan on the house, just pay it off.  In this way you can have several month’s worth of payments ready should you lose your job.

4.  The 100% Down Plan.  There is nothing that says you absolutely need to have a mortgage at all.   Without one, none of your money will be going for interest, meaning that all of your savings will  be building equity.  When you sell the house, all of your money comes with you! 

One option is to save up and buy a very cheap house (or even a used trailer) for cash.  Then start saving the money that you were paying for rent and moving up in house every five years or so, paying cash each time.  If you enjoy home improvement, you could even buy fix-up houses and repair/improve them to gain equity each time.  Yes, this is not normal, but then again most people have no money.

By starting from a smaller house and properly planning, you could have a paid-for house in your mid-forties or sooner.  That will give you great free cash flow to grow wealth and secure a sound financial future.  While everyone else is sweating to make a house payment, you’ll be sending a mortgage payment each month off into investments which will pay you interest.  Just imagine where you will be ten years after that.

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.