The Money Class

by Suze Orman

  Now, if all of that checks out, I then want you to do a full 360-degree inspection of your unit. Look, you are going to be living with neighbors quite near. So you better make sure you will be content amid all that closeness. Spend some time walking around the development and talk up as many residents as possible; are they effusive or complaining? You also want to do a noise check: If it’s a multilevel unit, I would ask to have someone walk around the unit above you; I personally would never go near a place where I could hear my neighbor’s every move. Same goes for any attached units nearby. Are the walls soundproof? And if you are highly sensitive to cigarette or cigar smoke, try to find out if neighbors you will be sharing ventilation systems with are smokers; in many buildings that smoke could end up wafting into your unit. And be sure to visit at a few different times, especially a weekend night. If you enjoy peace and quiet, it is better to know now if your neighbors tend to be more outgoing—and noisy—party types.

  WHERE TO COME UP WITH THE DOWN PAYMENT

  As discussed in “Stand in Your Truth,” the way to save for capital purchases is to create automated savings accounts so you can add to your dream funds every month. Set up a separate account for your down payment. The money should be kept in a stable bank or credit union account; money you expect to need within 10 years should never be invested in stocks.

  DO NOT TOUCH YOUR RETIREMENT SAVINGS

  In the past I have given first-time buyers the option of taking money out of their retirement savings for a home down payment. There is indeed a special rule that allows first-time buyers to withdraw up to $10,000 from a traditional IRA for a down payment, and be exempt from the 10% early withdrawal penalty levied when you are younger than 59½. (Though you still will owe income tax on the withdrawal.) Roth IRAs are another down payment source; you can always access money you contributed to a Roth without any tax or penalty, and first-time buyers can take $10,000 of earnings without paying the early withdrawal penalty. Income tax is only charged if the account is less than five years old.

  However, I do not subscribe to that advice anymore. Given the struggles so many of you are having saving for retirement I am going to insist that you leave every penny of your retirement money invested for retirement. If that means you need to spend a year or two saving up for a down payment, that’s the truth I am asking you to stand in. Remember, the New American Dream is not just about sensible homeownership, but about retiring with security as well.

  I also do not advocate borrowing large sums from your family for the down payment. This is primarily a lesson in personal accountability. I want you to be responsible for what likely will be your single biggest investment ever. For a 20% down payment I do not want your family chipping in more than one-quarter of that amount, or 5%. And it is your responsibility to make sure your family members are standing in their truth. They must never give you money if it compromises their own financial security.

  MAINTAIN AN EIGHT-MONTH EMERGENCY SAVINGS FUND

  In late 2010, more than 40% of unemployed Americans had been out of work for at least six months. That statistic alone should make it obvious why I insist you have ample savings set aside so you can continue to cover your mortgage and other housing costs in the event of a layoff or furlough. In fact, mortgage lenders will be looking at your savings when evaluating your application. Without at least four or five months’ worth of mortgage payments saved up you may find it hard to land a deal.

  OPT FOR A 30-YEAR FIXED-RATE MORTGAGE

  As I write this in early 2011, a 30-year fixed-rate mortgage for a well-qualified buyer is below 5%. I can’t tell you how seriously great that is. When you can lock in a low rate and you never have to worry about it changing, you must grab that deal. Yes, I know five-year and seven-year adjustable rate mortgages have even lower rates, but they also come with risk as well. Haven’t we all learned the risks that come with adjustable-rate mortgages? Many of today’s foreclosures came about because people took out adjustable mortgages during the bubble that they assumed they would be able to refinance out of before the rate adjusted. When that didn’t pan out as expected the troubles began. And given that interest rates are currently at historic lows, the trend going forward is for rates to rise, not fall. All the more reason to lock in a safe-not-sorry 30-year fixed-rate mortgage.

  TIP: Consider a 15-year mortgage if you are at least 45 years old. As I explain in the retirement chapter, I think one of the best retirement strategies is to get your mortgage paid off before you retire. So if you are purchasing a house today that you anticipate you will retire in, and retirement is within 15 to 20 years, I want you to consider taking out a 15-year mortgage. Yes, that means your monthly payments will indeed be higher, but at today’s super low interest rate—4.0% as of early 2011—a 15-year is incredibly affordable. If you have the income and savings to be able to handle the higher monthly payments you will save tens of thousands of dollars in total interest payments as well as arrive at retirement mortgage-free.

  And if you are confident you can afford the higher required payments with the 15-year loan, it is the better strategy than just settling for a 30-year mortgage that you intend to pay off in 15 years. The interest rate on a 15-year mortgage is typically about a half a percentage point lower than the rate on a 30-year loan. That helps keep your overall interest costs lower. The website Bankrate.com has a calculator that will walk you through the math of a 15-year vs. 30-year mortgage.

  UNDERSTAND THE RISK OF DISTRESSED PROPERTY

  In most parts of the country, foreclosed homes and homes that are listed as short sales account for one-quarter or more of the homes for sale. These so-called distressed properties often sell for below-market rates, but you need to be extra careful if you are considering bidding on either type.

  A short sale is when a lender agrees to let a homeowner sell a home for less than the current balance left on the mortgage. The lender is essentially agreeing to take a loss on that shortfall. As a buyer you must understand that you have two sellers in a short sale: the homeowner who is listing the home, and the lender. When you make a bid, even if the seller accepts, you then must wait to hear if the lender agrees to the terms. That can take months. And if the seller has a second mortgage on the home the process becomes even more difficult; the sale can’t go through without the approval of the second-mortgage lender, and that is not something that happens easily or quickly.

  A foreclosure is when a lender has already taken back possession of a home from a borrower. Sales of foreclosed homes can move much more quickly; once the bank puts the property on the market it is eager to make a deal. But I don’t have to tell you about all the problems rocking the foreclosure market; as I write this in early 2011 we are dealing with revelations that many lenders may have foreclosed on homes without going through the proper steps. More troubling is the concern that many lenders lack the proper documentation to prove they in fact have title (ownership) of the home. What seems most likely is that this will clog the foreclosure process for months as banks—prodded by regulations and lawsuits—will have to scramble to prove their paperwork is in place. Given the turmoil in the foreclosure market I advise you to think very long and hard and ask yourself if you are up for navigating your way through the maze. It can take months. And you must work with a real estate agent with experience in foreclosures, as well as a real estate lawyer well equipped to review all documents. You need legal proof that a title search has been conducted and that you will indeed have free and clear title to the property.

  TIP: Title Insurance on Foreclosed Homes. If you are purchasing a foreclosed home and you anticipate making sizable renovations to the property, ask your title insurer for a policy that includes a special rider that would cover not just your purchase price, but also the future value after renovations as well. In the event the foreclosure documentation mess escalates and your ownership is questioned in the future, you want to know at the very least that your title insurance policy will provide ample reimbursement for the renovated value of
your home. I recognize that there are some seriously great prices available on foreclosed properties, but I want you to be very careful if you decide to focus on foreclosed property. The buying process can be lengthy and full of pitfalls, and the current legal issues swirling around add a dose of uncertainty. Please stand in your truth: Maybe paying a slightly higher price for a home that is not a foreclosure is in fact the better deal for your family.

  LESSON 4. WHAT TO DO IF YOU ARE UNDERWATER

  The steep fall in home prices in many parts of the country means that many homeowners who purchased a home during the bubble—often with little or no down payment cushion—currently have a mortgage that is higher than the market value of their home. According to housing data firm CoreLogic, more than 20% of homes with a mortgage in the third quarter of 2010 were underwater. Arizona, California, Florida, Michigan, and Nevada have the highest concentrations of underwater homeowners.

  In this lesson I want to address separate strategies for two very different types of underwater households: those that can’t afford their mortgage and those that can. If you can’t afford your mortgage and you are in fact underwater, I want you to stand in the truth that walking away may in fact be the right and honest move for you and your family.

  If you are underwater and can still afford your home, the math and the ethical questions require a different strategy.

  IF YOU ARE UNDERWATER AND CANNOT AFFORD YOUR MORTGAGE

  I need to start this lesson by telling you what I absolutely do not want you to do, ever: You are never to touch your retirement savings to keep up with a mortgage you can no longer afford. You must respect your retirement truth as much as your housing dream: You will need to have savings to support yourself in retirement. Using that money today to cover your housing costs raises the risk you will permanently doom your retirement dream.

  I know this is such a painful truth to face, but it is the right truth. Please try to step back for a moment and think through the outcome of using retirement funds to cover a mortgage payment: All money withdrawn from a traditional 401(k) or IRA will be taxable, and there may be a 10% early withdrawal penalty as well. That reduces what you will have to put toward your housing costs. And whether the tapped funds are taxed or not, the more important issue is that they are being used at all. What’s most upsetting for me is when families withdraw money from their retirement funds to cover a mortgage, and then when those savings are used up they still can’t afford the mortgage. They depleted their retirement savings to do nothing more than delay the inevitable: They can’t afford that mortgage, period.

  And as I explain on this page in the retirement chapter, I do not recommend you ever take out a 401(k) loan. So please read that advice before you make this costly mistake.

  That brings us to the right strategies to pursue if you have a mortgage you can no longer afford. I am not going to sugarcoat anything here. The very sad truth is that banks have, on the whole, been incredibly unresponsive in working with homeowners who cannot afford their mortgages. The help that was promised, I’m sorry to say, did not materialize for so many of you. The federal government’s programs have proven to be woefully ineffective, in large part because lenders are asked—asked, but not mandated—to participate. So far, banks haven’t shown much enthusiasm for helping. I mention all of this to make sure you understand the resolve and tenacity that is required to try to negotiate a deal with a lender.

  There are four basic options for dealing with your predicament; I list them here in order of their appeal for distressed homeowners.

  Loan Modification: Your lender agrees to reduce your payments to an affordable level.

  Short Sale: The lender agrees that you will sell your home for whatever it can get in today’s market. If the sale price is less than the outstanding balance of your mortgage, the lender will forgive that amount.

  Deed in Lieu of Foreclosure: You hand the house back to the lender, and the lender agrees to not go through the foreclosure process. A lender will typically require you to attempt a short sale before considering a deed in lieu of foreclosure.

  Foreclosure: The lender takes back your house and sells it. Depending on your state the lender may be able to sue you for any loss it incurs if the sale price is less than the outstanding mortgage balance.

  Please understand that the lender, not you, is in the driver’s seat here. What you want is irrelevant; this is all about what a lender is willing to offer you. Let’s walk through each option in detail.

  Loan Modification

  If you can prove you have financial hardship, a lender may be willing to reduce your current monthly payment to a more affordable level. I want to stress that this does not mean your principal balance will be reduced. While that is possible, banks have been loath to offer this relief. What is more likely—if you can even win a modification—is that your interest rate will be reduced to lower your payment.

  The federal Home Affordable Modification Program (HAMP) offers lenders incentives to reduce the mortgage payments for qualified borrowers. Some lenders may have their own modification programs as well. The bottom line is that you want to start working with your lender as soon as you have any inkling you are headed for trouble. You do not need to be behind on your payments to qualify for the HAMP program; if you can prove financial hardship, such as a drop in your income due to a layoff, or the fact that your mortgage payment is adjusting to a new, higher cost that will make it hard to pay the loan, you may be able to win a reduction.

  HAMP Basics

  To be eligible for HAMP:

  The mortgage must be for a primary residence that was obtained before January 1, 2009. Vacation homes and investment properties are not eligible.

  The mortgage amount must be $729,750 or less.

  You must be able to prove financial hardship: Either your mortgage has increased or your income has decreased.

  Your monthly mortgage payment (including property tax, insurance, and homeowners’ association fees if applicable) must be more than 31% of your current gross income.

  TIP: In the summer of 2010 the Treasury Department, which oversees HAMP, introduced a new variation specifically for households in which a layoff has made it hard to keep up with the mortgage payment. The Home Affordable Unemployment Program (HAUP) offers a reduced payment for a short period while the household looks for reemployment. As with all of these programs, lenders are not required to participate, and so far it does not seem to be widely adopted. But please check with your lender to see if it may be willing to use HAUP to give you a temporary reduction in your mortgage cost.

  If you meet all those criteria you may be able to win a mortgage reduction that brings your monthly payment down to 31% of your gross income. The HAMP website has a calculator that will show you an estimate of what your monthly payment could be if you win a modification: www.makinghomeaffordable.gov.

  I need to be very honest here: To date this program has been a huge disappointment. Through the summer of 2010 only one-third of applicants who were given a “trial” modification were able to win a permanent modification. One of the issues was that the program initially enrolled participants before verifying their eligibility. In many instances lenders disqualified people during the trial period if they could not document financial hardship or their payments did not exceed 31% of gross income. A change in the program—effective in June 2010—requires verification of eligibility before a trial modification begins. What this means is that you will know early on if you are a bona fide candidate for a modification. However, the reality has been that many eligible homeowners are often being strung along for months—the average modification trial period in 2010 was about fourteen months—only to be turned down for claims of faulty paperwork.

  And what is particularly upsetting is that when you go into a trial modification you could be making matters worse, as you’ll soon see.

  The Risks of Asking for a Trial Modification

  When a lender offers you a trial modification, your monthly
payment will be reduced. That’s the good news. The bad news is that this will have a negative impact on your credit score. Why is this? Because even though the bank agrees to lower the payment, it must still report the fact that you are no longer paying the full amount due. So if you have been current on your mortgage and other payments, and you enter into a trial modification, be aware that your credit score is going to take a tumble. The hit your score takes will depend on your score prior to the modification. Unfair as it may be, a high score will actually fall more—possibly 100 points or so—while a lower score will not see as much impact.

  The second risk is what happens if you are turned down for a permanent modification, a fact of life for more than two-thirds of borrowers who had gone through HAMP as of the summer of 2010. If you are deemed ineligible for a permanent modification, the lender can turn around and demand repayment for the difference between your regular payment and the trial payment.

  Here’s an example: Let’s say you had a $2,000 monthly mortgage payment that was reduced to $1,500 during a 10-month trial period. Then the lender decides you do not qualify for the permanent modification. It can then demand that you repay the $500 monthly reduction you had for the 10 months. Suddenly you find yourself back at owing $2,000 to cover the monthly mortgage and you have a $5,000 balloon payment you must pay pronto. If you can’t handle both of those costs, the bank then starts the foreclosure process. In late 2010 the Treasury Department said it was looking into the balloon payment issue.