Chapter 12
In This Chapter
Selecting the best real estate investment financing
Locating an excellent real estate agent
Negotiating and inspecting your deals
Making smart selling decisions
In this chapter, I discuss issues such as understanding and selecting mortgages, working with real estate agents, negotiating, and other important details that help you put a real estate deal together. I also provide some words of wisdom about taxes and selling your property that may come in handy down the road. (In Chapter 10, I cover what you need to know to purchase a home, and in Chapter 11, I review the fundamentals of investing in real estate.)
Unless you’re affluent or buying a low-cost property, you likely need to borrow some money via a mortgage to make the purchase happen. Without financing, your dream to invest in real estate remains just that: a dream. So first you have to maximize your chances of getting approved for a loan, which has become harder since the real estate market downturn in the late 2000s. Shopping wisely for a good mortgage can save you thousands, perhaps even tens of thousands, of dollars in extra interest and fees. Don’t get saddled with a loan that you may not be able to afford someday and that could push you into foreclosure or bankruptcy.
Even if you have perfect or near-perfect credit, you may encounter financing problems with some properties. And, of course, not all real estate buyers have a perfect credit history, tons of available cash, and no debt. Because of the soft real estate market in the late 2000s and the jump in foreclosures since that time, lenders tightened credit standards to avoid making loans to people likely to default. If you’re one of those borrowers who ends up jumping through more hoops than others to get a loan, don’t give up hope. Few borrowers are perfect from a lender’s perspective, and many problems are fixable.
Most people, especially when they make their first real estate purchase, are strapped for cash. In order to qualify for the most attractive financing, lenders typically require that your down payment be at least 20 percent of the property’s purchase price. Investment property loans sometimes require 25 to 30 percent down for the best terms. In addition, you need reserve money to pay for other closing costs, such as title insurance and loan fees.
Late payments, missed payments, or debts that you never bothered to pay can tarnish your credit report and squelch a lender’s desire to offer you a mortgage. If you’re turned down for a loan because of your less-than-stellar credit history, find out the details of why by requesting (at no charge to you) a copy of your credit report from the lender that turned down your loan.
If you do find credit report problems, explain them to your lender. If the lender is unsympathetic, try calling other lenders. Tell them your credit problems upfront and see whether you can find one willing to offer you a loan. Mortgage brokers may also be able to help you shop for lenders in these cases. (I discuss working with mortgage brokers later in this chapter.)
Sometimes you may feel that you’re not in control when you apply for a loan. In reality, however, you can fix a number of credit problems yourself, and you reap great rewards (access to better loan terms, including lower interest rates) for doing so. And you can often explain those that you can’t fix. Remember that some lenders are more lenient and flexible than others. Just because one mortgage lender rejects your loan application doesn’t mean that all the others will as well.
Besides late or missed payments, another common credit problem is having too much consumer debt at the time you apply for a mortgage. The more consumer debt you rack up (including credit card and auto loan debt), the less mortgage credit you qualify for. If you’re turned down for a mortgage, consider it a wake-up call to get rid of your high-cost debt. Hang on to the dream of buying real estate and plug away at paying off your debts before you attempt another foray into real estate.
To find out more about how credit scores work and techniques to improve yours, see the latest edition of my book Personal Finance For Dummies (Wiley).
Even if you have sufficient income, a clean credit report, and an adequate down payment, a lender may deny your loan if the appraisal of the property that you want to buy comes in lower than you agreed to pay for the property.
If you’re self-employed or have changed jobs, your current income may not resemble your past income or, more importantly, your income may be below what a mortgage lender likes to see given the amount that you want to borrow. A way around this problem, although challenging, is to make a larger down payment.
Two major types of mortgages exist: those with a fixed interest rate and those with an adjustable rate. Your choice depends on your financial situation, how much risk you’re willing to accept, and the type of property you want to purchase. For example, obtaining a fixed-rate loan on a property that lenders perceive as a riskier investment is more difficult than getting an adjustable-rate mortgage for the same property.
Fixed-rate mortgages, which are typically for a 15- or 30-year term, have interest rates that stay fixed or level — you lock in an interest rate that doesn’t change over the life of your loan. Because the interest rate stays the same, your monthly mortgage payment stays the same. You have nothing complicated to track and no uncertainty. Fixed-rate loans give people peace of mind and payment stability.
In contrast to a fixed-rate mortgage, an adjustable-rate mortgage (ARM) carries an interest rate that varies over time (based on a formula the lender establishes). Such a mortgage begins with one interest rate, and you may pay different rates for every year, possibly even every month, that you hold the loan. Thus, the size of your monthly payment fluctuates. Because a mortgage payment makes a large dent in most property owners’ checkbooks, signing up for an ARM without fully understanding it is fiscally foolish.
The advantage of an ARM is that if you purchase your property during a period of higher interest rates, you can start paying your mortgage with a relatively low initial interest rate, compared with fixed-rate loans. (With a fixed-rate mortgage, a mortgage lender takes extra risk in committing to a fixed interest rate for 15 to 30 years. To be compensated for accepting this additional risk, lenders charge a premium with fixed-rate mortgages in case interest rates, which they have to pay on their source of funds in the form of deposits, move much higher in future years.) If interest rates decline, an ARM allows you to capture many of the benefits of lower rates without the cost and hassle of refinancing.
You can’t predict the future course of interest rates. Even the professional financial market soothsayers and investors can’t predict where rates are heading. If you could foretell interest rate movements, you could make a fortune investing in bonds and interest-rate futures and options. So cast aside your crystal ball and ask yourself the following two vital questions to decide whether a fixed or adjustable mortgage will work best for you.
How much of a gamble can you take with the size of your monthly mortgage payment? For example, if your job and income are unstable and you need to borrow an amount that stretches your monthly budget, you can’t afford much risk. If you’re in this situation, stick with fixed-rate mortgages because you likely won’t be able to handle a large increase in interest rates and the payment on an ARM.
If, on the other hand, you’re in a position to take the financial risks that come with an adjustable-rate mortgage, you have a better chance of saving money with an adjustable loan rather than a fixed-rate loan. Your interest rate starts lower and stays lower if the market level of interest rates remains unchanged. Even if rates go up, they’ll likely come back down over the life of your loan. If you can stick with your adjustable-rate loan for better and for worse, you may come out ahead in the long run.
Adjustables also make more sense if you borrow less than you’re qualified for. Or perhaps you regularly save a sizable chunk — more than 10 percent — of your monthly income. If your income significantly exceeds your spending, you may feel less anxiety about fluctuating interest rates. If you do choose an adjustable loan, you may be more financially secure if you have a hefty financial cushion (at least six months’ to as much as a year’s worth of expenses reserved) that you can access if rates go up.
Saving interest on most adjustables is usually a certainty in the first two or three years. By nature, an adjustable-rate mortgage starts at a lower interest rate than a fixed-rate mortgage. However, if rates rise while you hold an ARM, you can end up giving back the savings that you achieve in the early years of the mortgage.
You may think that comparing one fixed-rate loan to another is simple because the interest rate on a fixed-rate loan is the rate that you pay every month over the entire life of the loan. And as with your golf score and the number of times that your boss catches you showing up late for work, a lower number (or interest rate) is better, right?
Unfortunately, banks generally charge an upfront interest fee, known as points, in addition to the ongoing interest over the life of the loan. Points are actually percentages: One point is equal to 1 percent of the loan amount. So when a lender tells you a quoted loan has 1.5 points, you pay 1.5 percent of the amount you borrow as points. On a $100,000 loan, for example, 1.5 points cost you $1,500. The interest rate on a fixed-rate loan must always be quoted with the points on the loan, if the loan has points.
Suppose that one lender quotes you a rate of 5.75 percent on a 30-year fixed-rate loan and charges one point (1 percent). Another lender, which quotes 6 percent for 30 years, doesn’t charge any points. Which is better? The answer depends on how long you plan to keep the loan.
The 5.75 percent loan is 0.25 percent less than the 6 percent loan. However, it takes you about four years to earn back the savings to cover the cost of that point because you have to pay 1 percent (one point) upfront on the 5.75 percent loan. So if you expect to keep the loan more than four years, go with the 5.75 percent option. If you plan to keep the loan less than four years, go with the 6 percent option.
All things being equal, no-point loans make more sense for refinances because points aren’t immediately tax-deductible as they are on purchases. (You can deduct the points that you pay on a refinance only over the life of the mortgage.) On a mortgage for a property that you’re purchasing, a no-point loan may help if you’re cash poor at closing.
Consider a no-point loan if you can’t afford more out-of-pocket expenditures now or if you think that you’ll keep the loan only a few years. Shop around and compare different lenders’ no-point loans.
Selecting an ARM has a lot in common with selecting a home to buy. You need to make trade-offs and compromises. In the following sections, I explain the numerous features and options — caps, indexes, margins, and adjustment periods — that you find with ARMs (these aren’t issues with fixed-rate loans).
The formula for determining the rate caps and the future interest rates on an adjustable-rate mortgage (see the next section) are far more important in determining what a mortgage will cost you in the long run. For more on rate caps, see the section “Analyzing adjustments,” later in this chapter.
The first thing you need to ask a mortgage lender or broker about an adjustable rate is the exact formula they use for determining the future interest rate on your particular loan. You need to know how a lender figures your interest rate changes over the life of your loan. All adjustables are based on the following general formula, which specifies how the interest rate is set on your loan in the future:
Index + Margin = Interest rate
The index determines the base level of interest rates that the mortgage contract specifies in order to calculate the specific interest rate for your loan. Indexes are generally (but not always) widely quoted in the financial press.
For example, suppose that the current index value for a given loan is equal to the 6-month Treasury bill index, which is, say, 2 percent. The margin is the amount added to the index to determine the interest rate that you pay on your mortgage. Most loans have margins of around 2.5 percent. Thus, the rate of a mortgage driven by the following formula
6-month Treasury bill rate + 2.5 percent
is set at 2 + 2.5 = 4.5 percent. This figure is known as the fully indexed rate. If the advertised start rate for this loan is just 3 percent, you know that if the index (6-month Treasuries) stays at the same level, your loan will increase to 4.5 percent.
The different indexes vary mainly in how rapidly they respond to changes in interest rates. Some common indexes include the following:
If you select an adjustable-rate mortgage that’s tied to one of the faster-moving indexes, you take on more of a risk that the next adjustment will reflect interest rate increases. Because you take on this risk, lenders cut you breaks in other ways, such as through lower caps or points. If you want the security of an ARM tied to a slower-moving index, you pay for that security in one form or another, such as through a higher start rate, caps, margin, or points.
After the initial interest rate expires, the interest rate on an ARM fluctuates based on the loan formula that I discuss earlier in the chapter. Most ARMs adjust every 6 or 12 months, but some adjust as frequently as monthly. In advance of each adjustment, the lender sends you a notice telling you your new rate.
All things being equal, the less frequently your loan adjusts, the less financial uncertainty you have in your life. However, less-frequent adjustments usually have a higher starting interest rate.
Almost all adjustables come with an adjustment cap, which limits the maximum rate change (up or down) at each adjustment. On most loans that adjust every 6 months, the adjustment cap is 1 percent. In other words, the interest rate that the loan charges can move up or down no more than one percentage point in a given adjustment period.
Loans that adjust more than once per year usually limit the maximum rate change that’s allowed over the entire year as well. On the vast majority of such loans, 2 percent is the annual rate cap. Likewise, almost all adjustables come with lifetime caps. These caps limit the highest rate allowed over the entire life of the loan. It’s common for adjustable loans to have lifetime caps 5 to 6 percent higher than the initial start rate.
Some loans cap the increase of your monthly payment but don’t cap the interest rate. Thus, the size of your mortgage payment may not reflect all the interest that you owe on your loan. So rather than paying the interest that you owe and paying off some of your loan balance (or principal) every month, you end up paying off some, but not all, of the interest that you owe. Thus, lenders add the extra, unpaid interest that you still owe to your outstanding debt.
Negative amortization resembles paying only the minimum payment that your credit card bill requires. You continue to rack up finance charges (in this case, greater interest) on the balance as long as you make only the artificially low payment. Taking a loan with negative amortization defeats the whole purpose of borrowing an amount that fits your overall financial goals.
Some lenders offer loans without points or other lender charges. However, remember that if they don’t charge points or other fees, they charge a higher interest rate on your loan to make up the difference. Such loans may make sense for you when you lack the cash to close a loan or when you plan to keep the loan for just a few years.
You can easily save thousands of dollars in interest charges and other fees if you shop around for a mortgage deal. It doesn’t matter whether you do so on your own or hire someone to help you, but you definitely should shop because a lot of money is at stake!
A competent mortgage broker can be a big help in getting you a good loan and closing the deal, especially if you’re too busy or uninterested to dig for a good deal on a mortgage. A good mortgage broker also stays abreast of the many different mortgages in the marketplace. She can shop among lots of lenders to get you the best deal available. The following list presents some additional advantages to working with a mortgage broker:
Even if you plan to shop on your own, talking to a mortgage broker may be worthwhile. At the very least, you can compare what you find with what brokers say they can get for you. But again, be careful. Some brokers tell you what you want to hear — that they can beat your best find — and then can’t deliver when the time comes.
If your loan broker quotes you a really good deal, ask who the lender is. (However, do be aware that most brokers refuse to reveal this information until you pay the necessary fee to cover the appraisal and credit report.) You can then check with the actual lender to verify the interest rate and points that the broker quotes you and make sure that you’re eligible for the loan.
Many mortgage lenders compete for your business. Although having a large number of lenders to choose from is good for keeping interest rates lower, it also makes shopping a chore, especially if you’re going it alone (instead of using a broker). But there’s no substitute for taking the time to speak with numerous lenders and exploring the range of options.
Real estate agents may refer you to lenders with whom they’ve done business. Just keep in mind that those lenders won’t necessarily offer the most competitive rates — the agent simply may have done business with them in the past or received client referrals from them.
When you buy a property, you take out a mortgage based on your circumstances and available loan options at that time. But things change. Maybe interest rates have dropped, or you have access to better loan options now than when you first purchased. Or perhaps you want to tap into some of your real estate equity for other investments.
If interest rates drop and you’re able to refinance, you can lock in interest rate savings. But getting a lower interest rate than the one you got when you took out your original mortgage isn’t reason enough to refinance your mortgage. When you refinance a mortgage, you have to spend money and time to save money. So you need to crunch a few numbers to determine whether refinancing makes financial sense for you.
For a better estimate without spending hours crunching numbers, take your tax rate as specified in Chapter 3 (for example, 28 percent) and reduce your monthly payment savings on the refinance by this amount. That means, continuing with the preceding example, that if your monthly payment drops by $100, you’re actually saving only around $72 a month after you factor in the lost tax benefits. So it takes about 28 months ($2,000 divided by $72), not 20 months, to recoup the refinance costs.
Refinancing a piece of real estate that you own to pull out cash for some other purpose can make good financial sense because under most circumstances, mortgage interest is tax-deductible. Perhaps you want to purchase another piece of real estate, start or purchase a business, or get rid of an auto loan or some high-cost credit card debt. The interest on consumer debt isn’t tax-deductible and is usually at a much higher interest rate than what mortgage loans charge you.
If you’re like most people, when you purchase real estate, you enlist the services of a real estate agent. A good agent can help screen property so you don’t spend all your free time looking at potential properties, negotiating a deal, helping coordinate inspections, and managing other pre-closing items.
All real estate agents (good, mediocre, and awful) are subject to a conflict of interest because of the way they’re compensated: on commission. I respect real estate agents for calling themselves what they are. They don’t hide behind an obscure job title, such as “shelter consultant.” (Many financial “planners,” “advisors,” or “consultants,” for example, actually work on commission and sell investments and life insurance and therefore are really stockbrokers and insurance brokers, not planners or advisors.)
Real estate agents aren’t in the business of providing objective financial counsel. Just as car dealers make their living selling cars, real estate agents make their living selling real estate. Never forget this fact as a buyer.
A mediocre, incompetent, or greedy agent can be a real danger to your finances. Whether you’re hiring an agent to work with you as a buyer or as a seller, you want someone who’s competent and with whom you can get along. Working with an agent costs a good deal of money, so make sure you get your money’s worth out of him.
As you speak with an agent’s references, ask about these traits in any agent that you’re considering working with, whether as a buyer or as a seller:
Agents who pitch themselves as buyers’ brokers claim that they work for your interests. However, agents who represent you as a buyer’s broker still get paid only when you buy. And agents still get paid a commission that’s a percentage of the purchase price. So they still have an incentive to sell you a piece of real estate that’s more expensive because their commission increases.
When you buy a home, you need an agent who is patient and allows you the necessary time to educate yourself and who helps you make the decision that’s best for you. The last thing you need is an agent who tries to push you into making a deal.
You also need an agent who’s knowledgeable about the local market and community. If you want to buy a home in an area where you don’t currently live, an informed agent can have a big impact on your decision.
After you locate a property that you want to buy and you understand your financing options, the real fun begins. At this point, you have to put the deal together. The following sections discuss key things to keep in mind.
When you work with an agent, she usually carries the burden of the negotiation process. But even if you delegate that responsibility to your agent, you still should have a strategy in mind. Otherwise, you may overpay for real estate. Here’s what you should do:
Price is only one of several negotiable items. Sometimes sellers fixate on selling their homes for a certain amount. Perhaps they want to get at least what they paid for it several years ago. You may get a seller to pay for certain repairs or improvements or to offer you an attractive loan without all the extra fees that a bank charges. Also, be aware that the time for closing on the purchase is a bargaining point. Some sellers may need cash fast and may concede other terms if you can close quickly. Likewise, the real estate agent’s commission is negotiable.
Unless you’ve built homes and other properties and performed contracting work yourself, you probably have no idea what you’re getting yourself into when it comes to furnaces and termites.
Hire people to help you inspect the following features of the property:
With multi-unit rental property, be sure to read Chapter 11 for other specifics that you need to check out.
Inspection fees often pay for themselves. If you uncover problems that you weren’t aware of when you negotiated the original purchase price, the inspection reports give you the information you need so you can go back and ask the property seller to fix the problems or reduce the property’s purchase price.
As with other professionals whose services you retain, interview a few different inspection companies. Ask which systems they inspect and how detailed of a report they can prepare for you. Consider asking the company that you’re thinking of hiring for customer references. Ask for names and phone numbers of three people who used the company’s services within the past six months. Also request from each inspection company a sample of one of its reports.
Mortgage lenders require title insurance to protect against someone else claiming legal title to your property. For example, when a husband and wife split up, the one who remains in the home may decide to sell and take off with the money. If the title lists both spouses as owners, the spouse who sells the property (possibly by forging the other’s signature) has no legal right to do so. The other spouse can come back and reclaim rights to the home even after it has been sold. In this event, both you and the lender can get stuck holding the bag. (If you’re in the enviable position of paying cash for a property, buying title insurance is still wise to protect your investment, even though a mortgage lender won’t prod you to do so.)
An insurance company’s ability to pay claims is always important. Most state insurance departments monitor and regulate title insurance companies. Title insurers rarely fail, and most state departments of insurance do a good job of shutting down financially unstable ones. Check with your state’s department if you’re concerned. You can also ask the title insurer for copies of its ratings from insurance-rating agencies.
Buying and holding real estate for the long term really pays off. If you do your homework, buy in a good area, and work hard to find a fairly priced or underpriced property, why sell it quickly and incur all the selling costs, time, and hassle to locate and negotiate another property to purchase?
Use the reasons that you bought in an area as a guide for considering selling. Review the criteria that I discuss in Chapter 11 as a guideline. For example, if the schools in the community are deteriorating and the planning department is allowing development that will hurt the value of your property and the rents that you can charge, you may have cause to sell. Unless you see significant problems like these in the future, holding good properties over many years is a great way to build your wealth and minimize transaction costs.
Most people use an agent to sell real estate. As I discuss in “Selecting a good agent,” earlier in this chapter, selling and buying a home demand agents with different strengths. When you sell a property, you want an agent who can get the job done efficiently and for the highest possible sales price.
When you list a property for sale, the contract that you sign with the listing agent includes specification of the commission that you pay the agent if she succeeds in selling your property. In most areas of the country, agents usually ask for a 6 percent commission for single-family homes. In an area that maintains lower-cost housing, agents may ask for 7 percent. For small multifamily properties and commercial properties, commissions often hover around the 3 to 5 percent range.
If you live in an area with generally higher-priced properties, you may be able to negotiate a 5 percent commission. For really expensive properties, a 4 percent commission is reasonable. You may find, however, that your ability to negotiate a lower commission is greatest when an offer is on the table. Because of the cooperation of agents who work together through the multiple listing service (MLS), if you list your real estate for sale at a lower commission than most other properties, some agents won’t show it to prospective buyers. For this reason, you’re better off having your listing agent cut his take instead of cutting the commission that you pay to a real estate agent who brings a buyer for your property.
The temptation to sell real estate without an agent is usually to save the commission that an agent deducts from your property’s sale price. If you have the time, energy, and marketing experience, you can sell sans agent and possibly save some money.
Besides saving you time, a good agent can help ensure that you’re not sued for failing to disclose known defects of your property. If you decide to sell on your own, contact a local real estate legal advisor who can review the contracts. Take the time to educate yourself about the many facets of selling property for top dollar. Read the latest edition of House Selling For Dummies, which I coauthored with Ray Brown (published by Wiley).