The Amateur Financier

Welcome back for the second edition of Financial Lessons, where you learn everything that should have been taught to you in high school (but probably wasn’t).  Today, our lesson plan includes some of the basics of house buying, a particularly good topic which should have been studied more closely in recent years.  What information about purchasing a home should be shared with people who probably don’t even pay rent yet?  Let’s head back to class (and I promise it’ll be more helpful than dissecting frogs).

The Lesson

Welcome to a particularly pertinent lesson, at least for any of you who hope to own a house one day.  There are numerous advantages to owning your own house, from the financial benefits to the psychological boost of having a place that is all your own.  If you do it right, owning a home can be a solid foundation on which to build your financial future.  This lesson is devoted to helping you do it right.

Home Sweet Home (Ownership)

The first step towards buying a home should be to save up for a down payment.  The days when you could get a good home in a great neighborhood with nothing down are gone.  If you can’t find enough money to save up a substantial down payment while still investing for retirement, building up an emergency fund, and paying for your regular living expenses (including your rent), there’s a good chance you don’t have the discipline to own your own home, with all the maintenance and regular expenses that home ownership entails.  Work to cut down on your monthly spending and start to put money away into a dedicated, non-emergency fund to save for your down payment. (Remember, class: you should always have three to six months worth of expenses set aside to cover emergencies, whether a loss of income or a sudden, larger than expected expense; this money is NOT to be used for your down payment.)  Your goal should be an amount equal to twenty percent of the house prices in your area, but you can get away with having ten percent, or even five percent, provided you can afford some added payments each month.

Speaking of which, while you are saving your down payment, you should try to figure out how much you will be spending each month on your new home.  Mortgage calculators, like this one from Bankrate.com, can give you an idea of what you’ll need to pay each month to cover your mortgage expense.  But don’t think that your mortgage is your only expense as a homeowner; you will have utilities, homeowner’s insurance, and repair costs  added to yur bill, most which would be included in your rental costs.  (In addition, you will also have private mortgage insurance (PMI) or a second mortgage if you put less than twenty percent down.)  Factor them in by learning what the expenses are for your would-be neighbors, or take a conservative guess at your total monthly costs by adding on fifty percent to the cost of your mortgage.  If you can’t afford that amount, you’ll have to work to increase your monthly earnings, decrease your (non-housing) expenses, save up a larger down payment to lower the costs of home ownership, or look at less expensive homes.  A combination of these four methods should enable you to get to the point where you are ready to purchase a home.

Once you have your down payment saved and know how much home you can afford, it’s time to go mortgage shopping.  Unless you are independently wealthy or have very rich, very generous parents, chances are that you won’t be able to afford the cost of even a little starter home at first.  Instead, you will need to go to your bank, credit union, or mortgage broker and borrow money in order to purchase your home.  Your goal is to become pre-approved for your mortgage; your lender will do a thorough check of your finances, to ensure that you can afford the mortgage, and when you pass all the checks they will do, as I’m sure all of my students will be able to do, you’ll have the promise of a loan from the bank to cover the expense of purchasing your house.

There are several types of mortgages, some of which have gotten quite exotic, but the two most basic types are fixed-rate mortgages and adjustable-rate mortgages (or ARMs).  A fixed-rate mortgage is exactly what it sounds like: the interest rate charged on your mortgage is fixed for the life of the mortgage, typically fifteen or thirty years, and won’t be changed at all while you have the mortgage.  This definitely makes planning for future expenses easier; you’ll have the same mortgage charge ten years from now as you have during your first year.  However, the initial costs for this type of mortgage tend to be a bit higher than ARMs.  With an ARM, your rate will start lower than a fixed rate mortgage of equivalent length; however, the rate could change (or adjust) to be higher in the future, after the initial, fixed rate period of the ARM is over (assuming your ARM has an initial fixed rate period; some ARMs do not).  ARMs can save you money initially (and possibly later, if they adjust downward), but are more risky than fixed-rate mortgages, and require more research and consideration to ensure you don’t end up on the wrong end of an adjusting rate.  There are also other types of mortgages, such as interest-only and option mortgages, but they can get rather complicated, and I think you should probably avoid them.  (If your lender hasn’t been scared off of offering them by recent events, anyway.)

Once you have a mortgage pre-approved and plenty of money for a down payment (as well as closing costs, inspection costs, and any number of legal and other fees; buying a house can get rather expensive), you’re finally ready to look for a house.  If you aren’t a seasoned pro at house hunting, you will probably want to hire the services of a Realtor; in exchange for a portion of the final selling price, you will get someone who will help guide you through all the inner workings of buying a house.  You’ll also want to have a home inspector working with you, to ensure that the home you buy meets structural standards.  Finally, you’ll need to make sure you have home owner’s insurance to cover your house before you finally close on the deal.  We’ll discuss all of these issues further in future, as I’m sure you’re already wondering just how long this class period is going to last.  Just remember, even after you have the money side of home buying in the bag, there’s still the actual house that you need to consider.

At this point, you might be wondering just why you should even buy a house.  There are several advantages to home ownership, many of which derive from preferential government treatment of housing-related expenses and profits.  The interest you pay on your mortgage (and in the first few years, most of the cost will be interest) is tax deductible, meaning that you will have a nice write-off on your taxes if you itemize your deductions.  Also, you can currently sell your primary residence and keep $250,000 of the profits without having to pay any tax if you’re single, $500,000 if you are married, provided you lived in the house for at least two of the past five years.

Of course, these benefits are based on current tax laws, and could change (for better or for worse) by the time you are ready to purchase a house.  One thing that won’t change is that over the long term, buying a house is cheaper than renting.  Because most of your home ownership expense is your mortgage, a cost that is either fixed or capped (with ARMs), your monthly expenses will grow at a lower rate than the rental costs for a similar place.  Furthermore, when you pay off your mortgage in fifteen or thirty years (which sounds like a lifetime to you youngsters, I know, but will pass faster than you think), the biggest housing expense you will have disappears, and you are suddenly living for much less than someone who rented for that period of time.  Of course, buying a home means you will also own the home; if and when you sell (or your children sell, if you pass it on to them), you will be able to profit from the sale, while you can’t profit from the rising price of a house you are renting.

All of that said, however, before going through this whole process of buying a home, you have to decide whether owning a home is really a better option for you than renting.  We just finished discussing some of the advantages of home buying, but renting has some perks as well, particularly for young people like yourselves who are just starting out in life and need flexibility.  It can be cheaper to rent than to own, at least in the short term: as we mentioned, there are expenses beyond the mortgage to consider when owning a home, most of which (with the exception of utilities, in many cases) are covered by your rent.  It’s also much easier (and cheaper) to move when you rent; just give notice to your landlord, pack up any belongings, try to clean the place up to get your security deposit back, and head out to your new home.  When you own your home and need to move, you’ll need to put it up on the market, wait for buyers, and have to pay out a substantial portion of the price to brokers (as well as paying closing costs and other expenses on a new house, potentially).

For these reasons, renting makes sense for those times when you aren’t going to stay in the area for long, if you are attending college for four years and are then planning to move away from your alma mater when you finish, for example.  You should obviously crunch all the numbers for yourself whenever you are making big decisions about your living quarters, I just don’t want you to take away the message that everyone should buy a home, as soon as possible (if not sooner); that’s simply not the case.

Alright, students, that’s enough talking from me for now.  You have plenty to think about if you are looking into housing, and hopefully, you’ll be able to sort through all the hype you’ll read in the media about houses, for better or for worse.  *The school bell rings; several students say ‘Finally!’ as they quickly get up*  Have a good day of learning, all of you!

Happy Labor Day, Everyone!  I hope you’ve all had a good, cook out and picnic filled day.  Myself, I spent most of the day as I do every day since I got my new job: sleeping.  Yes, the joy of being nocturnal on a day devoted to sun, freedom, family, and of course, the pending return to school for any under the age of eighteen.

And it’s to those people I’d like to devote this week’s articles.  One of the concepts bemoaned in the financial media (including blogs like this one) is that one of the big holes in the American education system concerns the lack of financial education.  In spite of the fact that everyone needs to know how to manage their money while only a fraction of the student body will make their living applying the lessons from chemistry and English class (to say nothing of gym), there’s little to no mention of money management and smart financial moves in high school.

That’s where I come in.  This week, we’re going to go through some of the basics about personal finance and money management that somehow never come up in your high school career.  If you’re a high school student (or even younger; it’s never too early to get a handle on personal finances) wondering how to get a jump on your financial education without taking a few lessons at the School of Hard Knocks, you’ve come to the right place.  But don’t worry if you’re an older reader; the information is just as valid for you, and perhaps you can even contribute to educating the youngsters in the crowd.  Let’s get started!

The Lesson

Alright, class, settle down, it’s time for class to begin.  *The sound of chairs scrapping as students return to their seats.*  Today, we’re going to be talking about credit cards.  In spite of what you may have gleaned from television commercials, credit cards aren’t a source of never ending wealth.  Nor are they the devil in plastic form, as you may have heard from certain financial personalities.

Credits Cards: Neither Friends nor Enemies

In reality, credit cards are simply a way to borrow money.  The agreement you make with the credit card company is that when you make a purchase, they will pay the merchant, and in turn, you will pay them back at some point in the future.  Credit card companies will give you a period of time after they calculate how much you spent that month, called a grace period, before the bill is actually due.  If you pay off the credit card bill in full by the grace period, congratulations!  You don’t owe any interest on the money you borrowed from the credit card company, and because you had that money to invest during the interim, you can come out financially ahead of anyone who made the same purchases with cash or a debit card.

The problems start to arise if you don’t pay off the card in full each month.  After the grace period, you will start to be charged interest on your borrowed money, up to 30% or more annually.  Furthermore, the interest is usually compounded daily, which means that every day during which you have your balance, the amount you owe will increase just a little more.  Don’t panic too much, though; even with such high interest rates, having a few hundred dollars on your card that need to wait a month to pay off isn’t a huge tragedy.  If a sudden, unexpected expense, a sudden decline in income, or simply a miscalculation causes you to put more on your credit card than you can pay off in a single month, just pay what you can and resolve to save up enough money to pay it off in full in the next month or two.

Credit cards only become really dangerous to your finances if you fall into the trap of believing that, ‘Because I can afford the minimum charge, my debt is under control’.  Unfortunately, most credit cards require minimum charges that only a small fraction of your overall debt (usually only a few percentage points of your total owed).  If you only pay that amount, even a card with a modest interest rate, in the range of 10% or so, will cause your balance to increase each month.  Soon, you can end up owing tens of thousands of dollars, much of it from interest and fees rather than actual spending, and no choice but bankruptcy or other extreme measures in order to balance your account.

How do you dig yourself out of such a situation?  While I hope none of you find yourself owing a large amount to a credit card company, there are a few simple tips to pay off your debt.  First, don’t add anymore to your amount owed; if you use your cards at all, you must, MUST pay off the added amount each month (or better yet, declare a moratorium on credit card spending until you get your debt undr control).  Second, pay more than the minimum on your cards; as we just discussed, paying your minimums will at best lead to your account total slowly increasing.  Pay as much extra as possible, preferably on the card with the highest interest rate.  Third, keep repeating this process until all of your credit cards are paid off.  It’s really that simple; no elaborate plans needed, as long as you can control your spending and put as much as you can towards your debt.

Alright, so now you know how NOT to use credit cards, let’s consider what you should look for in a credit card.  A decent interest rate is always good; although you will hopefully never carry a balance, knowing you won’t have to pay an arm and a leg in case you do can be a real comfort.  You might also consider the rewards offered by your card; getting cash, travel miles or other rewards for your normal spending is nice, and if you never pay interest, it’s basically free money.  You should also look at the annual fees (if any), and determine whether the rewards will outweigh the costs.  And of course, intangibles like costumer service and easy to use websites can also help you to decide which of two seemingly identical cards is best for you.

That’s it for our introduction to credit cards; hopefully, you all know now how to avoid the pitfalls of credit, while still using them properly.  For your homework, check out your credit card statements (or those of your parents, if you don’t have a card already) and try to understand all the minutiae of the credit card language used.  If you don’t understand the language used, bring in your questions and we can discuss them tomorrow.  *The bell rings*  Have fun in your next class.