FINANCING & MORTGAGES

By Markus Lehmann, Part 1

Your Home: the world’s best Tax Shelter

Owning your own home is a big part of the American Dream.

Not only is it the dream of most people to live in their own home to enjoy a stable life and create one of the best investments for the future, it's also one of the best ways to save substantially on taxes and create equity.

Property Taxes

Regardless if you finance your home or pay for it in cash, you can deduct all Real Property Taxes you pay on your home from your income taxes. That includes all state and local taxes.

You can deduct your Real Property Taxes not just for your primary or secondary residence, but on all homes you own. If you own ten homes then you are able to deduct the taxes on all ten.

Deduct the Interest You Pay

Uncle Sam wants you to live in your own home and subsidizes you by making your interest payments tax deductible.

The interest payments for your principal residence, second or vacation home are deductible up to a loan amount of $1 million.

In addition, you can deduct the interest on a home equity credit up to a loan amount of $100.000.

As long as the debt is secured by the home, the IRS doesn’t even care what you do with the money.

You may use it for any purpose: a vacation, a new car or for investments.

 Tax-Free Capital Gain

If you sell a property, which was your principal residence for 2 out of the 5 years prior to the date of sale, your capital gain up to $250,000 ($500,000 jointly) is tax-free.

This is not a one-time exclusion and you don't have to buy a new home.

But if you do buy a new home, you can get a new full $250/500,000 exclusion every 2 years.

If you should stay in one place for less than 2 years, you may still qualify for partial tax exclusion if you sold because of change in place of employment, for health reasons or because of unforeseen circumstances.

Unforeseen circumstances are situations such as divorce, inability to cover the cost of your home and living expenses anymore. etc.

Please consult with your CPA about your particular situation.

Home Offices

 Writing off your home office does not affect the new capital gains tax exclusion anymore.

Regardless of how much of the home you are using as a home office, the capital gains exclusion is still the same.

So, if you qualify for it, there is no reason to not deduct a home office.

 Bottom line:

Know and exercise all the tax advantages Uncle Sam offers to homeowners!

Paying cash versus getting a Mortgage

 For most people, there is no question about getting a mortgage or not, simply because they don't have enough cash to buy a home without one.

But there are more people than one might think who would have the money to buy a house without any financing.

Most of those buyers are not sure what to do in regard to financing and there is no general answer.

Following are some pro and cons, which should help you make your decision.

Benefits of paying in cash are:

+The cash buyer will have NO mortgage payments and mortgage insurance.

So, regardless of economy or employment situation, the buyer who owns his house free and clear is not very likely to lose it during a situation of financial distress.

Furthermore, there is no interest, which usually doubles the cost of a home when a mortgage runs full term.

 +Closing costs are substantially less and the cash buyer can often close on the new home within only a couple of weeks after signing the purchase contract. The timeframe between signing a purchase contract and closing on the home is usually between 3-6 weeks when financing is involved.

 +A cash buyer doesn’t have to obtain an appraisal and inspection and saves those fees.

 +A cash buyer will usually have greater purchase and negotiation power, because the transaction is free of financing contingencies.

+A cash buyer can take out a high home equity line of credit for which interest is only due if the homeowner actually uses the line of credit.

 Disadvantages of paying in cash are:

 +The cash buyer is potentially depleting reserves by paying with his or her own cash. This money could be used for other investment purchases or as reserves for emergencies.

Also, the buyer is NOT leveraging his money.

by putting it all into one real estate investment.

 +No mortgage interest means no tax deductions for interest payments. If consumer loans (such as high-interest credit cards) are used to finance other purchases, there is no tax deduction for it. The interest on consumer credits is usually higher than on mortgages, so the buyer might end up spending a big part of his income on high-interest loans.

 +The cash buyer who didn't appraise his property could end up overpaying for the property.
That's why an appraisal should always be done, regardless of the financing situation.

 +Mortgages applied for after the property was purchased with cash might be more difficult to obtain.

Taking out a mortgage after purchase closing is considered refinancing and the cash out amount might be very limited.

Another disadvantage is that the LTV on refinancing is usually lower than on purchase financing. Lenders don’t like borrowers to take too much equity out of their property.

Why not the middle way?

 Many people with enough money to buy a home in cash often compromise on the decision of whether or not to finance, by financing 50% of the purchase price. This still gives them a lot of negotiation power with the seller, because financing is no problem. A buyer with a large down payment and plenty of reserves is always able to secure financing, so the seller doesn’t have to be concerned about the buyer backing out of the contract because of financing issues.

And even with only 50% financing on the home, the buyer still has some interest to deduct from the taxes and usually doesn't need to borrow high-interest money for other purchases.

Going the middle way gives the cash-strong buyer most of the advantages of a cash purchase, without the need to worry about many disadvantages.

Bottom line:

If you are nor sure if you should buy a home in cash or with financing, go the middle way and finance 50% of the purchase price!

Mortgage Insurance 

Lender guidelines depend on the rules of the secondary market, which restricts the ability of the lender to make high loan-to-value (LTV) mortgages. A high LTV mortgage is a mortgage with an LTV as high as 80% of the purchase price (less than 20% down payment) or more than 80% of the appraised value for refinancing.

Loans with higher LTVs have statistically a much higher default rate. The lender can lose much more money with a higher LTV loan than by giving out a loan with a lower LTV.

The explanation for this fact is very easy: In case of foreclosure, the lender on a low LTV loan has some equity in the property to cover for legal fees and the discounted sales price usually reached at foreclosures. Furthermore, a borrower with a lot of equity in his property will do everything possible to avoid foreclosure; that’s why borrowers with more equity in their property are less likely to default on the mortgage payments.

There is always big risk for the lender to actually lose a lot of money in case of foreclosure, when granting a high LTV loan.

That’s why since the 1950s borrowers have had to buy mortgage insurance in order to minimize the risk for the lender on high LTV loans.

It's fair to say that it’s only because of the availability of mortgage insurance we have so many lenders offering up to100% financing.

The borrower usually has to pay his mortgage insurance (MI) premium monthly with the regular mortgage payments.

Mortgage programs with high LTVs, but without

required MI, are mostly loans with a higher interest rate. The lender prices the MI into the loan by raising the interest rate.

Removing Mortgage Insurance

 Most borrowers are not aware of the fact that the mortgage insurance can be removed once the homeowner has at least 20% equity in his home. In times with fast-appreciating home values, the required 20% in equity can sometimes be reached within in a year or two.

For loans originated after July 29, 1999, federal law requires the lender to remove the mortgage insurance once the borrower has 20% equity in his property and payments are current.

This law is enforced by the Department of Housing and Urban Development (HUD) and requires the lender to inform the borrower of this law at time of closing and on a yearly basis.

Consumers have the option to inform the lender at any time about the fact of high equity

in their home and ask for the mortgage insurance to be removed.

The 20% or more in equity is usually reached by appreciation or principal reduction.

If the equity was reached by appreciation, it's very likely that the lender will order a new property appraisal. The borrower always pays the fee for this appraisal. But the monthly savings by removing the payments for the mortgage insurance should make up for it within a few months.

Reaching the 20% equity mark by principal reduction will be reached with the portion of the borrower’s payment which is applied towards paying down the principal amount of the loan. Extra principal payments will help you to reach a home equity of 20% faster.

Finance Contingency

 From the financing point of view, one of the most important things when executing the purchase contract is the Finance Contingency Clause.

Regardless of what kind of Real Estate Purchase Contract a buyer signs, it’s imperative to make the purchase contingent upon receiving financing (unless of course it’s a deal without any financing involved).

This clause is so important because if financing cannot be obtained as spelled out in the purchase agreement or in the time frame specified, the buyer does not have to complete the sale and the earnest money deposit will be returned 100%.

The wording of the financing contingency should be as specific as possible and state at least the rate, term and maximum loan size (down

payment, LTV).

It’s very likely that the seller will be able to keep the earnest money, if a buyer signs a purchase agreement without finance contingency (or even waives the contingency) and can’t close because he wasn’t able to secure financing.
To make it clear: Not closing on a property would mean for most purchase agreements, breach of contract, even if it was only because the buyer wasn’t able to get financing.

Only a finance contingency would protect a buyer in case of default because of not being able to obtain the planned financing.

That’s why most standard Real Estate Purchase Contracts have a financing clause.

There are hundreds of ways to word a financing clause, but it could read somewhat like the following:

“Purchase contingent upon the borrower applying for and receiving a (90) % conventional mortgage, (30) year fixed rate, interest not to exceed (7) percent.”

 A realtor or attorney can usually help buyers to structure and spell out a fair finance contingency.

A buyer shouldn’t sign a real estate purchase agreement without finance contingency or if it has one, waiving it.  Even if a buyer has a pre-approval letter from a lender or if somebody private has promised to lend the money, a contingency regarding financing should at least spell out the terms and rate of this mortgage.

Many things can happen within the timeframe (usually 3-6 weeks) of signing the purchase agreement and the actual transfer of ownership (closing).

That’s why it’s wise, at the time of negotiating a contract, to always assume the worst-case scenario and to ad a clause which will provide protection in case unplanned events happen.

It’s fair to assume that the majority of homebuyers will be able to obtain a mortgage and close the deal. Sometimes unforeseen situations occur and the buyer can only get a mortgage with a much higher interest rate or down payment than originally planned. In this event the buyer is protect by the finance contingency, and can back out of the contract without losing money.

A small number of buyers might not be able to get a mortgage at all and have no other choice but to back out. Let’s hope they have a firm finance contingency.

 Buyers should always be very wary, if any party involved in negotiating the purchase agreement is asking the buyer to waive the finance contingency or to state in the contract that it’s a cash transaction, even knowing that financing has to be secured in order to close the deal.

In some cases even buyers’ agents ask their clients to waive the finance contingency.

A buyer should never listen to this advice to waive finance contingency, unless it’s a cash deal. Real Estate agents who are not protecting their clients with a proper finance contingency, either don’t know what they are doing or are just not working the client’s best interest.

The good news is that most real estate agents are aware of the importance of this clause and always make sure the client is protected by it.

Bottom line:

Make sure your purchase agreement has a clear

FINANCE CONTINGENCY

 Prepayment  Penalties

  When shopping around for a loan, borrowers will often find loan products with a prepayment penalty (PPP) attached.

Many lenders are using such a penalty as a way to recoup profits should a borrower pay off his mortgage early, because of selling the property or refinancing it.

Borrowers have to understand that a lender will make a profit on the loan only in the long run and might even lose money should a borrower pay off his loan after only one or two years or maybe even after just a month.

The lender spends substantial money in the origination of a loan and won't make any actual profits on the loan in the first few months or sometimes the first 18 months.

That is why many lenders try to protect themselves against early payoffs caused by the borrower refinancing after only one year or selling a property after a short period of time.

The term for a PPP can be anywhere between one to five years.

The prepayment compensation can be either

a fixed dollar amount or a percentage of the

loan balance or original loan amount.

There are two common kinds of PPP's.

The one is the so-called Hard Prepayment Penalty, which usually means if you pay off your loan for any reason within a certain period of time (like within the first 36 months) you have to pay xy dollars or xy percent of the original loan amount. “Paying off for any reason” means clearly that regardless of the reason for paying off the mortgage before maturing of the PPP term, the borrower will have to pay the PPP.

The second common kind of PPP is named Soft Prepayment Penalty, soft because the PPP will only hit you if you pay the mortgage off early for any other reason but selling your home. So you may sell your place even a few months after you got your mortgage without paying any penalties. But you may not pay off the loan for any other reason, such as refinancing or because you came into money and decided it would be better to do without mortgage payments.

Some lenders like to combine the features of a soft PPP with the features of a hard PPP.

So an agreement for your PPP might read that you have a hard PPP for the first 12 months but a soft PPP for years 2 and 3.

There are too many combinations of PPP to explain all of them here.

But every borrower should make sure to ask his loan officer at the time of new loan application, if there are PPPs on the suggested loan program and what the prepayment details are.

The lender has to disclose the exact terms and conditions at the closing of the loan and the borrower has to sign an extra disclosure (PPP rider) for it. Borrowers should read this PPP disclosure very carefully and make sure it's what they agreed on.

If there is fair chance that the borrower might have to sell or refinance the property soon, it would be wise to go with a loan product which has no PPP, even if it means a higher interest rate.

Fannie Mae loans are very popular, not just because of their competitive interest rates, but also because there are never PPP on loans underwritten under the Fannie Mae guidelines.

Borrowers should always check if they qualify for a Fannie Mae loan.

Income Documentation

 When it comes to documenting income for mortgages, there is one basic rule:

 "More documents mean less in payments”

 Why is that?
Very simple: If you bring all or most of your documents to prove your assets and income for the last two years, you'll receive the lowest interest rate available for your credit score range.

So more gets you less!  The lender will reward you with a lower interest rate for proving your income and asset situation.

Vice versa: If you bring a little or no income and asset documentation, your interest will be on the much higher end for your credit scoring range.

The lender will require higher down payments for purchases or more equity for cash out refinancing, if you wish to not document your income or only bring a few documents.

Some lenders will only accept borrowers with low or no income documentation if the borrower has a minimum credit middle score of 600 or higher. Full documentation on the other side can get a borrower a mortgage with a high LTV even if the credit score is in the lower 500s.

 Following are the most common document types for conventional mortgages:

Full documentation (FULL DOC) Loans

 The borrower must provide proof of income and assets, and must have worked in same line of work or profession for the last 24 months. Two months of bank statements for assets, two years of tax returns, W2s and pay stubs for the last month of work (pay stubs only if not self-employed) are the standard requirement.

Working in the same line of work for at least two years must be documented by written verification of employment, or for self-employed people, with a copy of your professional license or a letter from the CPA.

It’s ideal for the loan application process, if the borrower can fully prove job history and income for the last two years.

The lender considers the risk of default on loans to applicants with proven job, income and asset situations as the lowest, and therefore is willing to give a higher loan to value (LTV) and a lower interest rate.

Limited documentation loans (LOW DOC)

 Limited documentation loans, also called "light doc" or "low doc" loans, are a good and

rewarding compromise between full documentation loans and no documentation loans.

The loan to value (LTV) and interest rates are somewhere in between full and no-doc loans.

This kind of loan is very popular with self-employed borrowers or employed borrowers with extra income which can't be verified.

There are hundreds of different variations of low doc loans.

Some programs ask the applicant only to prove that he is working, but not to document income or assets; or only to document income for the last 12 months with copies of bank statements. Or the client just states but does not verify his income and/or assets etc., etc.

Every loan applicant will clearly see that bringing more documents can make a substantial difference in interest and a maximum LTV.

 No Documentation Loans (NO DOC)

 Probably the easiest to obtain, but also the most expensive loan programs because of highest interest rates, are the no documentation loans.

The borrower basically only provides his name, address and social security number, and the loan will be approved based on his credit scoring and the appraised value of the property.

There will be no questions or documentation about income, assets or work situation.

This kind of loan is very easy to obtain, but this convenience will usually cost the borrower thousands or even tens of thousands of dollars over the life of the loan. 

No-doc loans are really only recommended if the borrower has a serious lack of documentation, because he has no way of verifying his assets, income and work situation.

Even if you think you have to go no-doc, a mortgage broker will often find a way to squeeze you into a light doc program and save you a serious amount of money over the life of your loan.

Hard Equity Loans

 A lender will give you a mortgage based only on the appraised value of the property. Hard equity lenders usually don’t care or even ask about your credit history, income or asset situation.

Hard equity loans usually have the highest interest rates in the industry, even higher then no-doc loans.

They also allow only a low maximum LTV, in the range of 50-65% of the appraised value of the property.

In addition to the high interest, the hard equity lender charges points for loan origination (between 2-6% of the loan amount);

and on top of the high interest and origination points, there will almost certainly be a pricey prepayment penalty.

Last but not least:

A loan applicant should regard it as a very positive sign, if a loan officer asks him to provide many different documents. The applicant should make a real effort to get the documents together as quickly as possible.

In order to save the client money, a good loan officer will try, in every possible way, to get a loan applicant into a low doc program before placing him into a no-doc mortgage.

The applicant should co-operate by providing the loan officer with all necessary information and documents.

A good loan officer will ask his client many questions in order to have a better understanding of the current situation, as well as of future plans and goals.

One should be wary of a loan officer who talks to the applicant only for a couple of minutes and then acts as if he already knows what's best for the client.

Don't be afraid of talking to different lenders and then choosing the one you feel most comfortable with.

Equity Loans

 Equity loans, also called home equity line of credit (HELOC), are basically a second mortgage structured almost like a credit card line of credit, secured by the equity in the borrower’s home.  And, similar to a credit card, the borrower will only have to pay the interest on the amount he actually uses, regardless of the available credit limit.

The process to get a HELOC is the same as for a refinance. The loan officer will take the application and most likely approve it contingent upon satisfying the appraisal and verification of borrower information. Once the appraisal report is ordered and comes back, all your information and documents will be processed, verified and evaluated and the loan usually funded very quickly.

As with other mortgages, there are hundreds of different HELOC programs. You may choose a fixed rate, adjustable rate, full amortization or interest-only payment.

Some banks are offering no-income-verification (stated income) HELOCs if your credit history is good or excellent.

Many lenders will give the homeowner a line of credit up to 100% of the value of his home, minus the amount of the first mortgage.

Example: If a borrower has decent or good credit, owns a house recently appraised for $100,000, but only carries a first mortgage of $70,000, and then he would be able to get $30,000 as line of credit. This equals a 100% equity line of credit.

The calculation is easy: Appraised value minus first mortgage = home equity.

The calculation in numbers: $100,000 minus $70,000 = $30,000.

Please keep in mind that the numbers can change with the approved CLTV of the equity line of credit. So, if the approved line of credit were only 90% of the value of the home, the line of credit would be smaller. In our case the line of credit would drop down to $20,000.

The calculation is now: Appraised home value ($100,000) X 90% ($90,000) minus first mortgage ($70,000) = approved line of credit ($20,000).

Some lenders are even willing to approve a line of credit up to 125% of the appraised value.

That would mean if the borrower’s house is valued at $100,000, the line of credit could be up to $125,000.

A home equity line of credit can be of great benefit if, for example, you carry balances on high-interest-rate credit cards. With the line of credit you'll be able to pay off all or some of your credit cards and should usually end up with smaller monthly payments. An additional benefit is that the interest on lines of credit which are secured by your home, are tax deductible up to a loan amount of $100,000 if the LTV is not higher than 100%.

The interest rate payments on those tempting 125% equity lines of credit are NOT tax deductible, regardless of the loan amount. This tax rule might cost the borrower hundreds or even thousands of dollars in tax advantages.

Furthermore, borrowers should be very cautious if the loan amount on first and second mortgages are combined (CLTV) higher than 90%.

In case the homeowner has to sell the property shortly after taking out a 100% home equity line of credit, he might end up having to bring money to the closing table in order to sell the house.

Yes, that’s right: In this case the seller might end up bringing money in order to close the deal.

The explanation is very simple. If a homeowner borrows against his home 100% of the market value or more, chances are that paying off both mortgages and all closing costs (realtors’ fees, taxes and settlement charges can add up to around 8% of sales price) will require more money than the sales price brings in. This is almost for certain if a homeowner borrows 125% of the value of his home and tries to sell a few months later. Homeowners can be badly trapped if they have to sell, but wouldn't be able to get a high enough purchase price to cover the pay-off of both mortgages and the closing costs. Remember, realtor’s fees, taxes and settlement charges can add up to around 8% of the sales price.

The same could happen if you own a home in a neighborhood with depreciating home values.

A homeowner who borrowed 100% against his property, which then depreciated 10% in value since the funding of the new loan, might not be able to sell. In a situation like this, the borrower would have to be able to cover the difference with other money sources in order to sell the property.

Should there be no other course of action for the borrower but selling the property, then a settlement with the involved lenders or foreclosure is unavoidable.

Bottom line:

Unless it’s a real emergency, don’t borrow more than

 90% against your home!

>> Click here to learn more about financing >>

Florida Mortgages and Refinancing

FHA, VA, CONVENTIONAL LOANS