9.4: Purchasing and Owning Your Home

Learning Objectives

1. Identify the components of a purchase and sale agreement.
2. Explain the importance of a capital budget in determining capital spending priorities.
3. Identify the financing events you may encounter during the maturity of a mortgage.
4. Define the borrower's and the lender's responsibilities to the mortgage.
5. Explain the consequences of default and foreclosure.

The Purchase Process

Now that you've chosen your home and figured out the financing, all that's left to do is sign the papers, right? Not quite. You are off to a good start, but the purchase process will also include offers, negotiations, agreements, and a deposit.

Once you have found a house, you will make an offer to the seller, who will then accept or reject your offer. If the offer is rejected, you may try to negotiate with the seller or decide to forgo the purchase. If your offer is accepted, you and the seller will sign a formal agreement, known as a purchase and sale agreement, which specifies the terms of the sale. You will be required to pay a non-refundable deposit or earnest money upon signing the purchase and sale agreement. That money will be held in escrow or a restricted account and then applied toward the closing costs at settlement.

The purchase and sale agreement will include the following terms and conditions:

• A legal description of the property, including boundaries, with a site survey contingency
• The sale price and deposit amount
• A mortgage contingency, stating that the sale is contingent on the final approval of your financing
• The closing date and location are mutually agreed upon by the buyer and seller
• Conveyances or any agreements made as part of the offer; for example, an agreement as to whether the kitchen appliances are sold with the house
• A home inspection contingency specifying the consequences of a home inspection and any problems that it may find, if not already completed and included in the price negotiation
• Possession date, usually the closing date
• A description of the property insurance policy that will cover the home until the closing date

Legally, problems with the property must be disclosed, but specifics vary by state; however, lead-paint disclosure is a federal mandate for any housing built before 1978.

After the Purchase and Sale Agreement is signed, all specified conditions must be fulfilled before the closing date. If those conditions are the seller's responsibility, you will want to check that they have been fulfilled before closing. Read all documents carefully before signing them and obtain copies of everything you sign. Do not hesitate to ask questions. You will probably live in your home and be responsible for mortgage payments for a long time. Be sure you understand the process.

Capital Expenditures

A house and property need care; even a new home will have repair and maintenance costs. These costs are now part of your living expenses or operating budget.

If you have purchased a home that requires renovation or repair, you will decide how much of the work you can do immediately and how much can be done on an annual basis. A capital budget helps project these expenditures and plan for income or savings to finance them. You can prioritize these costs by urgency and by the method of completion.

For example, Mai and Quan just closed on an older home and are planning renovations. During the home inspection, they discovered that the old stone foundation required some repair work. They would like to install more energy-efficient windows, paint the walls, and strip and refinish the old wooden floors.

The home's foundation should be the number one priority. The windows should be next on the list, as they will provide comfort and reduce heating and cooling expenses. Cosmetic repairs, such as painting and refinishing, can be done later. The walls should be addressed before the floors are refinished. You don't want paint spots!

Renovations should increase the resale value of your home. It is tempting to customize renovations to suit your tastes and needs. Still, excessive customization can make it more difficult to recoup the value of those renovations when it comes time to sell. You will have a better chance of selling at a higher price if the renovations appeal to as many buyers as possible. The more customized or quirky the renovations are, the less broad their appeal.

Early Payment

Two financing decisions may come up during the life of a mortgage: early payment and refinancing. Some mortgages have an early payment penalty that fines the borrower for repaying the loan before it is due, but most do not. If your mortgage does not, you may be able to pay it off early (before maturity) either with a lump sum or by paying more than your required monthly payment and having the excess payment applied to your principal balance.

Suppose you are considering paying off your mortgage with a lump sum. In that case, you are weighing the value of your liquidity, the opportunity cost of forgoing cash, against the cost of the remaining interest payments. The cost of giving up your cash is the loss of any investment return you would have otherwise earned from it. You would compare that to the cost of your mortgage, or your mortgage rate, less the tax benefit that it provides.

For example, suppose you can invest cash in a Money Market Mutual Fund (MMMF) that earns 7 percent. Your mortgage rate is 6 percent, and your tax rate is 25 percent. Your mortgage costs you 6 percent per year, but saves you 25 percent of that in taxes. Therefore, your mortgage ultimately costs you 4.5 percent, which is 75 percent of 6 percent. After taxes, your money market mutual fund earns 5.25 percent, which is 75 percent of 7 percent. Since your cash is worth more to you as a money market investment, which nets 5.25 percent, than it costs you in mortgage interest (4.5 percent), you should leave it in the mutual fund and pay your mortgage incrementally as planned.

On the other hand, if your money market mutual fund earns 5 percent, but your mortgage rate is 8 percent and you are in the 25 percent tax bracket, then the real cost of your mortgage is 6 percent, which is more than your cash can earn. You would be better off using the cash to pay off your mortgage and eliminate that 6 percent interest cost.

You also need to weigh the use of your cash to pay off the mortgage versus other uses of that cash. For example, suppose you have some money saved. It is earning less than your after-tax mortgage interest, so you are thinking of paying down the mortgage. However, you also know that you will need a new car in two years. If you use that money to pay down the mortgage now, you won't have it to pay for the car two years from now. You could consider getting a car loan to purchase the vehicle, but the interest rate on that loan would likely be higher than the rate on your mortgage, and the interest on the car loan is not tax-deductible. If paying off your mortgage debt forces you to use more expensive debt, then it is not worth it.

One way to pay down a mortgage early without sacrificing liquidity is by making a larger monthly payment. The excess over the required amount will be applied to your principal balance, which then decreases faster. Since you pay interest on the principal balance, reducing it more quickly would save you some interest expense. If you have experienced an increase in income, you may be able to do this relatively painlessly; however, there may be a better use for your increased income.

Over a mortgage as long as thirty years, that interest expense can be substantial, possibly more than the original balance on the mortgage. However, that choice must be made in the context of the value of your alternatives.

Refinancing

You can consider refinancing your mortgage if better rates are available. Refinancing means borrowing new money, typically by acquiring a new mortgage to repay an existing one. It also involves closing costs: The lender will want an updated appraisal, a title search, and title insurance. It is valuable to refinance only if the mortgage rate is significantly lower than your current rate, resulting in a substantial reduction in your monthly payment. That, in turn, depends on the size of your mortgage balance.

You may be able to refinance and increase the principal balance on the new mortgage without increasing the monthly payment over your old monthly payment. If interest rates are low and your home has appreciated in value, your home equity may increase. You can withdraw equity from your house, but doing so means you are not allowing it to function as an investment. You are not storing your wealth.

Using gains from the house and investing them may be a good choice. But if you take gains from the house and use them for consumption, you reduce the investment returns on your home. You are also using non-recurring income to finance recurring expenses, which is unsustainable. There is also a danger that property values will decrease, and you will be left with a mortgage worth more than your home is worth.

Default, Foreclosure, and Fraud

If you have a change of circumstances (you lose your job in an economic downturn or you have unexpected health care costs), you may be unable to meet your mortgage obligations as planned. You may become unable to make payments. A mortgage is secured by the property it finances. If you miss payments and default on your mortgage, the lender can foreclose on your property, evict you, take possession of your home, and then sell it or lease it to recover their investment. Under normal circumstances, lenders incur a cost in repossessing a house, and usually lose money in its resale. It may be possible to renegotiate the terms of your mortgage to forestall foreclosure. You may want to consult with a legal representative or contact federal and/or state agencies for assistance.

You may believe you are having trouble meeting your mortgage obligations because they are not what you thought they would be. Lenders profit by lending. When borrowing, it is essential to understand the terms of your loan. If those terms adjust under certain conditions, you must understand what could happen to your payments and the value of your home. It is your responsibility to understand these conditions. However, according to federal and state laws, the lender is required to disclose the lending arrangement and all associated costs. Some rules may vary from state to state, but if you believe that all conditions and terms of your mortgage were not fairly disclosed, you should contact your state banking regulator or the U.S. Department of Housing and Urban Development (HUD). Consumer advocacy groups can also help clarify laws and explore any available legal recourse.

Just as your lender has a legal obligation to be forthcoming and transparent with you, you must be truthful. If you have misrepresented or omitted facts on your mortgage application, you can be held liable for mortgage fraud. For example, if you have overstated your income, misled the lender about your employment or your intention to live in the house, or have understated your debts, you may be prosecuted for mortgage fraud. Some forms of mortgage fraud are more elaborate, such as inflating an appraisal. Whether the errors are intentional or accidental, you are responsible for providing the lender with accurate information.

Summary

• The purchase and sale agreement details the conditions of the sale
• Conditions of the purchase and sale agreement must be met before the closing
• A capital budget can help you prioritize and budget for capital expenditures
• Early payment is the trade-off of interest expense versus the opportunity cost of losing liquidity
• Refinancing is the trade-off between lower monthly payments and closing costs
• Both borrowers and lenders have a responsibility to understand the terms of the mortgage
• Buyers, sellers, lenders, and brokers must be alert to real estate scams and possible cases of mortgage fraud
• Default may result in the lender foreclosing on the property and evicting the former homeowner

Exercises

1. Read what the National Association of Realtors has to say about real estate purchase agreements (www.nar.realtor/closing/real-estate-purchase-agreement), and view a sample California residential purchase agreement (www.eforms.com/purchase-agreements/ca/). For comparison, find a sample purchase and sale agreement for your state.
2. According to this chapter, what information is included in a purchase and sale agreement?
3. Use this mortgage refinancing calculator (www.bankrate.com/mortgages/refinance-calculator/) to find out if you would save money by refinancing your real or hypothetical mortgage at this time. What factors should you take into consideration when deciding to refinance?
4. Read about mortgage fraud (www.investopedia.com/terms/m/mortgage-fraud.asp) as defined by Investopedia. What constitutes mortgage fraud? What common ways do home buyers become involved either directly or indirectly in mortgage or real estate fraud?
5. Explore the ways to avoid foreclosure (www.usa.gov/avoid-foreclosure) at USA.gov. What steps should people take to avoid foreclosure?