9. Home Sweet Home: What You Need to Know About Real Estate

American families’ net worth plunged 40% between 2007 and 2010, the Federal Reserve tells us. Most of that loss was driven by the huge drop in home values during that period. The real estate recession came as a shock to people who assumed home prices could go nowhere but up. Millions are still struggling with the fallout of underwater mortgages, as well as changes in lending practices that can make buying or refinancing harder than it used to be.

But I want to start with a question I answered way back in 2005, before the housing bubble burst. I’m proud of this response, since I emphasized the importance of limiting your borrowing to what you can really afford rather than what lenders say you can afford. If more people had followed that advice, the bubble may not have built to such fantastic proportions, and the subsequent bursting of the bubble may not have been so devastating.

A: You have actually asked two of the more difficult questions to answer when it comes to real estate.

Many people believe strict formulas determine how much they can borrow for a home. In reality, lenders have loosened their standards considerably in recent years (remember, this was written in 2005), and some borrowers may find—much to their later sorrow—that they can get a much bigger mortgage than they can comfortably repay.

A good rule of thumb is to keep your total housing costs, including mortgage, taxes, and insurance, to about 25% of your gross income. That way, you’ll have enough money for other goals, such as retirement savings and vacations.

You can stretch a bit more if you expect your income to rise considerably within a few years or if you have no other debt. But you might want to be even more conservative if your income is uncertain or your debt load is particularly heavy.

When you have a target monthly payment, you can play with the online mortgage affordability calculators offered by sites like Bankrate and MSN to see how much house that will buy.

As far as how much to bid, you might consider consulting an experienced real estate or buyer’s agent who is well versed in the neighborhoods you’re targeting for your house hunt.

There are no hard-and-fast rules. Some sellers overprice their homes; others set the price too low, hoping to set off bidding wars. A smart agent can help you figure out which is which and coach you on the best bidding strategies for your market.

Okay, now we return to questions and answers posed since the financial crisis.

A: If you don’t have a down payment saved, you aren’t ready to be homeowners. Homeownership is expensive, with lots of unexpected costs constantly popping up. Some are relatively minor, like having to replace a worn-out appliance. Others are major, such as having to replace a furnace or a roof. That’s why homeownership isn’t a good idea for people who aren’t already in the habit of living below their means and saving a decent proportion of their incomes.

Take the next year or so to tweak your spending and save up a down payment. You’ll need at least a 3.5% down payment to qualify for an FHA loan. A bigger down payment will give you more loan options and won’t leave you upside down on your home from the first day. (“Upside down” means you owe more on the home than it’s worth, and it’s where you’ll be if you make much less than a 10% down payment. That’s because the costs of selling a home typically eat up at least 6% and often more of its sales price.) A 10% down payment is what you should shoot for; a 20% down payment is even better, since you can avoid private mortgage insurance. You’ll want to save enough to cover your closing costs in addition to your down payment—these costs average about $4,000 on a $200,000 loan, according to Bankrate. Ideally, you also want to have three months’ worth of mortgage payments in the bank after closing.

A year also gives you time to polish those credit scores from “okay” to “good.” The higher your scores, the better the interest rate you’ll receive.

But the fact that you’re receiving a “bad report” from your bank is worrisome. You don’t specify what happened, but anything that could be reported to the credit bureaus, such as a missed credit card payment, could cause major damage to your scores. Simply switching to another institution won’t prevent that. And if you’ve piled up a bunch of bounced checks, your credit reports may not be damaged, but you could find it difficult to open new accounts at other financial institutions.

Whatever happened, you should try to straighten it out with the bank before you decamp, even if you ultimately decide to switch accounts.

A: Student loans are installment loans that typically have a positive effect on your credit scores, but your payments on these loans may affect the size of the mortgage you can get.

Many lenders these days have returned to traditional lending standards and don’t like to see total debt payments exceed a certain portion of your income (typically 36%, though some go as high as 43%). If the minimum payments on your loans and the mortgage on your desired home would push you over the lender’s limit, you may need to consider alternatives, such as a cheaper house.

That’s probably a smart course anyway, since taking on too much debt can make it tough to meet your other goals. A big mortgage, plus all the related costs of homeownership, could prevent you from saving enough for retirement, emergencies, or fun stuff, like vacations.

A: Your lender isn’t under any obligation to help you save money. As a result, and as you’ve discovered, there’s often little advantage in sticking with the lender you have.

Whenever you refinance, you should shop hard. Get quotes from several different lenders that detail not just the interest rate, but the fees they will charge. (LendingTree.com can provide you with multiple such offers. Another online resource for mortgages is Quicken Loans, a direct lender. Your credit union may offer mortgages, and all the major banks certainly do.)

Applying with at least two lenders enables you to compare refinancing deals. It’s possible that another lender would have given you a low appraisal as well, but at least you wouldn’t be held captive in the way you are now. Double applications cost you twice as much, obviously; many lenders require you to pay an application fee as well as the cost of the appraisal. Consider it an investment in getting the best deal.

If you want to continue with this lender and expect to remain in the home for more than a few years, bring the cash to the closing so you can pay down your loan balance to the point that you won’t need mortgage insurance.

The experts’ argument boils down to this: You can make more money by investing the proceeds than you’d save by paying off the mortgage. Keeping the mortgage—with an interest rate of, say, 5.8%—is fine because the returns on your investments, plus the tax deduction for the mortgage, will more than cover that cost. A mortgage is the cheapest money you can get and a hedge against inflation. This plan also gives you more liquidity.

I say, unless I can guarantee that I can make 5.8%, I might lose money. And I’d basically be borrowing money just to invest it (and keep some liquidity). That seems risky! If certificates of deposit were earning 6%, it would be a no-brainer, but they’re not. Also, it’s impossible to put a price on the sleep-well-at-night factor.

I’d like to read your thoughts.

A: You’re right that the investing argument requires a lot of assumptions that may not hold up in real life. But that’s not the reason most people should think twice about paying down a mortgage.

The reality is that most people have better things to do with their money than pay down a low-rate, potentially tax-deductible debt such as a mortgage. For one thing, they should be taking maximum advantage of their tax-deferred retirement options, especially if their company plan offers a match. They also need to pay off other, higher-rate debt before considering extra mortgage payments, and they should have a substantial emergency fund set aside as well. Then there’s insurance to consider: If you don’t have adequate life, health, disability, and long-term care coverage, you’ll want to purchase those policies before considering mortgage repayment.

If you’ve got all your bases covered and still want to pay down or pay off your mortgage, then have at it. For many people, the security of a paid-off home is well worth forgoing some extra investment income.

A: If you’re on track saving for retirement and your child’s college education, the smart course would be to gut it out and get the property paid off. You’re so close to the end of this loan that the majority of your payments go toward principal. Refinancing might lower your payments but would dramatically increase the amount of interest you’d pay over time.

If you’re stinting your savings, though, the math gets more complicated. You could view the paid-off vacation home as an asset you could tap later for retirement expenses or college. In that case, getting it paid off on the current schedule would make sense. If selling or borrowing against the home in the future isn’t an option, though, lowering your payments so you can save for your other goals starts to make some sense.

If that’s the option you choose, consider a 15-year loan rather than a 30-year loan. The shorter loan will still dramatically reduce your payment, but you’ll pay about 60% less interest over time.

A: Thirty-year loans offer the most financial flexibility, since the payments are lower than shorter-term loans. But many people want to be debt-free in retirement, and that’s certainly a reasonable goal. Retiring your mortgage before you retire means that you won’t have to pull as much cash from your savings to cover your expenses. That means the money in your retirement can grow tax deferred for longer—which is what you typically want.

Of course, some people are comfortable carrying a mortgage into retirement, and some people have no choice. Perhaps they were serial refinancers, always opting for 30-year loans, or maybe they stretched to buy a home in their 40s and 50s and can’t get it paid off before they quit work. Those who have the option, though, should at least consider repaying their mortgage before they retire, as long as doing so won’t mean stinting their retirement accounts.

A: A payment that’s 30% of your income isn’t ideal, but it’s not what’s causing your financial problems. Most likely, overspending in other areas, such as a too-expensive car loan or credit card debt, is where the problem lies. But you do face a significant risk of your payment rising to unaffordable levels when interest rates finally start marching up again.

Your first step should be contacting a HUD-approved housing counselor to discuss your options, including the new enhancements to the federal Making Home Affordable program. You can get a referral at www.hud.gov. (Many housing counselors work at credit counseling agencies that can also help you work out your budget issues.)

If you can’t get a loan modification or refinance, you can consider a short sale, in which, with the lender’s approval, you sell your house for less than what’s owed and the lender typically accepts the proceeds as settlement of your loan. Short sales will hurt your credit, but you’ll be able to buy another home sooner than if you simply walk away or let your home go into foreclosure.

A: Talk to a housing counselor approved by the Department of Housing and Urban Development about your situation, including the rental property. (You can get a referral to this free or low-cost help at www.hud.gov.)

You don’t need the financial drag of this property adding to your woes. Ideally you’d be able to slash the price for a quick sale or, if you owe more than the property is worth, to arrange for a short sale. Otherwise, you may need to let the property go into foreclosure.

You may not be able to save your primary residence, either. If you don’t have any income, you’re unlikely to get a refinance or a modification, but the HUD counselor can apprise you of your options. If you have any equity in the property, it probably makes sense to sell it while you can rather than let the bank take over and lose a small fortune in foreclosure-related fees. For more information, read attorney Stephen Elias’s book The Foreclosure Survival Guide: Keep Your House or Walk Away with Money in Your Pocket (Nolo Press, 2009).

A: A foreclosure would be a major black mark on the couple’s credit reports and probably would reduce their scores to subprime territory (below 620). Recovering from such credit blows is tougher than it was a few years ago, when lenders were still eager to give money to people with shaky credit.

That means your son and his wife could spend several years in credit limbo. They may have trouble renting an apartment, be required to make bigger deposits for utilities and phone service, and even (in many states) pay more for insurance. Whether their credit will recover before home prices do, though, is an open question. Typically, negative marks like a foreclosure fall off credit reports after seven years, and credit scores can recover to near-prime levels before that.

A foreclosure also puts borrowers in a kind of penalty box with lenders. They may not be able to get another mortgage for several years. If they were to arrange a short sale or voluntarily hand over the keys to the bank rather than waiting for a formal foreclosure, their “penalty box” period could be as short as two years, although they would still suffer significant damage to their scores.

If the couple are having trouble making their mortgage payment, they should contact a housing counselor approved by the Department of Housing and Urban Development and see whether they should try to pursue a mortgage modification to make their payments more affordable. Relatively few homeowners succeed in getting permanent modifications, but it’s certainly worth a try before they walk away.

A: Unfortunately, your experience is all too common—and, too often, people waiting for an answer from their lender wind up losing their homes to foreclosure. Lenders’ poorly trained and poorly staffed loan modification departments have created endless nightmares for homeowners trying to avoid foreclosure.

You should immediately enlist the help of a counselor approved by the U.S. Department of Housing and Urban Development. You can get referrals from www.hud.gov or by calling (800) 569-4287. For little or no cost, a counselor can help assess your situation, offer alternatives, and guide you through the modification process—if a modification is still an option.

You also should read attorney Stephen Elias’s excellent book The Foreclosure Survival Guide: Keep Your House or Walk Away with Money in Your Pocket (Nolo Press, 2009).

What you shouldn’t do is expect the lender to do the “right” thing, including honoring any promises or commitments made to you. The people who get loan modifications have to be tenacious, persistent, and savvy about the process.

A: If your loan was backed by Fannie Mae or Freddie Mac, and if it was originated before June 1, 2009, you may be in luck, thanks to recent improvements to the federal government’s Home Affordable Refinance Program, or HARP.

Federal officials eliminated certain fees and barriers that made lenders reluctant to refinance underwater mortgages. They also eliminated the limit on how far underwater you could be to get help. In the past, you could owe no more than 125% of a home’s value.

You’ll first need to find out whether you have a Fannie Mae or Freddie Mac loan. You can visit www.fanniemae.com/loanlookup or call (800) 7-FANNIE [732-6643]. You’ll find information for Freddie Mac at www.freddiemac.com/corporate or by calling (800) FREDDIE [373-3343]. The toll-free numbers are open from 5 a.m. to 5 p.m. Pacific Standard Time.

Borrowers must be current on their mortgage payments, with no late payments in the previous 6 months and no more than one late payment in the previous 12 months. Loans that have been refinanced under the old HARP guidelines aren’t eligible for another refinance.

If your lender isn’t offering HARP refinances, you can search for others that are. You may want to contact a counselor approved by the Department of Housing and Urban Development (referrals at www.hud.gov) to help you through the process.

Don’t make the mistake of entering “HARP” or “Home Affordable Refinance Program” into a search engine. Most of the links that turn up point to for-profit sites, not all of them reputable. For the real deal, visit www.makinghomeaffordable.gov or call (888) 995-HOPE [995-4673].

A: A lot of finger-pointing is going on right now about why more mortgage modifications aren’t being done, but few would argue that lenders are doing a terrible job of communicating with their customers. You might want to consider enlisting the help of a housing counselor approved by the Department of Housing and Urban Development in your quest. The counselors’ services are free or low cost, and you can get referrals at www.hud.gov. Good luck.

A: The creators of the leading FICO score say the effects of a short sale are similar to those of a foreclosure, which would cause someone with a 780 score on the 300-to-850 FICO scale to lose 140 to 160 points. People with higher scores tend to lose more points to a black mark than people with lower scores, so you can pretty much assume that your scores will drop from excellent to near-subprime territory for a while.

How long the short sale will affect your credit also depends on how high your scores were to start, with a range of three to seven years. Again, the higher your scores were before the short sale, the longer it will take to recover.

You also should be cautious about any agreement you sign with your lender. Some short sale agreements don’t address what happens to the unpaid debt; others specifically keep you on the hook for any deficiency balance (the difference between what you owe and the price the home fetches). Ideally, you want this debt to be forgiven (although you may owe taxes on the forgiven debt). Otherwise, the lender could sue you and cause further financial and credit score problems.

If a short sale is indeed your best option—you can’t rent the place for what it costs you to own it and simply wait for prices to rebound—you’d be smart to get experienced legal help.

A: You’re suggesting that everyone should have been able to predict today’s financial, real estate, and unemployment situations. If that’s the case, your crystal ball is a lot better than anyone else’s.

The first wave of foreclosures primarily affected people who never should have been approved for the mortgages they accepted, if sane lending standards were in place. If they should have known better, so should their lenders. These days, however, many otherwise prudent people are getting caught in financial crunches because of high unemployment and the extraordinarily long duration of joblessness many face (the median duration of unemployment is currently about 20 weeks). And few of these homeowners are getting “bailed out.” Fewer than a million homeowners have received permanent loan modifications through the government’s Home Affordable Modification Program.

The investor in question is considering trying to arrange a short sale of a rental property, in which the lender would accept the proceeds from the town home as settlement of the greater amount the investor owed. That’s not a bailout—there’s no government assistance involved. It’s a private contract renegotiation between two parties.

As for buying stocks on margin, remember that the investments in your brokerage account are collateral for any loan you get from a brokerage. If your account plunges in value, brokerages can and will sell equities in your account. “Bailouts” for investors buying on margin typically aren’t needed because the brokerage usually makes sure it gets paid.

A: Offering a deed in lieu of foreclosure—in which your wife hands over the keys in return for being released from the loan—was probably your best bet to speed things along. If you don’t want to provide the financial information the mortgage company is requesting, you’re stuck waiting this out.

It’s unfortunate, because many lenders prefer deeds in lieu as a cheaper, faster way to get control of properties they’re going to wind up with anyway. The idea is that the homes probably will be in better condition than if an angry borrower or squatter trashes them, plus the costs of formal foreclosures are avoided. As foreclosure times have lengthened, some lenders have even sent out letters to underwater homeowners in default urging them to consider a deed in lieu transfer.

One thing you should investigate is whether the lender can come after your wife for a deficiency judgment. If it is allowed in your state, your wife could be liable for any leftover debt that isn’t paid off with a foreclosure sale. Talk to an attorney familiar with credit and foreclosure laws in your state.

A: If you are sued by this or any other lender, you should consult an experienced bankruptcy attorney about your options. If you can’t afford to pay a deficiency judgment—the difference between what you owe and what the property is worth—bankruptcy could allow you to erase or reduce the debt.

Although some states, including California, protect homeowners from such lender lawsuits, the protection does not extend to rental or commercial property. It can also be waived, inadvertently or otherwise, when a homeowner signs lender documents to arrange a short sale. Anyone who is selling an underwater home or who is in danger of losing one to foreclosure should discuss the situation with an attorney familiar with real estate and bankruptcy laws.

We paid the minimum monthly payment required, which didn’t cover all the interest owed, so that amount was added to our mortgage balance. Like others, we have experienced the nightmare of the current housing market, and with the negative amortization adding on even more debt, we are severely underwater.

We’ve worked with two companies trying to get a workable loan modification, but to no avail. The bank is not cooperating at all.

A lawyer I consulted is advising us not to pay at all going forward, saying that the upside-down home isn’t worth saving or worth the grief. She told us to put our payment amounts into savings so that we have something to live on after we have to leave the home, which I so far have been able to do. But I’m worried about the potential fallout.

Would we be required to pay taxes on the remaining balance we owe after a foreclosure? If we can’t afford to pay the taxes on $200,000 of untaxed income (that we really didn’t earn), what do we do then? Does bankruptcy help with that?

A: When a lender cancels or “forgives” debt, it typically sends you a Form 1099 for the amount of forgiven debt. This amount usually must be included as income on your tax return. But there’s a big exception when it comes to mortgage debt secured by your primary residence.

The Mortgage Forgiveness Debt Relief Act of 2007 generally allows you to exclude from your income the debt that’s left over after a foreclosure. The law applies for the calendar years 2007 through 2012.

You can find more information about the act in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, as well as in IRS news release IR-2008-17.

In some cases, lenders aren’t content to write off the excess debt and instead decide to pursue homeowners after foreclosure for the remaining balance owed. You may be protected by state law from such a lawsuit (as homeowners in California typically are), but you’ll want to discuss this possibility with your attorney. If you are hit with such a lawsuit, you may need to consider filing for bankruptcy.

A: Although foreclosures may not carry the same stigma they did before the real estate bubble burst, they still wreak havoc on your credit scores. Your scores will need three to seven years to completely recover, and that’s if you inflict no further damage. Paying your bills on time and using credit responsibly will help you rehabilitate those numbers.

In the meantime, you can increase your odds of finding a good place by looking for mom-and-pop landlords rather than applying at apartments managed by huge corporations. The big companies usually rely on credit scores to screen out applicants, whereas a smaller landlord may be more flexible. Offering to make a bigger deposit or to pay several months’ rent in advance might help persuade them, said Stephen Elias, author of The Foreclosure Survival Guide: Keep Your House or Walk Away with Money in Your Pocket (Nolo Press, 2009).

A: If her goal is to sell the house, she probably needs to cut the price even more. In most real estate markets today, what gets a home sold is a truly competitive price.

You also might consult an experienced real estate agent about what low-cost improvements could speed the sale. If the home is cluttered or stuffed with furniture, for example, removing one-third to one-half of the household contents can make the space seem dramatically larger. Your mom will be packing and discarding all this stuff anyway, and starting the process now can help sell the home. If she’s not able to manage this alone, consider taking a week or so off to help her or hiring a professional organizer to assist with the process. (You can get referrals to organizers from the National Association of Professional Organizers.)

Other relatively inexpensive fixes can include making minor repairs, refreshing the landscaping, washing the windows, and deep-cleaning the house. Your mom shouldn’t embark on any major remodeling projects because she’s unlikely to recoup the expense. But the money she spends getting her home ready for sale can be deducted when she determines whether she has any taxable profit on the sale. (Typically $250,000 of home sale profit is tax free. The limit is $500,000 for married couples.)

Another alternative is to simply move her in with you and rent out the home, but trying to manage a rental long distance can be a hassle. If that turns out to be your best option, consult the real estate agent for referrals to good property management firms.

A: Your first stop should be eBay. Look on the auction site for completed sales of time shares in your development, using the exact name of the property and clicking on the Completed Sales option on the left side of the page. If there have been any sales, you may be able to sell yours on the site, although you’re likely to get, at best, only a fraction of what you’ve paid. You also could try listing it on sites such as the Timeshare Users Group, at tug2.net; Bidshares.com; or RedWeek.com.

If you don’t find any completed sales on eBay, your time share may have little or no value. You can try contacting the project’s developer to see if you can transfer the time share back. You’re unlikely to get any money from the developer, but you could at least get out from under maintenance and other fees. Another possibility is to donate the time share to a charity. The Timeshare Users Group has information on how to find a charity that might be interested in accepting such a donation.

If you borrowed money to buy this time share, you’ll have to figure out a way to pay off the loan or risk a default that could trash your credit.

What you don’t want to do is pay anyone another big upfront fee. Con artists may insist that fat fees are necessary to “list” your property, or they may even promise that they have a buyer, but they’re only taking advantage of people who are desperate to get rid of money-sucking time shares.