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Three Big Financial Mistakes That Could Be Devastating

This article was written by Flexo in Debt Reduction, Real Estate and Home. 16 comments.

A few years ago, a friend of mine quit his job at a bank to focus on his own company. That can be a risky life change by itself, but in addition to his change in income, he and his wife were expanding their family. While I’m sure they would have been fine remaining in their apartment for a few additional years to ensure the new business could provide income, they wanted to purchase a house right away.

The mortgage broker they were talking to must have been very good. When they signed the paperwork for the adjustable rate mortgage, they were paying less per month (not including insurance and taxes) than the cost of rent in their old apartment. The premise could be valid. An adjustable rate mortgage allows you to qualify for a lower rate now while you’re earning less. Despite many studies that have recently declared that real income has been steady or has decreased for most workers over the past decade after taking inflation into account, most people have an impression that they can handle the increase in mortgage cost later because they’ll be earning more money.

For this particular friend, the decision to go with an adjustable rate mortgage paid off. His business found success early and he did not have a problem when the interest rate recently jumped. The situation could have easily gone the other way; in fact, it almost did. He managed to sign a major client at the right time, and it moved his business into profitability. Without the one client, his finances would have been in trouble.

Another friend of mine, when buying his second house, considered an interest-only mortgage. This is another good option to increase cash flow in the short term, but it means larger expenses later on. Unlike adjustable rate mortgages, if you’re paying only interest, you’re not building any equity in your home. In the beginning of mortgage repayment, building equity would be slow, anyway, but it’s helpful to start paying down the principal as soon as possible.

In the days of the runaway real estate market, homeowners could increase their equity just by watching the value of their home increase, but there are few locations where that strategy would work.

Along these same lines, homeowners would often take advantage of double-digit increases in value by refinancing their mortgage and walking away with cash. Enterprising individuals often find this cash helpful for making improvements to their home — and these improvements only pay off in terms of enjoyment of the living space, not future resale value — or investing in their own business.

Adjustable-rate mortgages, interest-only mortgages, and cash-out refinancing aren’t always mistakes. These could be the right options for many people, and several years down the road, one could look back and determine each one was, for any particular person, the best choice. These techniques often probe to be financially devastating if the housing market crashes, your income doesn’t increase as expected, or your business fails.

When plans don’t work out and the mortgage becomes too tough to handle, a family could find itself facing foreclosure.

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Florida’s Beach Property Boom: A Real Estate Lesson

This article was written by Dr. Dean Burke in Real Estate and Home. 29 comments.

This is a guest article by Dr. Dean Burke, author of The Millionaire Nurse Blog. Many years ago, someone I knew was fascinated with the real estate market in Florida, and he set up an investment company to allow others to invest through him. He promised his investors 20% returns. Needless to say, I didn’t participate and I thought he was a little nuts, but this is what the market was like during the bubble. Thanks to Dr. Dean Burke for sharing his experiences and lessons learned.

Unless you were there, it is impossible to visualize the Gulf Coast of Florida’s beach property boom just a few short years ago.

The Redneck Riviera was making a lot of people rich beyond their imagination. This area known for Spring Breaking bikini babes and beer-buzzed bozos was hotter than a teen at his first wet t-shirt contest.

Realtors were flipping or subdividing tracts of sand and scrubby shrubs and making hundreds of thousands in profit. To hell with 6% commission!

Everyone I knew was playing the game. The talk from the beauty shop to the coffee shop was not about Millionaire Housewives, high school football, or American Idol, but about 1031 property exchanges, setback zones, and building codes…

You might be saying, “Where were the grown-ups?”

Well the bankers were lending money to anyone with a pulse and a signature. In this case, “no doc” didn’t mean being without a physician, it meant no paperwork or proof of income required to qualify for a mortgage. “Step right up!” the carnival barker yelled!

My story

I had been visiting the Gulf Coast since I was a kid. My family rented a small concrete block home for a week every summer. My brothers and I had great fun digging fox-holes, waiting 30 minutes after eating to swim so we wouldn’t die of cramps, and building bonfires at night. When I was teen I kissed my first girl and had my first sip of Boone’s Farm while strolling these same beaches.

When I was able 15 years ago, I bought a vacation home in the same area, and I traded up three times since then.

The property boom hit in the early to mid 2000s. Prices began rising overnight. All my friends were making spectacular money! After watching their success, I wanted a piece of the action. The lot across the street from my beach place went up for sale and I jumped on it. No money down, interest-only, baby! Just a couple of months later with prices rising daily, I put that lot up for sale.

Later that same day, while I was nursing a cold one on the beach, a real estate agent trudged across the sand with a contract in his hand. With only the sweat equity involved in digging two holes to place the for sale sign and a signature, I had a pile of money! As I wanted a place on the bay so I could dock a sailboat, I tripled my money by selling my beach front home. (Sorry kids!)

Six months later I had three other properties, nearly worth a million bucks in all. One of these was my dream lot, a bay-front, with deep water dock — a perfect sailboat parking place!

Flexo suggested I include the details of my thought processes, whether there were any financial calculations that went into my purchases and how the decisions were made to sell. I laughed when I read that. The only calculations were greed on my part, making money. The idea that the lots might go down in value never even entered my mind.

Most of you are probably thinking, “I know how this ends: The Lehman Brothers bankruptcy and a spectacular crash.” You’d be wrong.

The needle that pricked this bubble was born in a little low-pressure weather area off the western coast of Africa. Once the levees broke from the Category 5 power of monster Hurricane Katrina, the nation’s spotlight was on how fragile the man-made dwellings on the Gulf coast were. We were 300 miles from the storm, but it might as well have been in our back yard.

Property values plummeted and the lives of everyone connected to that area of the country were changed forever. Businesses closed. Bankruptcies, foreclosures, and shattered dreams were common stories, all a couple of years before Lehman Brothers fell. The subsequent second-round real estate body blow was like pouring alcohol on an open sore.

I was only a bit player in this theater of the absurd and the sand. I had not mortgaged my future on my real estate venture. I learned many valuable lessons from those heady times. I’m reminded of it every month when I make my payments on land that is worth 30 cents on the dollar now.

I’m not looking for sympathy. I’m a big boy. The more cynical among you will think, “He got what he deserved!” I’m glad to say I have survived those days, and I am a much smarter investor today because of it.

Now I ask myself these questions before any major investments, particularly in real estate. They’ll help you too if you will let my pain be your gain.

How does this investment relate to my overall goals? If buying a home in two years is your top goal, investing in gold futures may not be the safest place for that money. Make sure you weigh your time horizon and risk tolerance when you are saving for a large investment.
Is this investment low-risk or speculative? If speculative, make sure it is only a very small portion of your net worth. In my case even with a 60% loss on the value of land I was and am able to make my nut as they say. Make sure your speculative investments won’t take you down with them if you suffer a total loss.
Who will I sell to? When everyone seems to be making the same investments around you, stop and think who the next buyer will be. If you encounter people making the same investment or gamble as you are, that normally aren’t a part of that world, your alarm bells should ring. You owe it to yourself and your family to consider potential negative outcomes. Can you say, “Bubble?”
What are the steps and potential outcomes during each step of the project/investment? If large investments makes you nervous, when you consider the investment, create a mind-map on a whiteboard outlining your potential good and bad outcomes. Do this for each step of the project. Get expert help. You can’t predict hurricanes or tsunamis, but when you live on or near a coast, they need to be considered. When you purchase a rental, consider the possibility of a fire or going months without a lessor. When you are investing in an oil company, what happens if oil prices drop or rise by 50%, or in the worst case, there is an oil spill? Think of as many outcomes as you can and weigh them appropriately.
What is the reward potential? Make sure you understand the possible gains and compare them to possible losses. Is that risk worth taking?
When will I divest myself of this investment? Know when to cash in your gains or minimize your losses. You know the old saying: Bulls make money, bears make money, but pigs get slaughtered. Don’t be a pig. (Oink oink!)

You will never bat one thousand when it comes to being successful with your money. Losses will happen. The secret is minimizing your catastrophic losses that take you down or take decades to overcome.

I have been an active investor through two investment bubbles. The dot-com bubble of the late 1990′s and the real estate bubble.

Investment bubbles are like being a married guy at a party without the wife, and having J Lo and Katie Holmes all over you. Resisting temptation can be almost impossible, but not giving in is what makes a successful marriage. Resisting the siren call during the peak of a bubble will make you a more successful investor, but it’s damn hard!

With luck maybe I’ll have those lots paid off by the time my future grandkids are grown. They will enjoy their beach property. When I get sand between my toes hopefully I’ll be able to remember the good times I had as a kid and not let my adult stupidity get in the way of those great memories!

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The Best Way to Invest in Real Estate

This article was written by Christian in Investing, Real Estate and Home. 4 comments.

This is a guest article by Christian of Money Obedience. If you enjoy this article, please consider subscribing to the MoneyObedience RSS feed.

My parents offered a very important piece of wisdom to me: Even if everybody is doing something, you do not have to do it, too.

Unfortunately I usually applied this advice to the great parties that were going on in town, where “everybody” showed up except for me. Like any teenager, I did not really appreciate the deeper meaning of this sentence until much later. It still doesn’t make much sense in connections with all the great parties that went down without me — maybe I am missing something — but I have applied the saying to many different areas of my life including personal finance.

It is so easy to get caught up in things like the housing frenzy, which seemed to give everybody who was in it overnight riches. Why not participate? “Everybody is doing it. Everybody is making money.” I think I stood aside then partly because my parents insisted often enough that I did not have to participate even if “everybody” else did. The other reason was that I could not see house prices going up for long when new houses were being built left, right, and center. But I am sure some who invested in real estate must have seen the same thing and yet they still invested in real estate.

It’s not like I didn’t feel any pressure to participate. All my in-laws became real estate investors and were getting rich. So, at times I felt stupid when “everybody” was making money hands over fist in real estate a few years ago. During that time my wife and I also bought a home, but we did not follow the prevailing trend to buy as much house as possible.

Instead, we bought a house that was well within our financial means. We did not think of ourselves as real estate investors; we viewed ourselves as future homeowners. My wife and I wanted to buy a house for our family because we needed a home and not a way to easy riches. We bought the house even though we knew that the housing market was in an unsustainable frenzy.

We didn’t feel like we participated in the speculation. We were “real” buyers.

Crazy stuff was happening then, but I could not see myself going along with some of these things. For example, I could never imagine to follow the majority when 82% of all refinancing were cash-out mortgages in the first quarter of 2007. Why would I want to take out a larger loan in refinancing, when I had done so well paying off my debt already? It makes no sense to me personally, but it did to all the people who joined the majority. All these missed parties paid off. I stood aside.

And now I feel like I am outside the mainstream again. Just as it was in fashion to be invested in real estate a few years ago, it now seems to be in fashion to deride real estate in general. After all, our most recent history teaches us that real estate led us to the current economic problems.

We humans have a tendency to give too much value to our most recent experiences which is why it is not so surprising that so many commentators are cautious about real estate investing right now. But let’s be daring and go back a little further than 2000 or 1990. Let’s look at our parents and grandparents. How successful were they in real estate investing?

In days gone by people did not invest in real estate. They, like my parents, got themselves a nice little house with a good enough down payment and then they made their mortgage payments month after month until the mortgage was paid off. They did not know what an interest-only mortgage or a cash-out mortgage was. From what I can tell, my parents did very well with their real estate investing. They ended up living in a house free and clear when they retired, which allows them a pretty comfortable standard of living and which also frees up enough money to indulge our kids with toys.

My parents ended up being pretty successful real estate investors, but they were not true investors. They were homeowners, plain and simple, just like their parents were. This real estate investing technique has worked very well for many decades. It worked until we forgot to understand that our parents’ and grandparents’ real estate wealth did not come from investing. It came from buying a home and paying it off with a mortgage that forced them to pay interest and principal each month. Nothing fancy here. Their house was not a drag on their finances as many argue now, their house was a piggy bank.

One way or another they spent money on living somewhere. Just like we do. But they used their monthly mortgage payments to accumulate wealth over time. These payments were not viewed as a drag on their finances; they kind of became forced savings. How can this make sense when they are paying interest, an expense, and not receiving income?

Here’s an example. Nicole pays $1,200 in interest and a minimum of $350 in principal right now. If we assume that another adequate living space would also cost around $1,200 a month to rent, we can view the $1,200 in interest payment as rent payments. (I am ignoring taxes to keep thing simple.) The $350 reduces the principal of her loan. Eventually she will own the house free and clear without a mortgage attached to it. Her net worth — everything she owns less the stuff she owes — will look pretty good then. And all she did was pay back a loan, month after month after month. But she actually added $350 a month to her net worth or savings without knowing it.

All we need to do is be sensible. We don’t need to gamble on real estate riches. At the same time we don’t need to be scared that buying a house will destroy our wealth for sure. We need to step aside and ignore the prevailing fashion of the times and just manage our own personal finances. That includes buying a house with a solid down payments and making sure that we can afford the monthly payments. That has worked so well for so many generations before us. It should work for our generation, too.

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One-Third of Home Loans are Under Water

This article was written by Flexo in Real Estate and Home. 12 comments.

A few years ago, a coworker formed an investment partnership in speculative real estate. He promised investors a 10 percent annual return and was using the capital to invest in Florida real estate, earning 15 to 20 percent overall. As most of the real estate had not even been inhabited or built yet, the investments were pure speculation. I haven’t been in contact with this individual, but I am wondering how this business is doing in this real estate market.

If you have a mortgage on a house you purchased recently, there is a good chance you now owe more on this loan than your house’s market value. These chances are even greater if you bought into the speculative markets in Arizona, Nevada, or Florida like my former coworker.

Owing more on your loan than the house is worth is not the worst financial situation, but it is risky. If you need to sell your house, you would still have to raise more money to pay off the remainder of the loan. If, on the other hand, you are lucky, you can remain in your house long enough to continue paying off the loan and to wait for home prices to return to the average rate of appreciation of about 3 or 4 percent. Eventually you could come out ahead.

If you find yourself in this position and you care not to be, you can make the time work harder for you rather than against you by increasing the payments towards your mortgage. A pure analysis of the numbers might say that it’s better to invest in the stock market rather than pay off your mortgage faster, but that doesn’t account for the risk of staying in a house whose loan is under water, and that risk can be measured differently by different families in different situations.

Robert Kiyosaki popularized the idea that a house is a liability. He is, of course, technically wrong. A house, and anything you own is an asset, while a mortgage, and anything you owe, is a liability, despite any marketing materials that try to redefine the words. But when your mortgage is higher than the market value of your house, you have negative equity, and that asset is not looking so helpful on your balance sheet.

This negative equity is mostly a result of speculative investing. The news that so many homes are under water invites criticism of home owners who bought a larger or more expensive house than they could afford and have now suffered the effect of a downturn in the real estate market or interest-only mortgages than have now adjusted to include principal payments. But that is only a small problem in this market, it is the speculative investing that accounts for the under water loans.

The areas that were identified as the largest contributors to the total number of home loans under water were the locations that saw some of the biggest increases in home prices as investors gobbled up as much property as possible. These investors intend on selling more frequently than a typical home owner, so they are more vulnerable to the market downturns that result in negative equity.

Are you under water with your home loan? Are you doing anything about it now or are you waiting for home prices to return?

Almost one-third of home loans under water, Emily Glazer, MarketWatch, August 13, 2009
Photo: respres

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Pros and Cons of Interest-Only Mortgage Payments

by Flexo

Yesterday, Consumerism Commentary reader Ryan suggested I write about interest-only mortgages. There is no such thing as an “interest-only mortgage.” Wouldn’t that be nice, though, to have a mortgage that did not require you to pay any principal back to the lender? Unfortunately, when you become a borrower, your lender will insist upon receiving interest ... Continue reading this article…

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Should You Walk Away From a House and Mortgage?

by Flexo

In the real estate boom, many homebuyers extended themselves financially to buy a house that may have been beyond their means. With the exuberant market, people were encouraged to buy with low introductory interest rates and interest-only loans, the belief that their income would increase to meet their payments, predictions that real estate prices would ... Continue reading this article…

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3 Reasons Not to Buy a Home

by Flexo

On Sunday, I noticed yet another new article describing the benefits of renting over buying a house. I’ve been following these articles with interest as my lease is getting closer to its end date six weeks from now, and I’ve been thinking about what to do. In this article, Liz Pulliam Weston provides 3 reasons ... Continue reading this article…

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Revisiting The Housing Bubble, Part 2

by Flexo

Part 1 on this short series about the housing bubble is here, driven by several articles from Fortune Magazine. Lately I’ve been splitting some of my longer posts into several parts — it’s better for digestion (metaphorically or otherwise). Today, about a third of new mortgages are nonstandard, fuzzy-math loans that have allowed many Americans ... Continue reading this article…

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