Thursday, 15 December 2011

Mortgage "good habits"

When we are buying a home, emotions are high. We're excited, already planning the colours of the walls and who gets what room. Its natural that smart financial habits take a back seat.

Here are some of my "good habits" that I hope others can relate to or perhaps learn from.

1. Don't buy the home you can afford but rather the home that you need. - For most people, the first step in the home buying process is a visit to the bank to figure out what they can afford. While its a good to know what you are allowed to spend, isn't it a better idea to first find out what is it that you need?

The first step has to be to assess your needs - the size of your family, plans for expanding the family in the next 3-5 years, do you need a bungalow because of mobility issues, location i.e. proximity to work, transit, schools, shopping etc, lifestyle etc. If you're a couple with no kids (and no plans to have any or they've already left home), you can likely do with a 2 bedroom place. If you've got a baby (or two) on the way, you need to plan ahead accordingly. If you always take public transit, there's no point looking for a home with a 2-car garage. If you have a very outdoorsy lifestyle and all you want from the home is a place to sleep, you likely don't care if there's a basement or a man-cave.

Once you have figured out what you need, the next step would be to figure out what the market is asking for your needs. Never overlook or outright ignore certain areas or kinds of homes, unless there is a valid reason to do so. Hear-say, perceptions are all useful tools but we're talking about big money here so you owe it to yourself to check out all the options.

Now that you know what you need and what it will cost, in most cases you should know whether you can afford it or not. The visit to the bank should simply be to confirm your calculations and to actually get something on a piece of paper that others will want before letting you have their home. Of course the banks will give you way more money than what you need. Resist the temptation to convince yourself to buy more house than you need. Its not like the bank is offering you free money. You still have to pay it back and more importantly you still have to pay all the interest on that extra money. And that extra money will be the last to be paid off and hence will cost you in interest till the very end.

2. Shop around for the best mortgage.
Most people do this already. But they tend to focus on the just the rate. When I am shopping for a mortgage, I am looking at a few other things as well. Here are all the balls that are in play in my calculations ...
- TOTAL interest cost over the life of the mortgage. Based on my financial situation, I prefer to guesstimate how long it would take me to pay off the entire mortgage. I prepare 2 tables - minimum required payments only & aggressive but feasible pay down. That instantly shows me how much I can save in total interest costs over the life of the mortgage and provides good incentive to follow the aggressive scenario. Always keep your eyes on the Total interest cost ... that's the ball you want to watch ... in fact add it to the purchase cost of your home because this is the true cost of your home.
- Pre-payment options. Most banks / lenders will allow you to increase your regular payments up to a certain percentage and / or allow you to make lump sum payments which go directly against principal reduction. All this with no penalties. Some banks will give you either or. Others will give you both but vary in the percentages. Check out the different options.
- Incentives. Are there upgrade dollars in play if you go with a certain lender? Is someone offering cash back? Is someone offering lower interest rates for the first year? In my experience, in most cases, these are simple gimmicks. In rare cases going one way or the other can be beneficial. Maybe if you take the mortgage from a certain bank, they waive various kinds of fees on other accounts you have with them. This could amount to hundreds of dollars per year and could be a definite plus.

3. Budget for closing costs.
Again most people do but some are very surprised. Avoid putting everything you have into your down payment. Once it goes to the bank, its gone and if you need it 2 days after closing, you aren't going to get it. Well not for cheap anyway. I like to keep a good chunk handy and once I have paid off all the closing costs, if I still have money left over, I use the lender's lump sum payment privileges. That way it only costs me a few dollars in interest over the month or 2 that I held on to the cash but it gives me a lot of flexibility and peace of mind.

4. Avoid unnecessary upgrades.
Very few people actually follow this. Its human nature to want what you don't have. But the smart buyer has his eyes on the bottom line. Every single dollar that you add to your purchase price, will get paid off last. As a result, you will be paying full interest on it for the life of the mortgage. So that $5k granite counter top that you sign off for instead of the standard laminate one is going to cost you over $6K in additional interest (at 5% over 25 years). So you're paying over $11K for that granite counter top. Why not get some use out of the standards that you are paying for anyway and replace them when needed. It'll cost you less.

5. Pay off that mortgage as aggressively as you can.
There is nothing sweeter than owning your home free and clear. And think of all the available cash flow you will have when you no longer have to pay the mortgage. Its like you just won the lottery or got a huge raise.

I'll deal with some more specific tricks in a separate post since this is long enough already. But hopefully this is useful itself.

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