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All about down payments and mortgage requirements

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It’s exciting to buy your first home, but act responsibly when it comes to making this purchase:

  • Live within your means.
  • Don’t get yourself into risky or untenable situations when it comes to choosing a home or taking out a loan.
  • Do not assume the value of the property will increase.
  • Do not assume you will be able to “flip” the home in a few years for massive profits.

Most people need to take out a mortgage to buy their first home. Typically, they’ll bring a down payment for a small percentage of the purchase price in addition to meeting the other mortgage requirements. On a $100,000 home, it might be $20,000.

Where do you get the money for the down payment? If you’ve followed my earlier advice in this guide to establish a special savings account for emergencies or other special situations, you can use this money for the down payment. A lot of people get help from relatives, or sell other liquid assets, such as stocks and bonds.

The remaining $80,000 will be paid for using a mortgage, which is essentially a large amount of money loaned to you by a bank. You pay back a small amount of money to the bank every month over many years.

Mortgages have to be paid back in monthly installments over 15, 20, or 30 years. The monthly payments are usually equal (exceptions include adjustable rate mortgages), and include principal as well as interest that the bank charges.

The size of the monthly payment depends on the amount of the loan, the length of the mortgage (also known as the “term”), and the interest rate offered by the bank at the time the mortgage started. Here’s how a $200,000, 30-year mortgage at a fixed 6% interest rate breaks down:

Monthly principal and interest payments: $1,199

Annual principal and interest: $14,389

Total interest over 30 years: $231,676

Total payments over 30 years: $231,676 + $200,000 = $431,676

The principal declines gradually over 30 years, until the mortgage is paid off:

$200,000 mortgage example - payments over 30 yearsIf you feel the interest rate is too high, you can apply points to the mortgage. Points are a method of lowering the interest rate in exchange for an upfront payment. You might pay a few thousand dollars for 1 point, which will drop the interest rate a full percentage point. This lets you lower your monthly payments, but you’ll have to deal with the upfront cost of “buying” the points at the closing.

Regardless of the interest rate and the length of the term, you’ll also need to pay so-called closing costs (translation: expensive fees) to seal the deal. Lawyers and appraisers need to be paid. There are “origination” fees, fees to make adjustments or filings relating to the deed, etc. These can vary a lot from bank to bank, from just a few thousand dollars to more than $10,000. Shop around and ask about the closing costs associated with a particular mortgage product. Some banks allow you to fold most closing costs into the mortgage, which is one way to reduce the pain.

Tips to deal with financial emergencies

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What if a financial emergency, crisis, or sudden need requires more cash than you have available in your savings account? It could be a large medical expense not covered by your health insurance plan, a large down payment on a house, or an extended period of unemployment.

You may be tempted to simply turn to your credit cards to make up the difference. While credit cards may help temporarily bridge the gap in a financial emergency, they are not a long-term crutch. In fact, turning to credit cards can lead to a new crisis, as high-interest debt turns into a monster that can’t be paid down.

What can you do once the special savings account runs out? There may be no magic solution, but there are ways to make the problem more manageable:

  • Talk with trusted friends or relatives, with the goal of eliciting fresh ideas about how best to deal with the emergency. They may come up with an alternate approach that lowers the overall cost.
  • See if the source of the cost (hospital, bank, etc.) is willing to accept an alternate payment plan. For instance, if a large down payment is required, is there any way to reduce it? Or, if you have just been billed for a $30,000 hospital procedure not covered by insurance, will the hospital allow you to work out an installment plan to pay it off? If the answer is yes, watch for special conditions, fees, or excessive interest.
  • Immediately come up with a plan to cut your expenses. Start with the flexible expenses that are nice to have, but are not absolutely necessary. Personal Finance For Beginners In 30 Minutes, Vol. 1 explained how opting for cheaper phones, cable TV service, and cars can potentially save thousands of dollars every year.
  • Start selling stuff. Furniture, antiques, jewelry, musical instruments, and collectibles may be hard to let go of, but they can provide cash in a pinch. Try to establish the fair market value for the items and your target prices before talking with potential buyers.
  • Consider radical approaches, including rethinking your housing and transportation requirements. For instance, renting out property, downsizing living arrangements, or shifting from cars to public transportation can make a huge impact on annual spending.

This post was excerpted from Personal Finance For Beginners In 30 Minutes, Vol. 2, by Ian Lamont. All rights reserved.

PayPal vs Dwolla

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Paypal vs Dwolla, pros and cons

If you use eBay or have paid someone over the Internet, you’re probably familiar with PayPal. The basic PayPal service lets people pay another PayPal account holder almost instantly. It’s an alternative to paying someone by check, or via cash.

The setup for PayPal and alternative services such as Dwolla is straightforward:

  • Enter your bank account information
  • Wait a few days for the accounts to be connected
  • Confirm that several small electronic funds transfers have taken place — typically a few pennies are deposited into your bank account, which verifies to PayPal, Dwolla, or competing services that the account is yours.
  • Transfer some of your bank funds to the PayPal or Dwolla account. You will be able to use these funds to pay other people who have an account with the same service.

The services have different fee structures:

  • PayPal transfers between private parties are supposed to be free, but business-related transactions are charged a fee that totals about 3% of the transaction.
  • Dwolla doesn’t charge anything for basic transfers, but has fee-based services for priority support and other features.

The services are convenient, and I have used both PayPal and Dwolla for my business. However, there are definite drawbacks:

  • Each service requires both the sending and receiving parties to have active accounts with the same service, and connected bank accounts. This means if you want to pay someone right away, and they don’t have an account, it will take that person at least three or four days to get the account set up and connected with his or her bank. In that time, you could easily write and send a check.
  • Although the services are supposed to be easy to set up, many people have trouble getting their bank accounts connected or performing other basic functions.
  • Because online payment systems have been abused by fraudsters and organized crime, these companies are often overzealous about sudden, unexplained flows of money. PayPal is notorious for freezing legitimate accounts and making it nearly impossible to quickly access frozen funds.

Many people have understandable qualms about trusting their bank information to a Web-based service that will store the data remotely. Conceivably, a lot of money can be instantly lost if passwords and other credentials are stolen.

There are other alternative payment systems (including new virtual currencies like Bitcoin) as well as traditional money transmission services such as Western Union. While these services have features that some people may find useful, they also come with risk and other drawbacks.

This post was excerpted from Personal Finance For Beginners In 30 Minutes, Vol. 1, by Ian Lamont. All rights reserved.

What is a mortgage?

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The following post was excerpted from Personal Finance For Beginners In 30 Minutes, Vol. 1, by Ian Lamont. All rights reserved.

If you’ve purchased a house or condo, you probably had to take out a mortgage. What is a mortgage? In a nutshell, mortgages are loans from banks that help homebuyers pay the difference between the cash they have available to pay for a home and the actual cost of the home.

Typically, mortgages have to be paid back in monthly installments over 15, 20, or 30 years. The monthly payments are usually equal (exceptions include adjustable rate mortgages, described below), and include principal as well as interest that the bank charges.

The size of the monthly payment depends on the amount of the principal, the length of the mortgage, and the interest rate offered by the bank at the time the mortgage started. Here’s how a $200,000, 30-year mortgage at a fixed 6% interest rate breaks down:

Monthly principal and interest payments: $1,199
Annual principal and interest: $14,389
Total interest over 30 years: $231,676
Total payments over 30 years: $231,676 + $200,000 = $431,676

The principal declines gradually over 30 years, until the mortgage is paid off:

What is a mortgage example

This is a greatly simplified view of mortgage payments. Not shown in the data above:

  • Even though the monthly payment never changes, interest payments are high during the early years of a mortgage. Toward the end of the 30 years, most of the payments will be paying back principal.
  • Local real estate taxes are not included.
  • There are fees related to setup, late payments, and other situations.
  • Lenders are required to reveal the annual percentage rate (APR), which is the mortgage rate plus fees, points, and some closing costs. If there is a big difference between the quoted rate and the APR, watch out!

Another risky situation that can lead to serious pain down the road involves monthly payments which “balloon” after a set number of years, which is typical of adjustable rate mortgages (ARMs). Here’s a typical ARM offer:

What is an ARM mortgage example
The initial rate is low, but the rate after the first 5 years is unknown. There is a real risk that the rate could more than double in the 6th year, which would greatly increase monthly payments.

You should always understand the terms of a mortgage based on the printed documents you sign as well as professional advice from an accountant, housing counselor, or experienced real estate lawyer.

This post was excerpted from Personal Finance For Beginners In 30 Minutes, Volume 1:
How to cut expenses, reduce debt, and better align spending & priorities.