9 Purchasing, Financing, and Insuring a Home

When a homebuyer takes out a mortgage, it is called a loan origination. Figure 9.9 shows the number of mortgage originations and the dollar amount (volume $) by loan type since 1998. The majority of mortgages have been conforming-conventional (GSE) loans, followed by FHA/VA/USDA loans. In 2023, over 3 million loans were originated and lenders loaned out over $1 trillion in mortgages, almost half of which were conforming-conventional loans. Among first-time homebuyers, 52 percent used conventional loans, 29 percent used FHA loans, and 9 percent used VA loans. The number of subprime mortgages funded by PLS dropped significantly following the 2008 financial crisis after anti-predatory mortgage lending laws were enacted. In general, lending standards have become stricter since 2008.

Figure 9.10 shows the average credit scores and average loan amount by loan type in 2024. The actual average credit scores were quite a bit higher than the stated minimum requirements for all loan types. The average loan amounts reflected the characteristics of each loan type. Since housing prices vary greatly in different parts of the country, so do the loan amounts.

Figure 9.11 shows the average conforming-conventional loan size by region. Knowing the historic average numbers will help you with your financial planning and setting your expectations.

Figure 9.11

Important Mortgage Attributes Affecting Your Monthly Payment Amount

For any given loan size, there are three key factors that affect the monthly mortgage payment amount. The first is the interest rate. Interest rate can be fixed throughout the life of the loan (fixed rate mortgage, FRM) or can change with market interest rate (adjustable rate mortgage, ARM). You can also pay points (sometimes called discount points) to get a lower interest rate. Points are stated as a percent of the loan amount and is paid up front. One point is one percent. You can think of points as prepaid interest. The second is the length of the loan, called loan term. The third factor is whether the loan is fully amortized. With a fully amortized loan, if you make the specified monthly payment, the loan will be paid off at the end of the loan term. This is because each payment contains a principal portion, also known as an equity portion, that reduces the remaining balance of the loan. Lenders are required by law to provide you with an amortization table showing all the monthly payments and their interest and principal (equity) portions, and remaining balances throughout the life of the loan. You can compute the same information using the following formulas. We will use an example to illustrate how to apply these formulas.

Points or no points?

Your credit history, DTI ratio, and down payment percent will be the most important determinants of your mortgage interest rate. A high credit score (780+), low DTI ratio (< 30 percent), high down payment (20+ percent), and a long stable employment history will qualify you for the lowest interest rates. Is it worthwhile to pay points to get a lower interest rate? The answer depends on a number of factors. The most important factor is how long you plan to hold the mortgage. You may pay off a mortgage early because you sell the house or to refinance because the interest rate decreases. The second factor to consider is how much reduction in interest rate you will get per point. A point is one percent of the loan amount. One point on a $350,000 mortgage will be $3,500. In the past, one point will often reduce the interest rate by 0.25 percent. If this trend holds, a rule of thumb is that you will break even if you hold the mortgage for more than 7 years. This is assuming you pay the points up front and not roll them back into the mortgage, increasing the loan amount. If you roll them back into the mortgage, the break even time will be 12 years.  Points must be paid up front. This means money that you spend on points can be used to increase the down payment. If your down payment is less than 20 percent and you have a conventional mortgage, you may be better off using the money toward down payment so you can eliminate PMI premium faster.

Fixed rate or adjustable rate?

Fixed rate loans have dominated the mortgage market in the past decade because interest rates have been at their historic lows. Figure 9.13 shows 30-year and 15-year fixed mortgage rates since 1970. Adjustable rate mortgages (ARMs) were popular when interest rates were high. There are three important characteristics to consider when evaluating an ARM. The first is the length of the fixed period and adjustment frequency. The label for ARM includes 2 numbers, the first indicates the length of time the rate is fixed and the second indicates how often the interest rate will change after the fixed period ends. A 5/1 ARM means that the rate is fixed for the first 5 years and will change every year thereafter. A 3/6m ARM means that the rate is fixed for the first 3 years and will change every 6 months thereafter. The second characteristic of an ARM is the index and the margin. The interest rate on an ARM is the index rate plus the margin. The index is usually the Secured Overnight Financing Rate (SOFR), the Constant Maturity Treasury (CMT) rate, or the Moving Treasury Average (MTA) rate. These indexes are benchmarks used by financial institutions and published daily online. For instance, if the current index rate is 4 percent and the margin is 3 percent, the initial interest rate on a 5/1 ARM will be 7 percent. After 5 years, the interest rate can change, depending on the index rate. The last factor to consider is the caps. The first adjusted interest rate cap is how much interest can increase when the fixed period elapses. The subsequent adjusted interest rate cap is how much interest can increase at each adjustment frequency. The lifetime rate cap is how much interest rate can increase during the term of the loan. For instance, the above 5/1 ARM has an first adjusted cap of 2 percent, subsequent adjusted cap of 1 percent, and lifetime cap of 5 percent. After 5 years, the maximum interest rate possible will be 9 percent (7 percent initial rate + 2 percent first adjusted cap). The maximum interest rate possible for this loan is 12 percent (7 percent initial rate + 5 percent lifetime cap).

Initial Low Payment Options – Opportunity or trap?

Some mortgages are designed such that monthly payments in the first few years of the loan are lower than fully amortized loans. Interest-only mortgage allows borrowers to pay only interest on the mortgage initially. This means that the loan balance remains unchanged during this period. To fully pay off the loan, borrowers must make higher payments in subsequent years. A graduated payment mortgage is a mortgage where the payments in the early years are very low, often less than the interest on the loan, and rise to higher levels over time. This kind of mortgage has negative amortization, meaning the loan balance actually increases during the early years because the payment is not sufficient to cover interest due. It is similar to making only the minimum payment on a credit card and the balance continues to increase. A balloon mortgage is a mortgage whose monthly payment is computed assuming a 30-year loan but the loan and the remaining balance is due much sooner, usually 5 to 7 years. Remember that most of the payments during the first years of a 30-year loan go toward interest payments. Typically less than 5 percent of the loan would have been paid off after 5 years. If the homebuyer is unable to get another mortgage (refinance), they will lose the house when the balloon mortgage is due. These mortgages were popular before the 2008 financial crisis and many borrowers were lured into loans by the initial low payments. They found out that they could not truly afford these loans once the higher payments kicked in. These mortgages are considered riskier than fully amortized loans.

15 years or 30 years?

The most common loan term is 30 years with fixed interest rate and fully amortized. In 2023, 96 percent of conforming-conventional mortgages and 99 percent of VA/FHA/USDA mortgages were in this category. The advantages of a 15 year loan include lower interest rate and paying off the mortgage faster. The downside is higher monthly payment. Take a $300,000 loan. If the interest rate on a 15-year mortgage is 6 percent, the monthly payment will be $2,531.57. The total interest over 15 years will amount to $155,683. For the same loan, if the interest rate on a 30-year mortgage is 6.5 percent, the monthly payment will be $1,896.20. Over the 30 years, interest payments will total $382,633. You could save a lot in interest with the 15 year loan. Unfortunately few borrowers will be able to afford the higher monthly payment. If your budget improves and you can afford to pay more, you can make additional payment on a 30 year mortgage. If you pay $200 per month extra, you can reduce the interest costs to $244,800 and pay off the loan in approximately 23 years. When you make extra payment on your mortgage, use a separate check and clearly indicate that the money should be used to pay off the loan balance.

Anatomy of the Closing Costs

You now know that closing costs can be expensive. This section explains the details of closing costs, which have three main components. The first are fees charged by the lender for processing and underwriting the loan. These fees include origination fee, discount points, and other processing fees such as credit report and appraisal fee. Origination fees typically range from 0.5 percent to 1.0 percent of the total loan amount. We discussed points in an earlier section in this chapter. Other processing fees can vary from $1000-$1500. The second component is related to title and settlement fees. These include costs for title search and title insurance for the lender and the homeowner, recording fee and transfer tax paid to the local government, and escrow fee to the escrow company for handling the closing process and managing escrow funds. These fees can total $4000-$5000. You may be able to negotiate with the seller of the property to have them pay part of these fees such as transfer tax. Lenders should be able to provide you with the estimated costs of the first two components based on the loan amount without needing specific information on the property.

The last component includes prepaid expenses and escrows, which is often the least understood and warrants more explanation. Prepaid expenses consist of accrued interest, initial premium on homeowners insurance, and prorated property taxes due at the time of the closing. First let us take a look at accrued interest. Your first monthly mortgage payment is typically due at the beginning of the second month after closing. For instance, if you close on a mortgage on April 10, your first mortgage payment will be due on June 1. The June payment will cover interest for the month of May. At the time of closing, you need to pay the interest from April 10 through the end of April, called accrued interest. Most insurance companies require one year or 6 months of premium when you take out the policy. This amount is due at closing. Cities and towns usually assess property taxes yearly and require quarterly or bi-annual payments. When the closing occurs between payment dates, the taxes are prorated between the buyer and the seller. If the seller has prepaid taxes that cover a period beyond the closing date, the buyer will need to pay the seller for the portion of the taxes after the closing date and vice versa. Sometimes prorated property taxes are handled through the escrow account. The escrow account is managed by the escrow company independent of the lender. Its purpose is to cover the future payments for expenses such as property taxes and homeowners insurance premiums. The escrow account usually requires 2 to 3 months of these expenses to be deposited at the time of closing. Since property taxes and homeowners insurance premiums vary greatly by location, the amount needed for this component depends on the specific property.

More on Escrows (Avoid Unhappy Surprises)

As indicated in the last section, the purpose of the escrow account is to accumulate funds for future payments of expenses to protect the lender’s interest. The property is a collateral for the lender. If the homeowners fail to pay property taxes, the local government can sell off the property. After taxes have been paid off the amount left may not cover the loan balance. If the homeowners insurance policy lapses and the property is damaged, its value may drop significantly. Therefore, many lenders require estimated property taxes and homeowners insurance premium to be paid into an escrow account. In addition to prepaying 2 to 3 months of these expenses as part of closing costs, an estimated monthly amount is added to the mortgage payment. For many borrowers the mortgage payment has 4 components. The interest portion paid to the lender, the equity portion used to reduce the loan balance, the PMI/mortgage insurance portion paid to the mortgage insurer, and the escrow portion deposited into the escrow account.

When the homeowners insurance policy or property taxes are due, the escrow company pays these bills with money in the escrow account. If the actual amount is greater than the estimation, the escrow company will increase the future escrow payment, resulting in higher monthly payment. To avoid unhappy surprises, you can keep abreast of changes to property taxes and adjust your budget accordingly. If your homeowners insurance premiums increase significantly you can shop for another provider. We will discuss homeowners insurance in a later section of this chapter. On the other hand, if the actual amount of these expenses is less than the estimation, the escrow company will send you a check for the difference. This may seem like a happy surprise. You may not want to spend that money right away. There is a good chance that the excess may be due to a quirk in the proration calculation rather than a decrease in property taxes or insurance premium. If that is the case your next escrow adjustment will be revised upward again. You will be better off saving that money for future escrow revisions.

Important Lessons from the Financial Crisis

Many people believe that a house is a good financial investment. Like all financial investments, there is risk. Figure 9.15 shows the quarterly percent change in median house prices. In most years, house prices increase but not always. Homeowners discovered that economic downturn can result in significant drop in house prices. The cumulative decrease in median house prices between 2007 and 2011 amounted to 19 percent. In some areas, the price drop was much greater. Prices in Las Vegas fell by 59 percent in that period. A large number of homeowners ended up with a loan balance greater than the value of the house. Risky mortgages and mortgage related financial products were part of the causes of the 2008 financial crisis. Congress responded by passing laws to improve consumer protection in the mortgage application process. Lenders now must show that they have made reasonable effort to ensure that borrowers have the ability to repay the mortgages. This is called the Ability-to-Repay (ATR) standard. Many lenders meet the ATR standard by issuing “qualified mortgages”. Qualified mortgages have three main features. The first is that lenders verify income, assets, debt, and other obligations to ensure borrowers have the ability to make monthly mortgage payments based on DTI ratio or the APR of the loan. The second is that the mortgages must not have risky features such as negative amortization, interest-only payments, balloon payments, or loan terms longer than 30 years. Lastly, points and fees must not exceed 3 percent of the loan amount. Qualified mortgages are cheaper than non-qualified mortgages due to their lower risk. When shopping for mortgages, you can and should ask your lender whether a mortgage is qualified.

Another useful legal provision after the financial crisis is the standardized loan estimation form. Appendix 7.1 contains a sample loan estimate. The Consumer Financial Protection Bureau has a loan estimate explainer that helps you understand different parts of the form. A loan estimate should include the loan term, the interest rate type, the loan type, estimated monthly payments, and details on closing costs. Lenders are required by law to provide loan applicants with the standardized loan estimation form within 3 days after receiving the following information:

• your name,
• your income,
• your Social Security number (so the lender can pull a credit report),
• the property address,
• an appraised value of the property, and
• the desired loan amount.

Credit Unions, Banks, Online Only Lenders, and Mortgage Brokers – Which Is Right For You?

Many of the considerations discussed in Chapter 7 for choosing a bank also apply to choosing a mortgage lender. The key determinants are fees, in-person communication, physical location, and reliability. Credit unions tend to have lower fees, lower interest rates, and personal services. In addition to common mortgages such as conforming-conventional loans, FHA loans, and VA loans, credit unions may have some flexibility in considering alternative income sources such as self-employment income. Credit unions are less likely to sell the mortgages they originate than other types of lenders. This means that as long as the credit union remains the servicer, you can contact them throughout the life of the loan if you have questions. Credit unions are a good option for first-time homebuyers. The main advantage of national banks is to have a single app and physical location for all your financial services. They also have more mortgage product offerings, including jumbo loans.

Online only mortgage lenders who do not offer other banking services compete by reducing overhead costs or specializing in niche markets. These lenders often advertise fast preapproval and processing time because the entire process is done digitally. For some homebuyers, especially first-time ones, the house hunting and mortgage application process can feel overwhelming and the absence of in-person discussions can be a significant disadvantage.

Some of these online only lenders are able to offer lower interest rates and lower closing costs due to automation. A small number of them offer subprime mortgages or non-qualified mortgages to borrowers with poor credit history or lacking verifiable income. As discussed in an earlier section, FHA loans are usually a better option for those with poor credit. Most online only lenders sell their loans soon after origination because servicing loans add to their overhead. If you are comfortable with minimum guidance and value speed and digital convenience, online mortgage lenders may be right for you.

Mortgage brokers are licensed professionals who are not lenders. They work with multiple lenders and have access to a wide range of loan options. They manage the paperwork and maintain communication with the homebuyers throughout the application process. Since the mortgage brokers are not the lenders, they do not service the loan after the closing. Some brokers charge a fee directly to the borrower. Most brokers are paid part of the origination fee or a commission as their compensation. If you want a wide variety of loan choices or have unique financial needs, mortgage brokers are more likely to be able to find a mortgage that will fit your requirements.

Shopping For A Mortgage

Before shopping for a mortgage, you should do some preparation. This includes reviewing your credit report, checking your credit score, reviewing your budget, computing your DTI and house cost ratios, and gathering financial documents such as W-2s, payroll records, and bank statements. Next, decide on the loan term and the type of interest rate. For most people, a 30-year fixed rate mortgage is the best option. Start with zero point loans in your initial inquiry to make the comparison easier. Lastly, review the criteria for different types of mortgage including conforming-conventional, FHA, or VA loans. Decide which mortgage type best fits your situation.

When you are ready, obtain quotes from at least 3 lenders. If the loans are conforming conventional mortgages, ask the lenders whether these are qualified mortgages. Be sure to verify that the lenders only conduct soft inquiries to provide you with the estimates. Soft credit inquiries do not affect your credit score. Non-financial factors to consider include the lender’s reputation, availability of in-person service, and accessibility. The key financial factors are closing costs and interest rate. Lenders may not use the standardized estimation form in Appendix 7.1 for quotes, making the comparison trickier. Check that the quote includes all the closing costs listed on the standard form except property taxes and homeowners insurance premium. If you have a preferred lender but their quote is less competitive, you may be able to get them to match another lender.

Once you have chosen a lender, the next step is to get a preapproval, which usually requires a hard credit inquiry. Your credit score will go down temporarily after a hard credit inquiry. Check the preapproved loan amount against the amount you estimated based on the affordability criteria. If the preapproved amount is lower than your estimate, you need to revise down your house price range. Do not increase your house price range if the preapproved amount is greater than your estimate. You may consider paying a fee to lock in the interest rate if you are worried that the interest rate will go up before you close on the house.

Redlining, What is It and How May It Affect You

The term “redlining” originated from discriminatory practices in the 1930s. Color-coded maps were created by government agencies to assess the perceived risk of different neighborhoods for mortgage lending. Areas marked in red were deemed high-risk and unworthy of inclusion in homeownership and lending programs. These redlined areas were overwhelmingly Black neighborhoods, systematically denying Black Americans access to financial resources for homeownership and wealth building.

This practice created a stark disparity: white consumers disproportionately benefited from government housing programs and access to low-interest mortgages, enabling them to purchase homes and build equity. Black consumers were largely excluded, leading to segregated communities and a widening racial wealth gap that persists to this day.

In response, the Fair Housing Act was enacted in 1968 to eliminate discrimination in housing by prohibiting bias based on race, religion, national origin, sex, sexual orientation, gender identity, disability, and familial status. While the Act made redlining and other discriminatory housing practices illegal, research and investigations have repeatedly revealed ongoing, widespread, and unequal treatment in real estate services.

Even with legal protections in place, various forms of discrimination continue to disadvantage protected groups in their pursuit of homeownership:

• Steering: This practice involves real estate agents or brokers intentionally directing prospective homebuyers toward or away from specific neighborhoods or areas based on their characteristics^[8]. For example, a Black homebuyer might be subtly discouraged from looking at homes in a predominantly white neighborhood, while a white homebuyer might be steered away from a diverse community.
• Bias in Home Appraisal: Appraisals can affect mortgage approval and loan amounts. Studies have found evidence of racial bias influencing home appraisals^[9]. In one example, a home’s appraised value dramatically increased from $472,000 to $750,000 after a “whitewashing” experiment, where the Black homeowner removed personal items that could signal their race and had a white friend stand in during the appraisal.
• Bias in Mortgage Lending: Studies have consistently shown that Black and Hispanic borrowers continue to face discrimination in mortgage lending^[10]. Even after controlling for risk factors such as credit scores and debt-to-income ratios, research indicates that these groups pay significantly higher interest rates on loans, including GSE FHA loans.

New technology relying on algorithms with no face to face interaction also showed bias. These modern forms of discrimination perpetuate the legacy of inequity in housing and homeownership.

Buying a House

Buying a house involves many steps. A real estate agent can help, especially for first-time homebuyers. However, remember that real estate agents work for the seller. Even buyer agents have incentive to close the deal or sell you a more expensive house because they work on commissions. Once you have determined your affordable house budget, stay in your price range. Tell the agent your target price range, not your loan preapproval amount. There are many hurdles in the home buying process. Do not get emotionally attached to a property too early. It is very common for an offer to be rejected or for an accepted offer to fall through.

Location, location, location! You and your family preferences are the key determinants in your location choice. Keep in mind commute time to work, school for children, and your own lived experience. Moving to a new environment means learning new skills and an adjustment period. Moving from the country to the city may mean learning the public transportation system or complex parking regulations. Moving from the city to the country may mean learning about septic systems and wells.

Your lifestyle and family situation will affect the type of housing you prefer. Single family houses are the most common form of housing in the U.S., especially outside of cities. They typically have more space than condos and townhouses and offer more privacy and freedom to modify and customize the property. Single family houses are usually more expensive and require more upkeep. You should budget 1 to 2 percent of the home value per year for regular upkeep. This amount will be higher for older homes. Condos tend to offer more amenities and much maintenance is usually done by the condo association. This convenience comes at the expense of more fees, less privacy, and more restrictions.

If you are buying a condo or a house in a homeowner’s association (HOA), be sure to review their bylaws. These bylaws govern many things, from yard maintenance standards to building materials and color choices. Most importantly, these bylaws specify what are considered common areas and common structures. The associations can levy special fees, in addition to regular monthly fees, to repair common structures. You may want to contact a board member of these associations and inquire whether there are pending major repairs and the status of reserve funds. Remember to update your budget with the monthly fees if they were not in your original analysis.

Making The Offer

Making the offer on a house means you are signing a purchase agreement. It is a legally binding contract and a deposit is required. The purchase agreement includes the offer price, which can be higher or lower than the asking price along with any stipulations (called contingencies). The most common contingencies are the approval of financing, a satisfactory home inspection, and an appraisal value at or above the offer price. Another frequent contingency is the home sale contingency, which gives the buyer time to sell their current home. Make sure you understand all the information in the purchase agreement before signing. You are likely making the biggest purchase of your life. Do not be pressured or rushed into it.

The seller can accept your offer, reject it, or make a counter offer. If the seller accepts your offer, both parties are committed. If you withdraw from the accepted agreement, you will forfeit the deposit. If the seller rejects your offer, you can make another one and the old offer is void. If the seller makes a counter offer, you can accept or reject it. Your old offer is also void.

After The Offer

The next steps following an accepted offer include home appraisal and home inspection. A home appraisal is a professional assessment of a property’s market value based on recent comparable sales, property condition and size, its features and amenities, and market trends. Lenders require an appraisal before formally approving a mortgage loan. The primary purpose is to protect the lender by ensuring the loan amount does not exceed the property’s actual worth. Ideally, the appraised value of the home will be equal to or greater than your offer price. If the appraised value comes in lower than your offer, you have three options. You can negotiate a lower price with the seller or walk away, assuming your contract has an appraisal contingency. The last option is to come up with more cash for down payment. However, buying a house above the appraised value is usually not a good idea.

Some lenders also require home inspection. In many states, home inspectors are licensed and regulated. The goal of a home inspection is to identify potential current and future problems with the property. This can include:

• Structural issues: Problems with the foundation, roof, or walls.
• Major systems: The heating, ventilation, and air conditioning (HVAC) system, plumbing, and electrical systems. For example, a 20-year-old furnace, while still operational, will likely need significant repair or replacement in the near future, representing a substantial potential cost.
• Appliance functionality: Checking major built-in appliances.
• Safety concerns: Issues like faulty wiring, carbon monoxide risks, or inadequate ventilation.
• Water intrusion: Signs of leaks or moisture problems in the basement, attic, or other areas.

In addition to a general inspection, some states or lenders may require specific inspections for:

• Pests: To certify the absence of termites or other wood-destroying insects.
• Radon: A naturally occurring radioactive gas that can accumulate in homes and is a health hazard.
• Mold: Identification and assessment of mold growth, which can cause health issues and structural damage.

The home inspection report provides a detailed overview of the property’s condition, often with photographs and recommendations for repair. If significant problems or defects are discovered during the inspection, the buyer typically has four options. You can ask the seller to fix the issues before closing. You can ask the seller for a credit at closing to cover the cost of repairs or negotiate a lower price. If the problems are too extensive or the seller is unwilling to negotiate, you can walk away, provided there is an inspection contingency.

After the lender receives copies of the appraisal and home inspection report, you should receive the final approval for the mortgage, assuming nothing significant has changed in your financial situation since the loan preapproval. The lender is required by law to provide you with the finalized loan estimate, including closing costs details. Check this information against the quote you have received. There should not be large differences. The mortgage approval will satisfy the financing contingency in the offer.

The closing is when the entire real estate transaction is finalized. At the closing, be sure to check that information in the closing documents matches the finalized loan estimate. You are signing a 30 year financial contract!

Renting versus Owning

Perhaps you have heard that owning a home will build equity and long-term financial security whereas paying rent is like throwing money away. This statement is an over simplification. The financial reality is more complicated. Owning a home is actually more expensive than renting in a large number of scenarios. The New York Times (NYT) first created a “Rent vs. Buy Calculator” in 2007 and last updated it in 2024^[11] The key factors used in the calculator include:

• Price of the potential home
• Potential monthly rent
• Years you plan to stay at the place
• Inflation rate
• Rate of return on investments
• Marginal tax rate
• Details about owning:
  • Mortgage rate, length of mortgage, private mortgage insurance cost
  • Down payment percentage
  • Estimated house price growth rate
  • Property tax rate
  • Closing costs of buying a home
  • Closing costs of selling a home
  • Home maintenance/renovation cost
  • Homeowners insurance
  • Extra monthly utilities
  • Common fees such as homeowner’s association fees or condo fees
• Details about renting:
  • Rent growth rate
  • Security deposit
  • Renters insurance

The large number of factors used by the NYT Calculator reflect the complexity of the buy versus rent analysis. The saying that “all real estate is local” is true, making it difficult to come up with a simple rule of thumb calculation. Most people focus on the price of the home, and the monthly mortgage payment versus the monthly rent. An often overlooked, yet very important factor, is the opportunity cost of investment return on savings from renting.

As noted earlier, moving is much, much more expensive for homeowners than renters. Transaction costs of selling one house and buying another can total 12 to 16 percent of the home price. When you relocate to a new city or town, it may be a good idea to rent initially to get to know the neighborhood. If your chances of moving are high within 5 to 7 years, renting is the better financial choice.

Financial benefit is only one of many factors in the rent versus own decision. A home usually has more living space and amenities than a rental. It is difficult to find two identical units for the rent versus buy comparison. Your personal values affect whether home ownership will be a source of pride and a personal accomplishment. Owning your home often provides a sense of permanence and stability and of belonging within the community. These other benefits are valuable even though they cannot be measured in dollars. Only you can decide how much they are worth.

Home Equity Lines of Credit (HELOCs)

A Home Equity Line of Credit, commonly known as a HELOC, is a revolving line of credit secured by your home. The interest rate is variable and tied to a benchmark rate such as SOFR. A HELOC has a draw period and a repayment period. During the draw period you can use money from this line of credit as needed, a bit like using a credit card to make purchases. The draw period typically lasts for 5 to 10 years. Interest is computed on the outstanding balance. You have to pay the minimum monthly payment during the draw period, which may be as low as just the interest amount.

Once the draw period ends, the repayment period begins and you can no longer borrow money from this HELOC. You must begin making the required monthly payments, which include both principal and interest. The payment term is usually 10 to 20 years. Since HELOCs have variable interest rates your monthly payments can fluctuate over time as benchmark interest rates change. There are interest rate caps similar to Adjustable Rate Mortgages (ARMs). Some HELOCs have early prepayment penalties. The closing costs for HELOCs are usually quite a bit lower than for mortgages. However, HELOCs often have annual fees, inactivity fees, transaction fees, and early termination fees.

What a HELOC is Good For

The primary advantages of a HELOC are its flexibility in borrowing and repayment during the draw period and often lower interest rates compared to unsecured loans like personal loans or credit cards. Some common uses include:

• Home Repairs: Home repairs can be very expensive. It is better to take out a loan to repair a leaky roof or flooding basement than to let the damages escalate.
• Educational Expenses: HELOCs can be a supplemental source of funding for college tuition.
• Debt Consolidation: If you have high-interest debts, such as credit card balances, a HELOC can be an option to correct your past spending mistakes. It is important to have a plan and budget to change your spending habits before doing a debt consolidation.

What to Watch Out For

Before taking out a HELOC, you should evaluate your ability to make the monthly payments, including those during the repayment period and the maximum potential interest rate based on the lifetime cap. Consider the following risks carefully when deciding whether to use a HELOC for financing:

• Your Home is the Collateral: If you are unable to make your payments, the lender can foreclose on your home.
• The Temptation to Overspend: The ease of accessing a large line of credit can lead to borrowing for non-essential purchases and accumulating more debt than you can comfortably repay.
• Low Initial Payments Can Be Deceiving: The low payments during the draw period may seem manageable. When the repayment period begins, your monthly payments will increase substantially as you start paying back the principal.
• Fees and Closing Costs: Be aware of potential costs such as application fees, appraisal fees, closing costs, annual fees, transaction fees, inactivity fees, and prepayment penalty.
• Risk of an “Underwater” Mortgage: If the value of your home declines, you could end up owing more on your mortgage and HELOC combined than your home is worth.
• Variable Interest Rates: If benchmark rates rise, the monthly payments can increase significantly.

Homeowners Insurance

The home is usually the most valuable asset and worth being insured. If you have a mortgage, the lender will require homeowners insurance. This section explains the terms used in  homeowners insurance policies and the important factors to consider when choosing one. The key elements of a policy include the types of coverage, the types of perils, and actual cash value versus replacement cost.

Types of coverage include the dwelling and other structure such as a detached garage or barn, personal property, loss of use, and personal liability. The personal property component protects everything inside the home, from heating system, appliances, furniture to clothing, and can be supplemented with “floaters” to cover especially valuable items like jewelry or fine art. When your home is uninhabitable, the loss of use coverage pays for additional living expenses such as hotel stays. The personal liability portion covers legal fees and medical expenses if someone is injured on the property.

The term ‘perils’ refers to the dangers that can cause damages protected by the insurance policy. Named perils policies will only cover dangers that are specifically listed in the policy. Basic perils include fire, smoke, explosions, lightning, hail, windstorm, theft, vandalism, vehicle, aircraft, riots, and volcanic eruptions. Broad perils expand the list to ice, snow, sleet, freezing of plumbing, falling objects, and artificially generated electricity. Open peril policies cover all dangers except those specifically excluded in the policy. Open peril policies are more common. Typical excluded perils include earthquakes, floods, landslides, nuclear accidents, war, mold and fungus, pests, neglect, general wear and tear. You can purchase special flood insurance through the National Flood Insurance Program.

Actual cash value provides compensation for the depreciated value of an item, which may be far less than the cost to replace it. Most homeowners opt for replacement cost coverage, which reimburses the full current market value.

Homeowners insurance policies have standardized forms based on the type of coverage, perils, and replacement cost options. The most common forms are the comprehensive form (HO-5) and the condominium form (HO-6). The comprehensive form (HO-5) is an open peril type policy covering the dwelling, other structures, and personal property at replacement costs, plus loss of use, and personal liability. The condominium form (HO-6) has similar coverage as HO-5 except it only covers the interior of your unit, including drywall, fixtures, cabinetry, and flooring but not the exterior of the building that is considered common property and common areas.

The key determinants for the cost of homeowners insurance are the location and value of the house, the value of personal property, the amount of personal liability coverage, and the deductible amount. The recommended coverage is 100 percent of the estimated cost to rebuild your home and $300,000 to $500,000 in personal liability. Creating a home inventory can help you more accurately assess the value of your personal property and very useful in case you need to make a claim. A rough estimate without an inventory is 50 to 70 percent of your home value. Deductible is the amount you pay out-of-pocket on a claim before your insurance company starts paying. A higher deductible typically results in a lower premium. Be aware that some policies may have special, higher deductibles for specific events like windstorms or hurricanes. A common deductible amount is around $2000-$2500 per incident.

Shopping for Homeowners Insurance

All the factors we discussed when choosing an auto insurance policy in Chapter 8 also apply to choosing a homeowners insurance policy. Review the section on “shopping for auto insurance” in Chapter 8 if you need a refresher. In fact, if you already have car insurance and are happy with your agent/underwriter, they will be a good place to start shopping for your homeowners insurance. This is also a good opportunity for you to reassess your car insurance. Obtain quotes from multiple companies before deciding. Ask about available discounts, especially multiple policy or bundled discounts. You may be surprised by the various types of discounts insurance companies offer. You may be able to negotiate a lower premium by presenting a quote from a competing company.

What To Do If You Have Damages To Your House

A home inventory is very useful in the event of damages or losses. Creating a home inventory is as simple as going from room to room and listing items in each. If that is too much, begin the process by taking a detailed picture of each room in your house. Update this list when you make major purchases such as appliances. Stored your home inventory off-site. This could mean cloud storage, an external hard drive kept at a friend’s house, or a safety deposit box. Relying solely on in-home storage risks losing your inventory along with your possessions during a disaster.

In the unfortunate event of a loss or home damage, contact your insurance provider immediately to report the incident and initiate the claims process. If the incident is a theft or burglary, contact the police and retain a copy of the police report. Presenting your home inventory to the insurance claims adjuster will accelerate their assessment and help them understand the scope of your losses. You may want to obtain an independent repair estimate from a reputable contractor or appraisal service. If the initial settlement offered by your insurer is insufficient to repair your home, do not hesitate to appeal. Having a home inventory and an independent estimate will support your case. Keep all receipts, especially if you need to stay at a hotel or purchase replacement items on your own. Accurate record keeping will ensure you will get fully reimbursed.

Appendix 9.1

Link to sample loan estimation.