Author: Christopher Mallon

Article:
If there's one thing American investors love, it's an
over-inflated market. Which is why they keep buying houses and
new ones keep coming onto the market. According to the latest
data, housing starts rose an annualized 3.4% in September,
matching a 17-year high. Whoo-ha! Go, baby go.

I wonder if the people buying these houses, for ever-rising
prices, are the same people who couldn't get enough Amazon.com
stock at $100 or Lucent shares for $75? Having been burned in
the stock market, I guess they decided to re-invest what was
left in their homes. Are we in a housing bubble? I don't know,
but I suspect that we are, at least in some areas of the country.

Don't misunderstand me, now. I own a home, and I think home
ownership is one of the great freedoms we enjoy in this country.
I get nervous about the people who are pulling all the equity
out of their homes with new mortgages. I suspect that most of
these people are spending the equity, not investing it. What
they're left with is a larger mortgage, and a bunch of worthless
Chinese made goods.

The current low-interest rate environment is a
once-in-a-lifetime chance to lock in a cheap 30-year mortgage on
your home. If you refinance the balance of your current
mortgage, you've won. If you refinance, and max out on your
equity, you're probably hurting yourself. You might say that by
refinancing the equity in your home, you're just cashing in on
your home's rise in value. Well, not exactly.

What you're really doing is collateralizing the portion of the
house that you own to get a cash loan, with the intention of
paying back the loan at a later date. You've really transferred
ownership of the equity in your house to your lender, not cashed
it out. If you want to cash out your equity, you have to sell
your house, plain and simple.

For those who are buying new homes, the low interest environment
is a double-edged sword. On the one hand, you can get a
tremendous rate on a 30-year mortgage, the likes of which you
see once in a lifetime. On the other hand, because we live in a
world where the monthly payment is all that matters, lower
interest rate mean higher home prices. The monthly payment stays
the same, but now you've got a much higher mortgage balance,
which could turn around to bite you in the future.

The dangers of refinancing the equity out of your home are
readily apparent, but why shouldn't you buy a home in the
current environment?

I'm not saying you shouldn't. What I'm saying is you have to be
careful. Most real estate professionals understand that the
monthly payment matters, not the price of the house, when
selling a house. Therefore, the lower interest rates fall, the
more money can be charged for a house. If you're a home buyer,
with a set amount of money for a downpayment, the price of the
house will determine how much equity you start with. And, it
determines whether you get a conventional mortgage, with 20%
down, or some other form with less downpayment. That equity
percentage will determine whether you'll be paying for the great
rip-off known as Private Mortgage Insurance (PMI). Trust me,
it's just another monthly payout that goes down a giant
rat-hole. There's no value in PMI, and you don't want to pay it.

For the sake of argument, let's assume that you won't be paying
any PMI. Now, let's compare two neighbors, with identical
houses, who have the same monthly payments on thirty year
mortgages. The first neighbor has a $100,000 mortgage at 10%
interest, the second has a $146,000 mortgage at 6%. You may
think this is extreme, but I can tell you that this is what has
happened in my neighborhood over the last 5-7 years. The type of
house I'm living in retailed for under $100,000 in 1999, and
retails now in the $130,000's.

Back to our example. Both of our neighbors are paying about $875
per month on their mortgage. Now let's suppose that both of them
decide to pay extra on their mortgages, upping their payments to
$1,100 per month. Both neighbors are reducing their principal
balances by $225 more per month, and here's where the first
neighbor has the advantage. The balance on the $100,000 mortgage
goes down much quicker than the $146,000 mortgage, such that
while the first neighbor is paying more in interest every month
than the second neighbor, by sometime in the seventh year,
neighbor one is actually paying less in total interest. Neighbor
one will pay his house off in a little over 14 years, while
neighbor two will take about 18 years to pay off.

In this example, we don't even take into account the possibility
that neighbor one could refinance the balance on his mortgage
when interest rates decline. This would lower his required
payment, and allow him to pay off his house even faster. In the
meantime, the "market value" of his house has risen to about
what neighbor two paid ($146,000). When neighbor one decides to
sell his house, he'll walk away with a lot more cash.

Obviously, this is a simplified example, but one that has been
occurring over and over again in the last few years. I know that
it's expensive right now to buy a house, no matter where you go.
What do you do in this situation? I recommend looking for, and
buying, a home that needs some work. You should look for houses
that are selling at about 80% of the average market value in a
neighborhood. These houses will generally need only cosmetic
work, and maybe a few minor repairs, but you'll save on the
price of the house and have extra equity right off the bat. Stay
away from houses that need plumbing or electrical work, unless
you know someone that will fix it for free. Those fixes cost big
bucks, and will eat up much of the savings on the price of the
house.

Buy the house, make the cosmetic changes, then have it
re-appraised. You'll be surprised at how much the "value" of the
house has gone up. (I put value in quotes because the only real
way to judge the value of a house is to sell it. An appraisal is
simply an estimate of value.) This will also help you get rid of
the PMI, if you didn't have the 20% downpayment, because once
the balance of your mortgage falls below 80% of your appraised
value, you can petition to get rid of the PMI. Houses can be
investments, and like any investment it takes a work to find
good value. But it can be done.

About the author:
Chris Mallon is the editor and publisher of the Undervalued
Weekly, a free personal finance and investment newsletter,
published every Saturday.

To sign up for the Undervalued Weekly, send e-mail to
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