down payment

House 12 & 13

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Surprisingly, I didn’t cover all our houses in posts last year. I was going to say, “let’s finish this up,” but we’ve since purchased #14! This is a long post. I tried to separate the stories, but since they were part of the same purchase, it was too convoluted to decide which story went with which house.

We spent the summer of 2019 living in Lexington, KY. Mr. ODA took a temporary job for 3 months, and we spent our summer looking for more rental properties to try another market. The housing costs in central Kentucky were less than central Virginia, but the rental rates were also lower.

We drove around with our Realtor for quite some time. We were hoping to find a multi-door complex. However, 4-8 door units have just not been well taken care of. We take care of our houses, and I didn’t want to inherit all the deferred maintenance of a poor landlord. Many of the places had long-term tenants, so there wouldn’t be a vacancy to ease getting work done either. Additionally, there were several that we saw where the tenant was home, smoking and telling us all that was wrong with the property. It was abysmal.

So after searching through many other options, we settled on two houses at the same time.

FIRST OFFER

Mr. ODA actually made an offer on a house in Winchester that I hadn’t seen. It was a large house that had been converted into 2 units. Mr. ODA and our Realtor went after work one day, and it wasn’t worth me packing up the baby and driving a half hour to meet them for one house. However, I did get to see some of it because I took on the home inspection appointment. Since I had never walked through the house, it was easy for me to objectively see the information on the inspection and convince Mr. ODA to walk away. There was just too many big-ticket items (e.g., not enough head room for stairs, water damage not properly cleaned up in multiple rooms, several code violations) and deferred maintenance that it wasn’t worth us putting the money into it. The tenants were sitting on the porch smoking during the inspection, and I didn’t love the idea of inherited tenants that were allowed to smoke in the house.

SECOND OFFER

I can’t tell the history of these purchases without this gem of a story. Mr. ODA found a house that was in a decent shape in Winchester.

Aside: We focused on Winchester because while the rent income was low, the housing cost was also low. Whereas in Lexington, the rent was low, but the housing prices were higher.

We made an offer on the house. In the offer, it lists the seller’s name. It was a State Senator! When we sent over the offer, the seller’s agent agreed to our details, but asked for a pre-approval letter before he’d sign. The amount of weight the people in Kentucky put on a pre-approval letter is absurd, in my opinion. We went through the effort to get the letter and send it over. About that same time, the seller’s agent said someone else came in with a better offer, so we could either submit our highest and best offer, or lose the deal. The sketchiness of the action floored us.

The house had been on the market for a month. We had a verbal agreement (that had even been put in writing, but not yet signed). What are the odds that someone came in at the same time as us with an offer over asking for a house on the market a month? We called his bluff, and we were wrong.

THIRD AND FORTH OFFERS – UNDER CONTRACT

In August 2019, we went under contract on two houses in Winchester, KY.

Property12 had been owner occupied and flipped to sell. The owner had lived there long enough that she wouldn’t Docusign the contract, and we had to wait for her to initial, sign, and date all the pages by hand. The house had been listed for 36 days when we made the offer. It was listed at $115,000, and we went under contract at $112,000 with $2,000 in seller subsidy (closing costs) on 8/7. It’s a 3 bed, 2 bath ranch at 1120 sf.

We received the home inspection on 8/14. We asked for the items below to be addressed, or to take $1000 off the purchase price. They agreed to fix the issues.

Property13 had been listed for nearly 3 months before we made an offer. It had been most recently listed at $105,500. Our offer was for $102,000 with $2,000 seller subsidy. We also included the following requirement in the contract: Seller agrees to remediate the water and mold in the crawl space, fix the down spout next to the crawl space door so that it channels the water away from the home, replace the missing gutter on the front of the house, and repair the rotted facia and sheathing on the front of the house.

Additionally, we had a home inspection on the house and identified the following items for them to repair.

Getting the sellers to identify that these items were done before closing was not an easy task. We checked the day that closing was originally schedule for and noted that several things were not complete.

Then, at 7:30 pm the night before closing (which had already been delayed a week), we received one receipt identifying a couple of things were done. Eventually we received documentation that it was taken care of.

LOAN DETAILS

The options we typically ask for when considering the direction of our loan are as follows.

We chose the 25% down – 30 yr fixed option for both properties. Our goal is to not pay points, so that led us to the 25% down options. Since there was no incentive to take a shorter term (thereby increasing your monthly mortgage payments and decreasing your cash flow), we chose the 30 year option.

These loans were originated in September 2019. We processed multiple cash-out-refinances on some of our properties in December 2021; we used it to pay off about $66k on Property12 and about $74k on Property13.

LOAN PROCESSING & DELAYED CLOSING

We had a lender that we loved in Virginia. She couldn’t cover loans in Kentucky, but the company itself had a branch that could do it. She referred us to someone in Kentucky. It was the worst experience I’ve had in closings. Our closings are always annoyingly stressful in that last week, but this was bad throughout the month and then bad enough that our closing was delayed a week – completely due to the loan officer’s inability to manage the loan.

We had multiple issues over the course of the week we initiated our relationship just accessing the disclosures. They kept telling us to sign things we didn’t receive, or they’d tell us our access code and then when I say it doesn’t work, act like they never told us different information and give new information.

On August 16, I had to tell the loan officer that one of the addresses was wrong. THE ADDRESS. On August 26, we received conditional approval of our loan from underwriting. On August 27, we received our appraisal with no issues noted. But at that point, our August 30 closing was delayed a week already.

That’s where the problem was – our appraisal was ordered late, had to be rushed, and still didn’t make it in time for them to develop the Closing Disclosure (CD) and get us to a closing on August 30. The loan officer never once acknowledged that he ordered the appraisals late, causing this delay. It took asking for timelines from his supervisor, and piecing together emails we had on hand, to show that it was his fault.

On August 29, I finally made contact with the loan officer’s supervisor and was rerouted to someone else to get the job done. I had to repeat all of our issues and the errors that were found on the CDs.

On September 3, I was given disclosures that were still wrong. The new loan officer claimed that what she put in the system was correct, so she wasn’t sure what was wrong, causing me to once again outline all the errors.

On September 4, I was asked for more documentation that wasn’t caught during underwriting. I was furious.

On September 5, I gave up talking to our lender about issues on the CD and spoke directly to the Title Attorney’s office, who was much more knowledgable and responsive. Here’s an example of what I’m questioning when I look over a CD. Some of these seem small (e.g., $4 difference, $25 difference), but you can see how these add up, both on a single transaction and when we’re processing several homes in one year. Not to mention – why pay more for something than you were quoted or you’re supposed to?

Another surprise that came our way was a “Seller Agent Fee” for $149 per transaction. At no point in time was an additional fee disclosed to us by our Realtor. A typical transaction has 6% commission paid by the seller, which is traditionally split 3% and 3% for the buyer and seller representation. Being that these were Rentals #12 and 13, in addition to 2 personal residences we had purchased, imagine the surprise when we, as buyers, were being charged for representation. We questioned why this wasn’t disclosed to us up front as a Re/Max requirement, and it was taken off our CD.

CLOSING DAY

I had planned to leave town the Friday after the original closing date because that was the last date that we had our apartment. I didn’t want to move me and the baby into my in-laws house and continue the poor sleep we had been dealing with by not being at home. So even though closing was delayed, I left. Mr. ODA had to be my power of attorney. He had to sign his name, write a blurb, and then sign my name on ALL those papers that are part of a closing….. times two. Eek. I didn’t know that at the time (but baby went back to sleeping perfectly once we were home, so it was worth my sanity 🙂 ).

At 11:30 am on closing day, the lender claimed that the power of attorney documents (from the lawyer…) were not complete enough to be counted as filed on their end. I appreciated the snip from the attorney when questioned.

I always wondered why tv shows always showed both at the closing table with a ceremonious passing of the key. We’ve had our share of weird closings (in a closet, in a parking lot, at our dining room table), but we never sat at the table with the seller in Virginia. We were so confused about how specific the closing attorney was being about the closing time options, and then we found out that the seller and buyer are at the table together in Kentucky. The seller for Property12 was so rude to Mr. ODA through the transaction! She kept grilling him on whether he addressed the utilities. The seller shouldn’t be allowed to talk to the buyer! We’ve since been able to process 3 transactions in Kentucky and avoid the seller at the table, but I’d like to advocate that Kentucky move away from this buyer/seller meeting process!

RENTAL HISTORIES

Property12 was listed at $895 on 10/2. Based on my birds-eye-view of the area, I thought $1000 was going to be easy to rent it at. Based on the 1% Rule that we had followed in Virginia, we should have a goal of $1,100 per month. However, we were trying for a Fall lease, which is more difficult than a Spring lease, so I thought listing at $995 would get quick movement instead of letting it sit for too long. Our property manager disagreed. She also said we were limited our pool of candidates by not allowing smokers; but, the whole house is carpeted and I was not budging on that.

We found a tenant on October 16 and allowed her to move in right away, but not start paying rent until November 1 if she agreed to an 18 month lease (we really wanted to be on a Spring renewal going forward). That was an unfortunate blow to our expectations – nearly two whole months without rental income on a house we didn’t need to do any work to.

We increased rent to $950 as of 6/1/2022 after no previous increases.

Property13 was listed for rent at $995 with no movement. We dropped to $875 and offered free October rent for however long was remaining in the month. A lease was established on 10/18/2019. Our property manager was supposed to establish an 18 month lease and didn’t. Luckily, the tenant agreed to a 6 month extension.

Property13 renewal came in April 2022. She had balked about the state of our economy in 2021, and we backed off the proposed increase at that time. Well, all the jurisdictions finally jumped on the increased assessments, and we saw a drastic increase in our costs. We told her that the new offer for a year lease is $950, which is higher than we’d typically increase in one year ($75 instead of $50). But we told her that we were willing to let her walk if she didn’t agree to it since she originally negotiated a lower cost and argued an increase at the 18 month mark, which we let go. She tried to fight it, but our property manager told her to check the rental options in the area to see that she’s still getting a deal. She agreed to the increase.

MAINTENANCE HISTORIES

Property12 requires a new heat pump in June 2021. We paid $3900 for a whole new system, which is a funnily low number just a year later.

The tenant there complained of high water bills. I asked to see a history of the water bills to know how much was considered higher than their average usage. The property manager agreed that the toilet was running and causing higher bills, but also admitted that they attempted to fix the toilet twice over a 3 week period, with multiple days between receiving a maintenance request and taking action. While I agreed that we could compensate her for the issue, I couldn’t quite pinpoint why this was my financial burden and neither the tenant’s nor the property manager’s. I followed up with more information from the property manager with questions like: Why did it take the tenant from 9/20 until 10/11 to identify the issue still remained and that there was a waste of water? They indicated that they believe they made a good faith effort to address the issues as reported. I eventually settled on a $25 concession on one month’s rent.

Property13 had several issues with the hot water installation that were eventually resolved, which was frustrating after we tried to manage issues with the hot water heater through the home inspection process and received documentation as if it was complete. The tenant requested pest control in July 2020 claiming that a vacant house next door caused an increase in pests. I was frustrated because that’s not how it works. I approved treatment at that time, and then she came back with another request in October. Luckily, I haven’t heard about pests since then. In my Virginia leases, we’ll handle some pest control requests, but if there are roach issues once a tenant has been there for some time, we don’t typically pay for that type of treatment.

SUMMARY

All in all, these tenants have been pretty quiet. They ask for random maintenance things here and there, but they’re not usually big-ticket items (except that HVAC replacement!). Our property manager has been more difficult than the tenants.

Being that we were used to the 1% Rule when we purchased these houses, it’s unfortunate that even at 3 years in, we’re not renting it at 1% of our purchase prices. Our cash-on-cash isn’t completely accurate right now because I won’t see our taxes for this year for another month or two. Being that jurisdictions kept the tax amount steady through the pandemic, I’m expecting to see an increase in assessments for this year. I’ve also seen big increases in our home insurance policies, so that will probably eat into our cash flow as well. Our cash-on-cash analysis on Property12 is about 6.5%, and it’s about 7.5% on Property13. These numbers are only slightly lower than our expectation/desire, with our average being about 8%.

In the upcoming year, we’re going to look to get rid of our property manager, so these houses may begin needing more attention from us. It’s been hard to take on more when paying a property manager has been a sunk cost at this point. However, the frustration of managing their management (e.g., making sure charges are correct, not getting a full picture of what work is being done, and then paying them a significant amount of management money and leasing money only for them to claim that checking on the property requires additional fees) has led to us wanting to take it on since we’re in town now. The current lease terms are up in April and May, so if we’re going to take on management, it should be before the possibility of paying them half a month’s rent for leasing it (not to mention they’re notoriously 4-6 weeks out in every leasing attempt they’ve done for us, whereas I’ve never had an issue getting a property leased within a week).

Making an Offer

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While the housing market has cooled some since I started this post in the Spring, there are still some areas that are moving quickly and aggressively, and this information is still helpful regardless of you being in a multiple offer scenario. Over the course of 6 years and 18 properties purchased (and countless offers made), we’ve caught on to some helpful parts of contracts. Again, keep in mind that I’ve seen real estate contracts in New York, Virginia, and Kentucky; this is not all encompassing or what may work perfectly in your market. This also doesn’t include all parts of a contract since most of them are standard and/or can’t be anything but matter-of-fact (e.g., will the property be owner occupied; is the property subject to a homeowner’s association).

BASICS

Your contract is going to encompass the basics of the purchase each time. This would be the buyer and seller names, address of the property, offer price, and closing date.

Typically, the buyer’s agent draws up the contract with the information being offered. If the offer is accepted by the seller, the seller signs the contract. If there are negotiations, the buyer’s agent will adjust, have the buyer re-sign, and then submit to the seller for signature. When the buyer makes the offer (which is just filling out the contract and sending it to the seller), the buyer will typically include an expiration date of the offer. This isn’t always enacted, but it’s there as a protection so the buyer isn’t sitting idle for extended periods of time waiting for a seller to make a decision. For example, we had an expiration clause in a contract recently where our offer expired at 8 pm that night, but we knew they weren’t going to review offers until the end of the weekend; we had put it in there as a way to hopefully push the seller to make a decision with just our offer instead of waiting for more offers to roll in. We ended up getting the contract on the house, even though our expiration date had technically expired.

In Virginia, the closing date language says “on or before X date, or a reasonable time thereafter.” In Kentucky, it says “on or before X date,” and if you can’t close by that date, you and the buyer have to process an addendum to the contract with a new closing date. We had a contract, as the seller in Virginia, close 2 months after the date in the contract. We were furious about that. We could have walked away and kept the buyer’s earnest money deposit, but then we’d have to formally list (it was an off market deal) and manage that process along with the home inspection issues that may arise. We also had a contract in Kentucky where our lender messed up and delayed our closing, so we had to sign an addendum to the contract to allow us to close a week late.

EARNEST MONEY DEPOSIT (EMD)

Earnest money, or good faith deposit, is a sum of money you put down to demonstrate your seriousness about buying a home. In most cases, earnest money acts as a deposit on the property you’re looking to buy. You deliver the amount when signing the purchase agreement or the sales contract, and it’s applied to your balance owed at closing.

This is not a requirement, but it’s showing your “good faith” to purchase the property because there’s a penalty to you if you try to walk away from the purchase.

In most cases, you pay the EMD to your realtor’s office and they hold it until closing. In Kentucky, they’re on it right away, asking you to send the check as soon as the contract is signed. In Virginia, I didn’t always send the EMD. The amount is listed in the contract, so if I were to default on the contract as a buyer, I would still owe that amount even though I hadn’t paid it to my realtor’s office.

Typically, you’re looking to put 1% down. On a $90k purchase, we gave an EMD of $900. On a purchase of $438k, we gave an EMD of $5,000 (but there were other factors at play as to why we went higher than 1% on that, which I’ll cover later).

CONTINGENCIES

Some items we’ve seen in our contracts are options for the buyer to back out of the contract, or a contingency.

Financing

A sale can be subject to financing. If it’s not an all-cash offer, and there will be a loan secured to purchase the property, data can be entered to protect the buyer’s interests. Typically, it’s going to list the years of the loan to be secured (e.g., 30 year conventional), a downpayment amount, and a maximum interest rate. The interest rates hadn’t been fluctuating much, but this would play into things in the past few months. If you tried to purchase a home when the prevailing interest rate was about 4%, and then interest rates rose to 5.5%, it may affect your ability to qualify for the loan or put you outside a comfort zone for your monthly payment amount. For example, on a $250,000 loan at 4%, your monthly payment is about $1200 per month (principal and interest); if the rate raises to 5.5%, your monthly payment becomes $1420 per month.

This information does not lock you into that break down. If the contract says 80%, and you decide to put 25% down based on the rate sheet, the contract isn’t changed nor is it voided.

Appraisal

If the sale is subject to financing, then it has to be subject to the appraisal. This is a lender requirement to protect their interests. There are some caveats to this, but I will cover them later since they’re more advanced. An appraisal will cost the buyer in the realm of $450-600.

If you’re attempting to qualify based on rental property income, the lender may require you to pay for a rental appraisal as well. We’ve seen this cost at an additional $150, but we’ve typically been able to negotiate our way out of that by providing leases and income history.

Home Inspection

This is one that I almost always recommend including in your offer. This is your “out” in almost every situation. If you get a home inspection, and it finds anything, you can walk away from the contract and not lose your EMD. If a house is important enough to you (a personal residence that you want regardless of what you find on an inspection report), you may eliminate this contingency, but you’ll typically include it. You can even include that you’ll do a home inspection and decide to not do it.

If the house is being sold as-is, it doesn’t mean you can’t get a home inspection. You can still get the inspection to know whether you want to move forward with the purchase. Being sold as-is just tells the buyer that the seller is not willing to negotiate price or fixing items if the home inspection finds something.

The buyer is responsible for the cost of the home inspection. We’ve paid between $300 and $650 for it. The inspector will take about 2 hours to look through the house, including the roof and mechanical parts behind the scenes. Sometimes the inspector will say “this doesn’t look right, but you need to consult a professional in that trade,” which is usually what happens when it comes to roofing. We have done a home inspection, found too many issues to manage (e.g., stairs built out of code) and walked away from the contract. In that scenario, we don’t lose our EMD, but we did pay about $500 for “nothing” (unless you count all the savings of not throwing money into the house to make it safe and livable).

If you find items on the home inspection that you don’t or can’t fix yourself, and the house isn’t being sold as-is, you can request the seller address them. An addendum to the contract will be filed to identify what the seller agrees to fix, and professional receipts have to be supplied before closing to satisfy the requirement. A seller may say they don’t want to be bothered with coordinating the trades to fix the items and offer financial compensation (e.g., we project the cost of these fixes to be $1000, so we’ll take $1000 off the purchase price).

In the realm of “the contract can say almost anything you want,” here’s an example of an additional term that was in one of our contracts. On this particular house, we should have walked away. The closing process was a nightmare because the seller hadn’t paid the electric bill, so we should have known that them wanting a free pass on inspection items was a red flag.

Virginia has a clause to protect the seller’s ability to walk away from the contract in the event of drastic home inspection repair costs.

Wood Destroying Insects (WDI)

A WDI is basically your termite inspection (may include carpenter bees, ants, etc.). We learned with our very first home purchase that this inspection is pretty useless. You can teach yourself what outward signs to look for regarding termite damage. It’s a visual inspection of what the technician can see. But the damage caused by WDIs is behind the drywall. If there’s signs of WDIs outside the studs of the walls, you’ll see it, and that means you have a big problem. Pay the $35 for a professional to say there are signs of active termites.

Another way we found that the WDI is useless is that we had a major termite problem in our house. We were paying for treatment when we sold the house. The treatments weren’t working and the next step was pulling up all the flooring in the basement and treating under the foundation ($$$). The termite company wrote their report: There is an active infestation of termites that are actively being treated. Technically, true. Productively, not the whole picture.

‘ADVANCED’ CONTRACT OPTIONS

I don’t know that these are necessarily advanced, but they’re less common options when making an offer. Some of them come in handy at opportune times, so it’s helpful to know the options at your disposal.

Seller Subsidy

The seller subsidy is the seller’s contribution to closing costs. It reduces the seller’s bottom line based on the offer amount, and it reduces the amount of money the buyer needs to bring to the settlement table. If a contract offer is $102,000 purchase price with $2,000 seller subsidy, then the seller’s bottom line is $100,000.

There is a limit of how much seller subsidy can be in a contract, which is based on the lender’s requirements and is typically 2% of the purchase price. We have had to adjust the contract to account for this limit before we were aware of it; we kept the seller’s bottom line the same, but adjusted the numbers so that we could maximize the seller subsidy.

In Virginia contracts, there’s a boiler plate section identifying the possibility of seller subsidy. In Kentucky, it has to be written into the additional terms section.

Escalation Clause

If you’re in a multiple offer scenario, it may be helpful to offer with an escalation clause. This is an option that a prospective buyer may include to raise their offer on a home should the seller receive a higher competing offer. The buyer will include a cap for how high the offer may go. It’s essentially a way for the buyer to compete with other offers, but not necessarily pay top dollar for the house.

Most recently, our offer was $420,000 and we were told there were at least 4 other offers. We added an escalation clause to our offer. We decided to make it a strange number (e.g., increase by $1770 at a time), and we capped it around $450,000. We were basically saying that we were willing to pay up to $450,000 for the house, but we didn’t have to commit to that number by making our offer at $450,000. The highest offer outside of our offer was about $436k, so our escalation of $1770 over highest offer got us the house for about $438k.

Appraisal Gap Clause

As mentioned, a home purchase with financing is going to be subject to an appraisal. With the housing market exploding purchase prices in the last couple of years, houses have been selling for well over list price. This is nice in theory, but that doesn’t mean that a bank is going to agree that your purchase price is “fair market value.” If your contract is for $500,000, but the home values in the area only support $420,000, the bank is not going to give you a loan based on $500,000. Either the seller has to agree to accept the lower purchase price, end the contract and start over with the listing, or the buyer has to agree to pay the difference in value in cash. A gap clause is preemptive attempt to address this difference between the contract price and the potentially lower appraisal price.

If the buyer believes that the area’s home prices will support a purchase price of about $450,000, but they want to make an offer of $500,000, the buyer may include a gap clause of $50,000. This means that the buyer is more attractive to the seller because the seller’s risk of the contract falling through after the appraisal comes back is minimized. This also means that a buyer would have to be able to show the lender that they have the cash to cover the gap clause needed (if needed), the down payment, and the closing costs.

We used a gap clause on our most recent purchase. The list price was $415,000. I was confident that an appraisal would cover up to $425k, but I didn’t see many comparable sales higher than that without venturing into different neighborhoods. We offered, with an escalation clause, up to about $450,000. Since we weren’t sure that the appraisal would go that high, we offered a gap clause of $25,000. Our final purchase price was $438k, and the lender waived an appraisal need, so our gap clause wasn’t enacted.

RANDOM CLAUSES

I mentioned that a contract can almost say whatever you want. Here are a couple of examples of protections we put in an offer that had to be satisfied within the term given or we could walk away from the deal with no penalty.

SELLER THOUGHT PROCESS

The seller’s comfort comes into play when you’re in a multiple offer scenario. A buyer can make an offer saying almost anything they want (within reason of a residential real estate transaction). You can manipulate your offer to show the seller how vested you are in the purchase. Sometimes a seller just cares about the bottom line numbers, but sometimes (like if you’re competing with a similar offer), a few tweaks to your offer may make you more desirable.

I mentioned that we went higher than 1% on our EMD for our personal residence purchase. We wanted to show that we were very interested in the property, so one way to do that is to show that we have a lot of “skin in the game.” If we default on this contract, we’re out $5,000 and getting nothing. Whereas, when we’re purchasing a rental property without emotion, if it doesn’t go through, it doesn’t go. Sticking to about 1% is showing that we’re “checking the box,” but not that we’ll do anything and everything to make sure this deal goes through. We would still be out some money and get nothing if we walked from a contract without enacting a contingency, so the higher EMD you include, the more serious you appear.

A seller may not understand the big picture of providing the subsidy, so that could be risky. If a seller sees that they’re contributing to $2,000 of your closing costs, they may balk at it. Hopefully, they have a realtor on their end that can explain “think of your offer as $100,000 instead of $102,000.”

Eliminating a home inspection may make a seller feel more comfortable too. They may know of some issues in the house and are waiting for the “shoe to drop” through the inspection process, so it could eliminate a stressor for them. I wouldn’t recommend eliminating a home inspection unless you’re confident there aren’t any fatal flaws in the house (e.g., quarter width cracks in the foundation, wet marks on the ceiling, warped/sunken flooring).

The housing market has slowed down, so some of the out-of-the-norm clauses may no longer be worth the buyer’s risk just to compete for a house, but these are some options out there. The general concepts still apply, like when to pay for extra inspections or to expect financing and an appraisal to go together. Know that everything is a negotiation and don’t feel stuck in a contract if red flags are flying.

Mortgage Evaluations

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Rate Sheet Options from your Lender

When reaching out to a loan officer, there are a lot of options to choose from. I’m hoping to break down the decision-making here. I’ll share how we ended up with several different options, too.

Basically, it boils down to: 

  • Put enough down to avoid paying Private Mortgage Insurance (PMI)
  • Don’t pay more than 20% unless there’s a decent incentive. 
  • Don’t pick a loan term shorter than 30 years unless there’s a decent incentive. 
  • Carefully evaluate any Adjustable Rate Mortgages (ARMs).

PMI

I broke down PMI in a previous post: PMI – Private Mortgage Insurance. We suggest doing whatever you can to meet the requirements to avoid paying this. The cost of PMI can be a couple hundred dollars per month, which is money that can be put towards the principal balance of your loan or other bills, rather than in the bank’s pockets. There are also hoops to jump through to remove PMI early, which may include paying for another appraisal on the house ($400-$700!).

LOAN TERMS

A conventional loan will likely require 20% to avoid paying PMI. There are some loan options out there that may allow a smaller down payment without a ‘penalty’ (e.g., PMI, higher interest rate), but 20% is the standard, and is usually required when purchasing an investment property.

There may be an option to put down more than 20% or you may think you can afford to pay a higher mortgage each month, so you’re interested in a shorter loan term. Unless there’s an incentive (e.g., lower interest rate, better closing costs), stick with the bare minimum to get the loan.

If there is an incentive, you’ll need analyze the math and your goals to determine if committing extra money to a higher down payment or a larger monthly payment is worth it. If you have extra cash each month, you can pay more towards your principal rather than pigeon holing yourself into a higher monthly payment. Plus, if you have more cash liquid, you may be able to purchase another rental property, which will increase your monthly cash flow.

While we evaluate the loan terms on every house purchase, I’ll share the details of the two most “unconventional” options we chose. Two things to note: 1) lenders add a ‘surcharge’ to the rate for it being an investment property, typically around 0.75%, which means the rates aren’t going to be the great, super-low, rates being advertised; and 2) the term “point” means a fee of 1% of the loan amount.

HOUSE #2

For House #2 (purchased in 2016), we were informed that if we put 20% down instead of 25%, the rate would increase 0.25% on average. If we assume a 30 year conventional loan, 20% down at 4.125% equates to about $69,700 paid in interest (assuming no additional principal payments); 25% down at 3.875% equates to about $60,800 paid in interest. By putting an additional $5,850 as part of our down payment, we saved about $9,000 in interest over the life of the loan.

Once we determined that we’ll put 25% down, we then had to figure out the appropriate loan length. On this particular offer, 30 year amortization wasn’t an option for us because we would have had to pay a point to get a competitive rate. We chose a 20 year amortization because the house already came with a well qualified tenant, we didn’t expect a lot of maintenance and repair costs due to the house’s age, and we didn’t have an immediate need for a higher monthly cash flow based on our place in life at the time.

While our long term goal was to have rental property cash flow replace our W2 income, this house was early in our purchasing. At the time, we were focused more on paying off House #1 (higher rate and a balloon payment after 5 years). Frankly, we didn’t truly understand the power of real estate investing at this time, and didn’t know how much it would accelerate the timeline for us to meet our goals. By decreasing our loan length, we increased our monthly payment, but also lowered the total interest paid over the loan’s life by over $22k. Since more of our monthly payment is going towards principal reduction than had it been a 30 year amortization, this loan isn’t on our priority list to pay off early.

HOUSE #3

For House #3, we evaluated the rate sheet for the loan term, interest rate, and down payment percentage again. This house was purchased a few months after House #2, so those rate decisions were fresh on our minds. We were quoted several options: 1) 20% down at 4.25% for 20 or 30 years, 2) 25% down at 3.75% for 20 or 30 years, or 3) 25% down at 3.25% with 0.5% points for 15 years.

As you can see, there’s no incentive to pick the 20-year term because it’s the same rate as a 30-year term. If we have additional cash, we can make a principal-only payments against the 30-year term rather than unnecessarily tying up our money.

At first, we thought paying points was an absolute ‘no.’ However, points aren’t a bad thing. Paying down your rate up front can save you an appreciable amount in interest. Plus, points are tax deductible.

Now for the breakdown of each options. Let’s say the house purchase was $110,000 (because it wasn’t an exact number, and it’ll just be easier to use a ‘clean’ number like this). Microsoft Excel has an amortization template where you can plug in the loan terms and see the entire amortization schedule. 

Option 1: 20% down payment equates to a loan amount of $88,000; the annual interest rate is 4.25%; the loan is for 30 years, with 12 payments per year. If we make no additional payments, this totals about $67,800 worth of interest paid over the life of the loan.

Option 2: 25% down payment equates to a loan amount of $82,500 at 3.75%. If we make no additional payments, this totals $55k worth of interest paid over the life of the loan. This requires an additional $5,500 brought to the closing table, but saves almost $13k in interest. It also decreases our monthly principal and interest payment (i.e., not including escrow) from Option 1 by $50.

Option 3: 25% down payment, 3.25% interest, and 15 years (instead of 30 years) equates to just under $22k paid in interest. To obtain the 3.25% rate, it required “half a point.” If a point is 1% of the loan amount, that would be 1% of $82,500. This rate only required 0.5%, so that meant paying $412.50 as part of closing costs along with the additional $5,500 of down payment required for 25%. However, the shorter loan length means that monthly payment is increased (between Option 2 and Option 3, the difference is $197.63).

For about $6k, we pay a higher monthly payment, but we also save a significant amount of interest over the life of the loan. The short loan term of 15 years means this one is also not on our radar to pay off while we focus on paying down other, higher interest and higher balanced, mortgages. In this case, the benefits of the big picture math outweighed the increase in monthly payment.

We are five years in on this mortgage and are already seeing significant reduction in the outstanding principal due to the amortization schedule becoming favorable more quickly. In 10 short years more, our house will be fully paid for, through rent collection, without a single dollar of extra principal payments from our other financials. What a great feeling.

ADJUSTABLE RATE MORTGAGES (ARMs)

An adjustable rate mortgage can be beneficial depending on the terms and how long you expect to own the house. For us, we expect to hold our investment properties for a long time, so it wasn’t worth the risk of an ARM. Many times lenders won’t even offer an ARM on an investment. However, when we purchased our DC suburb home, we knew we didn’t expect to be there for more than 5 years, so we chose a 5 year ARM.

After a positive experience with that decision, we also chose an ARM on our second primary residence. We chose a 5 year ARM, even though we expected to be there longer than 5 years. We figured we would either accept the new rate, if there was one, at the end of the 5th year, or we would refinance when necessary. As a result, Mr. ODA monitored rates and refinance options over the last year or so. Unexpectedly, we sold that house 3.5 months shy of the end of the initial ARM term so we didn’t have to do anything.

I break down all the details of an ARM and our decision making in a recent post.

SUMMARY

When I reach out to my lender to ask what the rates of the day are and begin the process of locking a rate on a new loan, I ask for options. These options are in the form of a “rate sheet.” When you ‘lock’ a rate, you’re actually locking the ‘rate sheet,’ not the individual decisions of loan length and percent down. For every house, we evaluate the rate savings that can come from doing something less “conventional” than a 30-year fixed at 20% down mortgage. Our decision is based on what’s best for our goals and our cash in-hand.

As shown above, in our early decisions, we favored shorter loan terms for rate savings. but since House #3’s purchase, we noticed how much more we cared about low monthly payments and low down payments to allow us to buy more properties along the way. Every investment property loan since House #3 has been the ‘standard’ 30-year fixed at 20% down. Because of this perspective shift, we were able to buy six properties in 2017, which gives us about $2,000 in monthly cash flow that we can then use to pay down mortgages.

PMI – Private Mortgage Insurance

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Don’t pay it. Get creative for your down payment. Here’s a brief on how PMI works and how we avoided paying it.

What is PMI?

A lender typically requires PMI when the loan is greater than 80% of the loan-to-value (LTV) ratio because it’s higher risk for them. If a buyer has less of their own money as equity in the property, the bank views this as a higher probability the homeowner will default on their loan. With that, the PMI is required until the borrower reaches at least 80% for the LTV ratio and the loan is in good standing for at least 5 years. This typically means that a borrower needs 20% of the purchase price as a down payment. There are a few exceptions, but overall, if you don’t have a 20% down payment, you’ll be paying PMI.

PMI can be up to 2% of the loan balance. The lender uses your credit score/history, the down payment amount, and the loan term to evaluate your risk and set the PMI rate.

While there are requirements that the PMI must be removed when your loan hits 78% and 5 years in good standing, you can request the removal of PMI earlier if your house value has risen (e.g., market fluctuation, improvements you made). If you request the removal of PMI, you may be required to pay for the new appraisal, which is an added cost. You should weigh the cost of the appraisal against the remaining payments. In a broad example, if the appraisal costs $450, and your monthly PMI is $120, then as long as you have more than 3 months left before hitting the 78% LTV ratio, it’s worth paying the appraisal fee to have PMI removed. There is also a risk that the appraisal doesn’t come back with a high enough house value, so you should be confident in your home’s value before requesting said action.

How did we avoid paying PMI?

While we were more than qualified to purchase a home in the D.C. suburbs based on our debt-to-income ratio, we restricted ourselves to what we could afford as the down payment.

A bank qualifies you based on your debt-to-income ratio. If you have low recurring monthly bills, then you’re qualified for a larger loan. At the time, our only recurring monthly payment was on my vehicle, at about $350/month. The bank pre-qualified us for about $700,000. Sure, we could “afford” a monthly payment on a $700,000 mortgage, but then we couldn’t eat, sit on furniture, or do anything else. 😉 We’d also be paying PMI because we didn’t have 20%, or $140,000, to put down.

Also due to our low debt-to-income ratio, we couldn’t qualify for any programs that would allow anything less than a 20% down payment for a mortgage. We set our purchase limit at $350,000, which meant we would need $70,000 for the down payment, plus closing costs. Due to the limited inventory at that price in the DC suburbs and the knowledge that we were pre-qualified for double what we were searching for, our Realtor kept pushing us to raise our purchase price. However, we advocated for ourselves and kept our focus on what we could afford as our down payment so we wouldn’t pay PMI. After months of searching and seeing places that were literally missing floors and walls, we increased our search to $400,000, hoping that if we found something in the 350k-400k range, we could negotiate it to 350k.

Our move to the D.C. area was not in our original plans. Mr. ODA had been saving through high school and college, expecting to buy a house in a lower cost of living locality. When we moved to D.C., we knew that we would need to change our expectations and day-to-day actions. We rented an apartment in Fairfax, but we didn’t want to be putting over $1600 per month towards rent for long, and we’d prefer to be paying towards a mortgage and building equity in a home. Positives to owning a home: mortgage tax deduction, appreciation, and the equity building that you get back when you sell the home.

While we rented, we were conscious of our spending. We aimed to spend less than $10 per day on food between the two of us, and we limited how much we ate out. We did activities with Groupons or restaurant.com coupons.

We moved to DC in December, and over the summer, we put an offer on a flipped foreclosure. The listing was $384,900; our offer was $380,000 with $2,000 in closing costs. It was denied by the bank, as we were told we were the 2nd best offer of 3. The next day, we got a call that the bank countered our offer. Apparently, the first offer attempted to negotiate their offer further, and the bank moved on to us. They countered $380,000 with no closing costs; we accepted. We now had to scrounge up about $80k for closing. 

We looked into a Thrift Savings Plan (Federal government’s 401k) loan. Many warned us against the idea, but our research showed it wasn’t as much of a concern as others let on. The details of this loan option are on another blog post. We decided to each take a residential loan from our accounts. I took a $15,000 loan and Mr. ODA took a $25,000 loan. We also borrowed $5,000 from Mr. ODA’s parents and paid it back within a couple of months. We avoided PMI.

An argument heard about not owning a home is that it costs a lot to maintain a home. While owning the home for 3.5 years, we gutted the main floor bathroom ($4,000), replaced the AC ($3,600), replaced the hot water heater ($1,100), resolved termite issues with treatment and wall replacements ($2,000), laid carpet in the basement living area, improved the yard through grass maintenance and purchased a shed, and painted a few rooms. We sold the home for over $60,000 more than we purchased it for (tax free since it was our primary residence the whole time), far more than the minimal expenses we put into it.

Key takeaways from our experience:

  • The efforts we put in to avoid paying PMI meant we had another $100-200 in our pockets per month. Instead of padding the bank’s ‘pockets,’ we paid ourselves back with interest into our retirement account.
  • We lived below our means, saved, and kept focus on the big picture.
  • We pushed ourselves to our financial limits to begin building equity in a home, rather than paying rent to a landlord (or in our case, an apartment company). The efforts put in that year have paid off time and time again, starting with selling the home 3.5 years later for a profit that led to some of our first rental purchases.