Robbing Peter to Pay Paul: A story of two houses


Nov 12, 2000




I warn you now that this story is not for the faint hearted, but it shows the limits of determining exactly how much house you can afford. Note that the dollar amounts here are huge based on Bay Area economics - you can scale down the numbers and the same ideas will apply.

Before you write me comments about how crazy I am (I got these on my last one), keep in mind that I am following the following maxim, which is a good one if you are in an area where real estate is growing and you view it as an investment:

Buy as much house as you can possibly afford, even if you have to stretch

Why?
1. Because you will earn more in the future, but your payments will stay the same.
2. Because you get more appreciation on more expensive property.
3. Because its really nice to live in the nicest home you can afford.

The Background
I bought my current house for $330,000. It is in an OK but not great neighborhood. We put $33K down, and had a first mortgage for 80% and a second for 10%. We barely squeaked in for the mortgage.

Over time, I grew tired of the area, and wanted to move to a nicer area. This month, about a year and a half later, I had a market analysis done, and got a $435,000 estimate. Not a bad gain for a year. Thus, I decided to look elsewhere.

The New Mortgage
By standard methodologies, I could only afford a mortgage for a house that would cost $450,000. See my review called The Mortgage Formula Simplified to see how this methodology works. Unfortunately, in this area, $450K doesn’t buy a whole lot of house - certainly not if you want to move up.

The New House
Fortunately or Unfortunately, depending on how you look at it, I found the house I wanted. It is a great house, in a great neighborhood, sitting on a great lot. It was listed for $500K. Seem huge? It wasn’t - my realtor and I agreed that it was way too low - more on that later.

The Offer
The selling realtor told us that 12 “disclosure packets” had been picked up. Typically, you get an offer for every two disclosure packets. Thus, we expected (and I think there were) six bids. How much were we going to pay? A very good question, and the reason for this entire editorial.

When deciding how much to pay, you have to look at what are called “comps” or comparisons to other sales. The street that the new house sits on is a bit busy, and the houses aren’t the nicest I have seen. Right across the street, however, are streets filled with gorgeous houses that probably sell for $800K or more. Right up the street a month earlier a house sold for $700K. I looked at a similar house in another area of town that was listed at $575 and likely to sell for a lot more.

From this, and the fact that I wanted the house, I decided that $600K was the likely price I would have to pay.

A $100,000 Overbid? Surely You Jest!
Overbids are, unfortunately, pretty common in this area. Nonetheless, this was my offer.

How Am I Going To Pay For This? OR Robbing Peter to Pay Paul
As I noted above, under the traditional methodology, there is no way I could afford this mortgage. Happily, though, I have some “soft income” in the form of bonuses that will make my income appear larger than it is.

However, here is where a little sleight of hand comes in. The “soft income” usually doesn’t count, because banks want “hard” income, and they verify paystubs to make sure of it. However, if you happen to have 25% down, banks are more lenient - they figure that if you have that much down, that you are not going to walk away from the house.

Where was I going to come up with $150K for the down payment? What a ton of money. I had some saved up, but not this much. Here’s what I did - I took a bridge loan on my current house (that since the market analysis now appraised for $450K) to pull my equity out, and put it into the new house.

To make this work, of course, the planets must align - I have to close the bridge financing, close the new home, and then get my current home sold ASAP. Otherwise, I am stuck with about 7 gazillion dollars in debt and interest payments.

On a side note, if you have ever seen that asian guy with the beautiful girls on the boat telling you how to get rich with no money out of pocket - this is how he is doing it.

But What About the Mortgage Payment? OR Teaser Rates
OK, so I now have financing, but how am I going to pay for the mortgage payment? After all, the “soft” income isn’t providing me with a monthly paycheck. In steps the “teaser” rate. This is a 3.95% introductory rate (note that you must qualify for your loan at the prevailing rate - otherwise everyone would do this). If you’ve never thought about the effect interest rates have, you might be surprised - this lower interest rate cut my payment by more than a third.

However, the bank keeps track of the payment that you would have if you were paying the full market rate. The difference between the special rate and the market rate is called negative amortization. At the end of the year, you either pay the excess if the “soft” income comes through, or you can add the amount to your loan. The next year the teaser goes to 4.95%, then 5.95%, etc. until it hits market.

Note that these teasers are month to month adjustable, so there is an interest rate risk involved.

What If That’s Not Enough
Well, if you don’t want to do the teaser, or if the mortgage payment is still not low enough, you can look at taking on a tenant, if only for the short term. I am going to get a tenant, and I can get a pretty good rate, primarily because I got a nice house in a nice area.

The lessons
To get the most house you can afford, there are a few lessons from this story:

1. You may have to move heaven and earth to get your down payment
2. If you are using use as much of the equity from your current house as possible
3. Use a good mortgage broker - bad mortgage brokers and banks just don’t think creatively enough
4. Explore all of the financing options with your good mortgage broker
5. Really interrogate your realtor and insist that they show you information (and even show you the house) for as many comps as you can - otherwise you just won’t know if you are getting the value.

That’s my story. We’ll see if it comes together, like the A-Team.


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