Many homebuyers underestimate the risk they take when they buy their first house. They buy with little or no down-payment. Sometimes they even borrow their down payment. They take a variable rate because the current rate is lower and they want to keep their mortgage payments as low as possible while they do not fully understand the risk they take. They take extended almost never-ending amortization. They don’t ask for a professional inspector to assess the house condition or they make many other mistakes that can penalize them for a long time and even put their financial freedom and financial security at high risk.
What’s funny enough is that it is often these same exact people who don’t want to take any risk with their savings and prefer to invest in bonds because “the stock market is too risky!”
Here’s why and how your dream house can turn into a nightmare. This is based on a real story. Names and numbers have been changed to protect identities. (Oh I love to say that! It sounds cool!)
Misunderstanding that a mortgage is a financial lever
I heard a young couple talking at the restaurant recently. They were discussing about the risk of using leverage to invest. The girl didn’t want her boyfriend to take his personal credit margin to invest in the stock market while the guy was trying to explain her how the potential gain could become exponential with leverage. He was so passionate and sounded convinced that he would make them become millionnaire very fast if she would only let him do what needs to be done.
The guy had heard from a colleague who had a lot of experience with the stock market that there were wonderful 3D printers and electric cars stocks he didn’t want to miss and bet big on them! (We all, dividend growth investors, know where the valuations of these stocks are at right now.)
What the guy didn’t seem to understand is that exponential gains if you are right can turn into exponential losses if you are not. The same applies with a mortgage.
When you borrow money to buy a house, what you are doing is the exact same thing. You are using leverage. Alone, you couldn’t afford it. But with the help of investors who are betting that you will be paying them back the capital and interests, you can now afford to buy a house with other’s people money.
The choices you’ll make here are crucial as you will sign a contract that will be binding! It might be the biggest contract you’ll ever sign. While these contracts usually have a way out, you might find out that the way out is pretty expensive. I’ve seen people paying 29,000$ to get out of a mortgage contract. Penalties are usually very high and very difficult to understand for the common of the mortals as they are for the “professional bankers” (who often make huge mistakes calculating them or explaining them when you call their customer service agents).
Julie and Sam bought the house of their… Nightmare!
Sam and Julie are buying the house of their dreams, a fifty years old two stories house with a finished basement and two bathrooms for 350,000$ with 5% down and will borrow 332,500$ from a bank to buy their house. To make ends meet, they decide to take a long 25 years amortization and chase for the lowest interest rate possible to reduce their payments to the minimum. They end-up dealing with a mortgage broker offering them a five years fix rate at 3,5% (discounted) or a five years variable rate at 3,0% with a credit union. Not bad!
Sam and Julie net 60,000$ per year or 5000$ per month. They both have good paying jobs. But, since they feel pretty tight budget already with both their brand new cars (and brand new 7 years car loans), they opt for the variable rate since the payment will be lower and Sam don’t expect any rate hike from the government for a while and because he also thinks that even if the rate increases to 5%, it’s only a small 2% increase and as such, he thinks they have an healthy margin of safety here… nothing to be scared of!
Yep, they didn’t understand the leverage effect.
How a 2% hike in interest became a 22,9% hike in mortgage payments!
So, their monthly payment will be 1573,55$ per month (excluding taxes, heating cost, insurance, maintenance…). This payment represents roughly 31,5% of their net monthly income (just the capital and interests). Julie and Sam sign the contract and buy their house like happy campers.
But suddenly, it turns out that Sam was wrong and that the government has decided to rise the interest rate by 0,5% every quarter for a year. So Julie and Sam now have to face a mortgage payment based on a 5% rate and they didn’t have the time to get a promotion at their job or a decent pay increase yet to cover that sudden hike in rates. (it happened before and it is most probable that it will happen again)
One day, after several interest’s hikes, Julie went to the supermarket to buy some food for a supper they had decided to organize during the week-end but her debit card was refused – no funds!
Upset and worried, she called her bank only to realize that her mortgage payment was now increased again to 1933,84$, a 360,23$ increase from their original payment (or a 22,9% increase)!!! The small 2% hike on rates became a 22,9% hike on their monthly mortgage payment within a year. What a surprise! Now, the capital and interests alone represent more than 38,7% of their budget, a 7,2% increase. Misunderstanding financial leverage can be a costly mistake.
This is how the apparent 2% hike became a 22,9% hike.
Understanding that rates can only go up from now on!
This is one of the reasons why I pay my mortgage very fast and plan to be mortgage free by 2020. I have signed a 5 years fixed rate contract last year and I can double my payments every month if I wish. As such, I can control what I pay and I have been able to control what minimum amount I owe for the next 4 years, but I can’t control what the rates will be four years, ten years or fifteen years from now.
One thing I know though, is that they will most probably be higher and this is a risk I’m not willing to take because I understand that a 2% hike in interest’s rate can make a lot of damage to my monthly budget.
While the rates are low, I prefer decreasing my mortgage balance as much as I can.
The old house to maintain quest and lack of proper prior inspection!
Sam and Julie’s house was an old house. They had a friend working as a carpenter and since he came with them when they first visited the house, they had decided not to pay for a professional inspector. But, even though it looked clean and well maintained, they soon found out that the roofing and windows where about to be due and that the look of the house wasn’t exactly to their tastes so they decided to upgrade the kitchen to please Julie’s tastes.
They started making quotes and soon realized that kitchen cabinets were not going to cost only a couple 100$ to change! Improvements can become very expensive very fast!
Their first quotes for BCBG kitchen cabinets were around 50,000$!!! Woah! But this would become the kitchen of their dreams. Since 50,000$ was a little over budget, they finally decided to put the kitchen magazine aside and be more conservative. In the end, most quotes were averaging at least 20,000$ to upgrade the cabinets, tiling and pantry and they decided to refinance and increase their mortgage balance to do it based on the as-improved value of the house.
The work started with a contractor and just after all the old flooring and cabinets were removed, the contractor found out that the dishwasher had been leaking for a long time and to make the necessary repairs they will have to add at least 10,000$ to their bill.
Sue the previous owner for a hidden defect?
As it was a hidden defect, they could sue the previous owner but for that, they would need to hire a lawyer (300$ per hour), probably appoint specialists to prove that the leak has been made before they acquired the house (several hundreds to several thousands), maybe a private investigator to find them and spend months or years in court…
Sounds like a lot of fun… huh?!
The house of their dreams suddenly became a nightmare.
But it was just the beginning.
Let’s upgrade the shingles!
The weather is becoming crazy nowadays. After a severe thunderstorm, the rain was pouring inside and many shingles just flew away from the roof. So, as soon as the weather could permit, they decided to upgrade the shingles.
The problem with houses is that it is difficult to forecast what is the condition of something hidden behind something else… like shingles! So, after removing the old shingles, the contractor told them that they would have to replace all the plywood before putting back new shingles. It was deteriorated and even rotten at some places. The quote that initially was at 8,500$ ended up at 11,200$… All of this came from their savings and credit cards which were now loaded because it was impossible for them to refinance again. The house insurance payed only for a minor part of that bill because the shingles were at the end of their lifespan.
They finally break up… and this costs a lot!
Will all these troubles, the tight budgets, the hidden defects, the exponential costs of repairs, the lawsuit… Sam and Julie just felt overwhelmed. They don’t have fun together anymore and Julie fell in love with one of her new colleague who’s life is more simple and refreshing. So, they ended up splitting two years after buying their dream house.
They could either sell the house or one of them could buy the other’s part. Unfortunately, when you own a house, a separation is not easy as 1,2,3…
Since they both had enough of this house they decided to sell it on the market with a realtor. They bought the house at 350k, have added 30k to their loan and now, two years later, they still owe 356,000$ on their mortgage loan.
The market has improved a little (but not that much with the recent hike in interest’s rates) but they upgraded the kitchen and the shingles so they are able to list the property at 380,000$.
After many weeks and many visits, a buyer finally makes an offer to purchase at 370,000$. Tired, Sam and Julie accepted the offer.
They thought : “hey, at least we’re going to end up with our down payment back and a small profit.”
Again, they underestimated the costs of selling a house.
The lawyer would cost them between 500-1000$ for the quitance.
The realtors are going to keep 5% of the sale plus taxes. Approximately 18,000$-20,000$ (tax rates depends of jurisdictions).
The mortgage balance is at 356,000$.
They are already in the red. 370,000$-18,000$-356,000$-500$= -4500$
After calculating they say to themselves : “well… were going to split the losses… It’s not so bad.” They feel okay because they just want to go away from that mess as soon as possible and since Julie now live with her new boyfriend, she’s pretty tired to pay the mortgage of a house in which she doesn’t live anymore.
Misunderstanding the mortgage penalty
But then comes the mortgage penalty. Unfortunately, you can’t quit a mortgage contract like that!!! Their realtor (not a mortgage specialist) told them he thought it would be 3 months of interests… not a big deal. They had called the bank to make sure and the clerk in the call center (which was a new employee barely trained) confirmed the same but now that they are at the lawyer, things are different. They owe more than 14,000$ in mortgage penalty to the bank!!! (*approximation – every banks and lenders have their own rules but usually small lenders offering lower rates have more severe rules)
They call again in panic to understand what’s wrong and the lender explains to them that when the rates were getting higher and higher, they (Sam and Julie) had decided to eventually fix their rate for a 4 years term at 5% to protect themselves from future rate hikes. As such, there are two ways to calculate the penalty and the borrowers must pay the higher of the two. It is either 3 months of interest or a second trickier option.
Even Einstein wouldn’t understand this!
If the current rate is higher than the rate you signed for, then the lender will ask you to pay 3 months of interests because he will be able to lend that money to someone else at a higher rate within those three months.
But if the current rate is lower than what you have signed for, then they will calculate what they would lose in interest for the remaining of the term and ask you to pay this amount as a penalty so that they make no loss.
Banks never lose a penny. Keep that in mind. They always dodge the risks and transfer their potential losses to customers and insurers.
Unfortunately for Julie and Sam, the rates eventually went back down and as such they are stucked in the second situation.
Julie was mad at Sam who was very pushy to take the variable rate in the beginning but even if she was mad, the penalty was real! A contract is indeed a contract.
The lender told them that they would have essentially been in the same situation if they would have first signed for a 3,5% fix discounted five years term anyways. Because there is a tricky clause in the mortgage contract.
In fact, even though Sam and Julie would have signed for a 3,5% rate and now the rate would be equal or higher today, they would have had to pay the penalty based on the second option. Because they also signed a clause that their real rate would have been 5.5% and that they had a 2% discount. The lender will calculate the differential with 5.5% (real rate), not 3.5% (discounted rate)… I know… It’s a shame… but that’s the way it is.
Banks have created that clause to avoid to have to deal with borrowers breaking their contracts every time there would be a lower rate.
What’s their total loss?
This situation costed Sam and Julie their initial down payment of 5% (17,500$), plus their initial welcome tax of 1,5% (5250$), plus the lawyer’s transaction fees of 1500$ when they bought the house, plus the 4500$ loss from the proceeds of the sale, plus the 14,000$ penalty, plus the quitance at 700$. Total : 43,450$!!!
They had to take personal loans (carrying a high interest rate) to cover their losses and pay everyone.
This amount does not even take into account the lawyers fees for the lawsuit (partially recovered because they were at least able to settle of court), the extra payment they made as owners (taxes, mortgage, maintenance) vs tenants and all the psychological stress they had to live.
I’ve seen so many of these cases in my career that I stopped counting. Buying a house is taking a huge financial risk. One should be aware of that and make all the necessary due diligence before signing anything.
Sam and Julie are now responsible for all future hidden defects found by the new owner and could get sued for them for the rest of their life.
Do you know of someone who had a bad experience as an owner? How did it turned out?
Disclaimer : I am not a licensed professional. Please consult a licensed professional before taking any financial decisions.
Image courtesy of domdeen & Stuart Miles & Hyena Reality & Witthaya Phonsawat & ambro & somkku9 / at FreeDigitalPhotos.net