A few days ago I wrote about the pros and cons of renting versus financing a home with a mortgage. In that post I presented mostly advantages to renting: no debt, more flexibility, less costs for insurance, maintenance and taxes, etc. However, I failed to present one major advantage to buying a home, and staying there until it is paid off – having a permanent residence for you and your kids.

This occurred to me just last night as I was logging on to ING Direct to check my savings account balances. One of ING’s security questions is, “What is the street number of the house you grew up in?” The question gave me pause. I didn’t “grow up” in any single house.

My mom was a Marine Corp brat, and traveled extensively around the country growing up, moving from base to base as my grandfather was reassigned. Eventually, she got married and had me, but was soon divorced from my dad and found herself a single mother trying to raise a son on her own. Thankfully, my grandparents were close and provided a lot of support.

Throughout my childhood my mom and I bounced around from apartment complex to another. It was a big deal when I was in junior high school because we rented a little house in a neighborhood – I had a yard! Unfortunately, that was short-lived, and we were back in an apartment for my high school years. In fact, my mom didn’t own her own home until she was in her 50’s.

Growing up, I was always a little jealous of friends who had their own house. Didn’t matter if it was a tiny shack, or a mansion, it was theirs. They always had a “home base.” My best friend in high school, and eventually my roommate in college, lived in the same home from the time he was in elementary school. His parents still live in that home today, and no matter where he goes, or decides to live, that is always his “home base.”

My wife’s experience growing up was much like mine. She did even more bouncing around than I did, especially when she was very young. Because of the background we both had, providing a stable home for our kids is something we have worked to provide for our own kids. I tend to believe home is where you make it, and I have very little emotional attachment to the “sticks and bricks” that make up your home. But I do very much value the idea of giving my kids a “home base” – somewhere they will always feel welcome and secure.

I know it must appear that I’m arguing with myself, after just writing at length about the benefits of renting only a couple days ago. I’m not waffling; I still believe renting makes a lot of sense in some situations. However, more and more, I find myself valuing the idea of settling into a permanent residence to raise our kids. My mom and my mother-in-law didn’t have a choice, but we do, and we plan to work hard and sacrifice a few toys to make it reality for our kids.

Lisa writes in with the following question regarding mortgages and inheritance:

My father-in-law passed away recently, and we would like to pay off our 2nd mortgage with some of the inheritance money that we will be receiving. We have been in our home for 15 years and took out the 2nd mortgage in 2006. While the thought of reducing our debt and increasing our monthly savings is our first priority, my husband and I are not sure how this will affect our taxes next year. Also, we were planning to move sometime within the next 2 years after our daughter graduates from high school. How will this affect the price that we sell our home for?

Lisa, first of all, I’m sorry to hear of your father-in-law’s recent passing. I know this is a difficult time for both you and your husband. And what a blessing it was to receive an inheritance.

As you know, I’m not a big fan of mortgages (they are a necessary evil for most of us), and I like second mortgages even less! That said, it may or may not be the best time for your to clear that mortgage depending on the shape of the remainder of your family’s finances.

First, if you do not have an adequate emergency fund, I would park some of this money in an online savings account to cover several months of household expenses. If you have already established a solid emergency fund, I would use some of the remaining money to clear high-interest, non-deductible debt such as credit cards and high-interest loans.

With your emergency fund in place, and debt free except the house (and the second mortgage), it is time to evaluate the second mortgage. I like Dave Ramsey’s rule here: if the second mortgage exceeds half your annual income, I would simply include it as “house debt” and pay it down on schedule (or a little early as income allows). If the amount of your second is less than half your annual income, use inheritance funds to clear as much as possible.

If you were deducting interest on the second mortgage at tax time this will affect taxes. However, I’ve never understood the argument to send a mortgage company $10,000 a year in payments to save $3,000 a year on taxes (rough example). My personal rant aside, if you have questions about the tax implications it might make sense to talk with a tax professional to determine what the bottom line impact of paying off the second mortgage would be.

As for selling the home in a couple years, by paying off the second mortgage you’ll increase the likelihood that you will get some equity out of the sale. Paying off mortgage debt also gives you more wiggle room when setting the sale price of your home. If the house was fully leveraged, you would be less likely to be in a position to reduce the price for a quick sale.

Whatever you decide, my best advice is to move slowly. When we lose family members emotions are raw, and rarely do we make sound financial decisions when emotions are driving us to make them. There’s nothing wrong with parking the money in a money market account, or CD, for a few months while you think over how best to use the inheritance. You only get one opportunity to use this inheritance wisely, so make it the blessing it was intended to be.

Ask the Readers:  What advice do you have for Lisa and her husband?

Jeremy writes in with the following question regarding maximum mortgage payments for a new house:

What percentage of your net income should go towards a mortgage?  I don’t want to rush into anything so I was hoping you could give me some ideas as to what to avoid.  Would you consider giving me a couple pointers?

Thanks for your question, Jeremy. Before we get into specific numbers, I have to commend you for even taking the time to ask the question. Unfortunately, many people are still rushing out to sign up for a mortgage without considering the years of financial obligation they are taking on, and what impact that will have to their overall financial plan down the line.

The 28/36 Rule

There are several ways to look at the answer to, “How much house can I afford?” Some people, including most Realtors and mortgage brokers, banks, etc. use what’s called the 28/36 rule. The formula means mortgage lenders like to see your monthly mortgage payment come in at less than 28% of your gross income, and your total monthly debt payments, including your mortgage, represent less than 36% of your gross income. Notice I said gross income, as in before taxes and deductions. The fact you asked your question specifying “net income” means you are on to something.

When someone asks how much our annual income is we typically respond with our annual salary, and any other income from self employment, etc. But the number we use to budget from, and live off, is much lower after Uncle Sam stakes his claim along with benefits deductions for health insurance, and other employment-related expenses that come right out of our paychecks. So why not use this figure to determine mortgage affordability?

Because using gross income increases the amount of house agents can sell you and mortgage brokers can lend you, which means higher commissions and larger interest payments in their pocket. It’s not that they are doing anything wrong, it is just a different way of looking at the question of affordability.

The Frugal Mortgage Calculator

I actually have a more frugal formula for determining how much you can borrow for a home. I personally would not spend more than 25-30% of my take home pay on housing. So if your combined household income is $4,000 a month, meaning the direct deposit or paychecks from your employer totals $4,000 a month, then I would not spend more than $1,200 a month on a mortgage. To do so would mean giving up money towards another financial goal such as debt freedom, kids college savings plans, or even an early retirement.

What If the House I Want Comes With a Higher Mortgage?

Well, this is a case of suffering from champagne tastes with a beer pocketbook. Who doesn’t want to buy more than they can afford at some point in their lives? As I see it, you have three options.

• Ignore my advice and buy the bigger home with a bigger mortgage payment.
• Save up for a larger down payment to drive down the amount financed, and the resulting monthly mortgage payment.
• Shop for a more modest home.

Of course I would strongly consider option number three, because larger homes come with larger expenses (taxes, utilities, maintenance, etc.), even if you can get the monthly mortgage payment lowered with a large down payment. Still, option two does have some advantages. By waiting to save a larger down payment, chances are you can also clear some debt, which may improve your credit score and qualify you for a lower interest rate (and a lower payment). Still, consider the increased costs of owning the larger home, even if you technically qualify for it based on income.

If you are wondering, we currently spend about 18% of our monthly take home pay on housing. But that wasn’t the case when we first moved in (fortunately our income has increased over the years) – and it caused a real pinch those first few months. Don’t make the same mistake we did!

Ask the Readers:  How much of your take home pay are you currently spending on housing?

Have you ever considered purchasing a home from a family member? If so, did you know you may be able to use the equity in their home as a down payment, and to cover closing costs?  Well, I didn’t know such an option was available. It is called giving a gift of equity, and it basically means the seller gifts the equity in their home to the buyer to serve as their down payment.

A Real World Example

A friend of mine is considering the purchase of his in-laws’ house. The house appraised for $205,000, and they owe roughly $150,000. His in-laws are looking to relocate for retirement, so if they can sell the house to their daughter and son-in-law without having to market the home, and gift the equity to their kids, everybody wins.

My buddy’s in-laws have graciously agreed to sell them the house for what they owe, and gift the equity in the home to him and his wife.  While they can easily afford the mortgage, they don’t have a pile of money sitting around to come up with down payment required by their lender.

Gift of Equity Letter Requirements

If you decide to go this route, you’ll need the seller to sign a Gift of Equity letter stating the following:

• Name of the donor
• Name of the recipient
• Relationship (son, mother, sister, etc.)
• Address of the property
• Assessed market value of the property
• Gift amount

The letter will also need to have some language explicitly stating the gift of equity is just that – a gift. There is no obligation or expectation of repayment.  Contact your lender, as most have a standard form or Gift of Equity Letter available in a format they prefer.

Tax Issues Associated With A Gift of Equity

Tax issues are of little concern if you receive a gift of equity. However, if you are on the giving end of a gift equity, there may be tax consequences to consider related to gift taxes in general.

As it stands, anyone can give up to $13,000 per year to another individual. If the gift of equity exceeds that amount then a gift tax may be reportable (that doesn’t necessarily mean you have to pay taxes on that money, but you will likely have to file IRS Form 709 to report the gift).

Even if you have to file Form 709 (IRS website) the amount of the gift of equity exceeding $13,000 per individual involved in the transaction will simply be deducted from the million dollar exclusion for which most of us are eligible.  It is probably not a deal breaker, but when discussing a gift of equity it makes sense to discuss the deal with a CPA or tax professional, particularly one familiar with real estate deals.

Refinancing a home loan in order to save a few hundred dollars each month on mortgage repayments is a smart move for long term home owners. However, if you are planning to refinance your mortgage and in the near future plan on relocating, refinancing your property may cause you more trouble than the entire process is worth. According to Bills.com, “It may take anywhere from three to five years to realize the savings, given the costs incurred during the refinancing process.” If you are ready to refinance your home and are willing to wait a while to reap the rewards, home refinancing is the ideal solution for you.

Approach your existing lender. You already have an existing relationship with the lender, if you have always kept lines of communication open and always sent your mortgage repayments on time, there is no reason for your existing lender to turn down your home refinancing request. A benefit to refinancing your home through your existing lender is that they will often offer you special deals just to keep you from taking your business elsewhere.

However, you may benefit from keeping an open mind. Just because it’s often easier to refinance your home mortgage through your existing lender, doesn’t always mean it’s worth it. Sometimes, switching to a different lender will get you a better deal in the long term. Contact at least ten different home mortgage lenders and ask them for a quote. Tell them that you are making a general inquiry and are currently contacting multiple lenders to find the most competitive rate. Letting the lender know that he’s got some competition can’t hurt any.

Review refinancing offers.  After you have called ten lenders and received their quotes, it’s now time to review the offers. Don’t fall prey to the common tactic used to draw in borrowers. For example, a common tactic used by lenders to draw in borrowers it to offer discounter of waived closing costs in exchange for a higher interest rate.

While you will not be losing any immediate out of pocket cash, in the long run accepting such a rate can turn out to be more expensive than simply sticking by your current home loan. If you have approached numerous lenders and are yet to encounter a package that suits your needs, keep looking. There will always be a lender offering more competitive rates.

Applying for the mortgage refinance.  It’s probably been a while since you have applied for a home mortgage, and luckily for you lenders have improved on their speed a bit.  The overall home refinancing application process is very similar to applying for your home’s first loan. However, the wait time for this application will be decrease to approximately three to six weeks and you can now apply for a home refinance loan through the comfort of your own home.

That’s right, you only have leave your home if you want to, you being present during the physical application is no longer a requirement thanks to technology. Loan officers fill out an application form on your behalf with the information that you provide to them through the electronic application.

Jazmin Espinal is a professional freelance writer and the owner of Capital Web Writing, a web content solution for businesses and webmasters. To contact Jazmin or to see samples of her writing, please visit CapitalWebWriting.com.