*”House-ownership is beginning to look more affordable by many measures. Adjusted for inflation, prices are close to their long-term trend after the bubble years of the 1990s and the first years of the 2000s. And the ratio of house prices to rents has returned to its pre-bubble level (see chart).”

*”Vacancies for apartments tumbled in the first quarter of the year and are now at a three-year low. Rents have been rising, and analysts expect them to increase by over 4% this year and next. Rent rises typically support house prices by making home-ownership more attractive.”

*”The credit markets are healing. Mortgage borrowing actually rose in the first quarter, according to the Federal Reserve Bank of New York. New foreclosures were 17.7% lower in the first quarter than they had been at the end of 2010, and household delinquency improved for a fifth consecutive quarter. Mortgage rates have fallen back to historic lows, tracking declines in yields on American government bonds.”

*”Perhaps the best news for housing has come from the labour market. The economy added over 200,000 jobs in each of the past three months and over 1.3m jobs in the past year. A better job market enables struggling households to make mortgage payments, reducing foreclosures. For most of the bust, borrowers that fell behind on their loans were likely to end up in serious difficulties. In the first quarter of this year, for the first time since 2007, more mortgage borrowers caught up with their payments than fell further behind.”

One quick note that is generally applicable to all three sources.  Typically funds derived from a retirement plan used towards the purchase of a home may only be used as a down payment and “usual or reasonable settlement costs” and may not be used to pay other debts in order to qualify for a new mortgage.

401K

Rules for each 401K plan are slightly different so homebuyers need to talk with their plan administrators to make sure they can use their 401K.  Technically, a person cannot generally withdraw money from their 401K to use towards the purchase of a home.  Instead most 401K plans will allow participants to borrow money from their 401K and pay it back with payroll deductions.  For funds being used to purchase a home the repayment period can be longer than the normal required period of 5 years but check with the plan administrator to make sue the payments won’t be onerous .

The plan will usually assign an interest rate to the loan but because the participant is paying and receiving the interest the effective cost of borrowing is 0%.  However, while the loan is outstanding keep in mind that it is  not receiving investment appreciation so the true cost of tapping into a 401K is the “opportunity cost”.  Homebuyers wishing to use their 401Ks should consider the impact this will have on their future ability to retire.  Also, keep in mind that repayment of a 401K loan is made with after-tax dollars.

Typically the maximum a person can borrow from their 401K is the lesser of $50,000 or 50% of their vested balance.  If the vested balance is less than $20,000 then sometimes they can borrow up to the vested balance or $10,000 whichever is greater.

It’s important to note that a person does not have to be a first-time homebuyer to use 401K funds.  It’s also important to note that because the homebuyer will pay back the 401K loan with payroll deductions then it is generally not possible to access funds in a 401K with a previous employer.  The homebuyer must currently be working for the plan sponsor.  This also creates a significant risk because if the employee is terminated during the repayment period on the loan and cannot pay back the remaining balance the amount will be treated as a non-qualified distribution and be subject to ordinary income tax plus a 10% penalty.

Please note that some 401K plans do allow “hardship” withdrawals for participants who qualify as a first-time homebuyer.  However, these distributions are taxable so unless cash-flow is a major concern often times a loan will make more sense.

IRA

IRAs are different from 401Ks in that a person is  able to take distributions instead of having to take out a loan.  The question then becomes whether or not the distribution will be a deemed a “qualified” or “non-qualified” distribution.  A “qualified” distribution IS NOT subject to a 10% penalty while a “non-qualified distribution” is subject to a 10% penalty.

In order for a distribution to be qualified the homebuyer must be a first-time homebuyer which the IRS defines as a person who has not owned real estate in the previous 24 months.  The $10,000 cap is a lifetime limit so once a person has utilized the $10,000 they may not use it again.

So long as the contributions to the IRA were tax deductible for the homebuyer then the distribution will be taxed as ordinary income.  If the distribution does not meet the criteria of being a “qualified” distribution then it will also be subject to a 10% penalty.  Since the homebuyer will typically incur income tax liability for an IRA distribution it’s important they account for that when budgeting out their money from the time of distribution to the following April 15th when taxes are due.

Roth IRA

The rules for Roth IRA distributions used towards the purchase of a home are similar to the aforementioned traditional IRA guidelines in that it is only available for those who meet the IRS’s definition of a first-time homebuyer and is only available up to $10,000.  However, there are a couple key differences.

One key difference is that for a distribution to be “qualified” it may not be made inside  a 5-taxable-year period which begins January 1st of the taxable year for which the very first contribution was made to any Roth IRA the homebuyer owns.  In other words, for a first-time homebuyer who wishes to take a “qualified” distribution from their Roth IRA account anytime in 2010 must have made their very first Roth IRA contribution (to any Roth account) no later than the 2005 tax year.

The other key difference is taxation.  Because Roth IRA contributions are not tax deductible at the time of contribution “qualified” distributions are not treated as taxable income.  However, if the distribution is not deemed to be “qualified” then it will be subject to a 10% penalty and depending on the contributions made and distribution taken may also have income tax implications.

I hope this summary enables homebuyers out there to make better decisions with their money.  Please remember that I am not a tax professional and tax code is subject to change.  It is best to discuss your options with a knowledgeable professional when you are close to make such a decision.  It is also important to consider the impact that the decision will have on your ability meet your retirement accumulation goals.

*Fee Simple Ownership: This type of ownership implies complete ownership of property by one individual who possesses all right associated with ownership of the property, including right to use, sell, gift, alienate, convey, or bequeath the property.  Upon death the property will transfer via the decedent’s estate via will or probate.

*Tenancy in Common: This is ownership held between two or more related or unrelated parties that can be of equal or unequal proportions (i.e. 50%/50% or 25%/75%).  Each parties ownership is undividable but may be conveyed without consent of other interested parties.  Upon death of an owner usually 100% of the value of their fractional ownership is included in their estate and transferred via probate or will.

*Joint Tenancy: This form of ownership is similar to Tenancy in Common in that it is held by two or more related or unrelated parties, is undividable, and may be transferred freely without consent of other joint owners.  However, under Joint Tenancy their is usually an automatic transfer of interest to the surviving tenants upon death.  Therefore, it is commonly referred to as Joint Tenancy with Rights of Survivorship or “JTWROS”.  The value to be included in the decadents estate is based on the current fair market value but is pro-rated based on the original contribution the decedent made to acquire the property.  This form is often used between related parties.

*Tenancy by the Entirety: This form of ownership may only occur between two spouses and is similar to JTWROS.  The difference with this form of ownership is that one spouse’s ownership interest may not be transferred without the joint spouse’s consent.  Upon death of one spouse 50% of the fair market value of the property is transferred to the spouse automatically.  The surviving spouse retains their adjusted basis on their 50% ownership interest regardless of contribution when the property was acquired.

*Community Property: This is a statutory regime in which married individuals own an equal undivided interest in all property accumulated during their marriage.  Property acquired before the marriage union and/ or inherited by one spouse is not considered community property.  Community property cannot be transferred without consent from both spouses.  Upon death community property is not automatically transferred to the surviving spouse because it is transferred through will or probate.  Community property has special “stepped up basis” rules in which the surviving spouse receives a “stepped up basis” for their 50% ownership interest AND the inherited 50% interest.  The community property statutory regime only applies to Louisiana, Texas, New Mexico, Arizona, California, Idaho, Washington, and Wisconsin.

However, in any economic environment opportunity exists.  Here are two ways in which you can benefit in the months ahead:

1) Mortgage rates are already low and may move even lower.  I have blogged about deflation on many different occasions.  Here’s what you should know about deflation: if the financial community expects that deflation is likely to occur in our economy mortgage rates will move lower.

In fact, the historically low rates of 2003 were a result of Alan Greenspan warning of a deflationary environment in our economy (although his warning never came to fruition).  If you are a homeowner and would like to reduce your mortgage payment this could provide an excellent opportunity.  We would encourage you to call us BEFORE mortgage rates dip so that we can analyze your situation and help you calculate how low rates would have to go in order to have it make sense to refinance.

Here are some links to better understand deflation and mortgage rates:

-Postings: #1, #2, #3, #4

-Here is a link to the rate update for November 20th where I include a you tube video explaining deflation and why it would cause rates to move lower.

2) Homebuyers will have HUGE leverage in negotiations this winter. If you don’t own a home now and are waiting for prices to drop further you may want to consider buying this winter.  Typically November and December are slow months for buyers to make offers on homes.  However, sellers are still hoping that one person will come along and make an offer.  With sellers strongly outnumbering buyers we expect that there will be some major bargains this winter.  In fact, we just had a client buy a home for $235,000 below appraised value!  If you’re in a position to buy a home your timing could not be better.

It may be true that you took an 80% mortgage and used your own funds for a 20% down payment but what you may not realize is that the funds you used for a down payment was “borrowed” from your asset base that could otherwise have been used to earn a return on investment.  Economists call this “opportunity cost”.

If cash-flow were not an issue then every home-buyer would be left to decide the optimal level of down payment and mortgage based on the return on investment they think they could earn versus the cost of borrowing the funds.

To demonstrate this concept lets assume that a family is buying a home for $250,000 and is deciding whether to put $50,000 down (20%) or $100,000 (40%).

-If they put $50,000 down they will take out a mortgage for $200,000 at 7.00% with interest-only payments of $1,166.67 (net after tax payment of $793).  With the $50,000 that was not used for the down-payment they will invest the funds into an account that will earn 7.00% annually.

-If they decide to put $100,000 down they will take out a mortgage for $150,000 at 7.00% with interest-only payments of $875 (net after tax payment of $595).  We’ll assume that they will use the difference in their net after tax payment ($198) to invest into an account that would earn 7.00% annually.

Here is a look at how these choices would perform over 30 years:

As you can see the decision to invest the money upfront would net this family almost $140,000 more after 30 years.

This concept it important in making decisions regarding how much a homeowner should borrow.  Here is a simple explanation:

1) First, it’s important to understand that most homeowner’s are able to deduct the interest that they pay on their mortgage from their taxable income to determine their tax liability.

2) Therefore, a homeowner’s interest rate does not truly represent the actual cost of borrowing.  For example, a person who has a mortgage with a 7.00% interest rate and finds themself in a 28% marginal tax bracket will have an EPR of 4.34% (7.00% * (1-.28%)=4.34%).

3) If cash-flow was not an issue this homeowner would be smart to borrow as much money as they could so long as the capital was used to earn a return in excess of 4.34%.

However, for those who feel secure in their jobs and have been waiting for prices to fall it is a good idea to start getting serious.  After all, mortgage rates for loans requiring only 3% down remain very attractive and I believe homes in Portland have become much more affordable over the past few months.

But if that isn’t enough to convince you consider the cost of waiting.  I actually got this example from a book I recently read entitled “Borrow Smart Retire Rich”.

The table below illustrates the savings an individual will make over a 4 year period assuming they can save $4,000 per year   We’ll assume that their savings earns 8% annually:

Conversely, here is a table that illustrates the cost of waiting. Here’s how much a $200,000 home will appreciate over the next 4 years assuming a 4% appreciation rate:

As you can see over a 4 year period even though the individual was able to save $23,466 towards a down payment the home that they could have purchased 4 years ago has now appreciated in value by $33,971.  Therefore, this individual has actually lost $10,000 in waiting this long to buy a home.

For example, if I buy a home for $300,000 and take out a loan for $240,000 at the time of purchase then my acquisition indebtedness is $240,000.

Why should anyone care?

Acquisition indebtedness is important because it is what the IRS uses to determine how much interest you can deduct from your income to determine your tax liability.  At the time of this writing the IRS would allow a household to deduct the interest expense on their acquisition indebtedness (plus $100,000 if the household does a cash-out refinance after they’ve purchased the home) so long as the loan amount(s) do not exceed $1.0 million.

Therefore, if you purchased your home back in 1980 for $50,000 and took out a $40,000 mortgage then your acquisition indebtedness is only $40,000.  If you have taken cash-out refinances over the past 25 years to fund college educations, debt consolidations, and/ or other objectives along the way without making significant improvements to your home then you may only be able to deduct the interest on first $100,000-$140,000 of your current mortgage.

There are many caveats, conditions, and exceptions to this rule so for details visit this link to go to the IRS website.

There are a few different ways that this tax rule will impact how we advise our clients.  One of the most common is when a client of ours purchases a home for cash.  Once they’ve done so they still have 90 days to establish home acquisition debt by taking out a mortgage on the property.

Once a homeowner’s acquisition indebtedness is paid (partially or entirely) that portion is no longer tax deductible unless the mortgage is used to improve the home OR is within the $100,000 cash-out exception.

Pillar 1: Creating a cushion

The first pillar in the 4 pillar system involves creating a financial cushion. It is important to have money on hand that is readily accessible for life’s little (or large) unbudgeted emergencies.  The purpose of this account is to allow a person to pay for these emergencies with cash instead of falling into the all too common habit of using credit.

In calculating how much a person needs to satisfy this first pillar we recommend that a person first estimate their “survival number”.  Their survival number is the amount that they spend each month on essential items in their budget such as housing payments, food, utilities, and minimum payments on credit obligations.  This amount would allow them to “get by” without spending money on discretionary items such as Starbucks, eating out, and other purchases which could be eliminated if need be.

Once this amount has been established a person can calculate how many months worth of survival reserves they’d like to have.  Most financial planners recommend that a salaried person have 3-5 months worth of survival reserves in a safe liquid savings account whereas a self-employed or commissioned earner keeps 5-7 months in reserve.

Pillar 2: Get Debt Free

Once a financial cushion has been established a person can now focus on the second pillar of cash management.  Reaching the second pillar involves eliminating all “non-preferred debt”.  Non-preferred debt is all debt which does not meet most, if not all, of the following criteria:

            → carries a reasonable interest rate

            → has tax benefits

            → is secured by an asset which is appreciating

            → has affordable payments

In general, non-preferred debt includes all debt that isn’t a mortgage (some exceptions apply).  That said, our focus is to develop a strategy that will help our client pay-off their non-preferred debt as quickly as possible. 

By eliminating these miscellaneous monthly obligations a person is able to free-up additional monthly cash-flow that can then be directed to savings & investment accounts.  The key to financial independence is for a person to have control of their money and then conserve it, instead of consuming it.

Pillar 3: Liquidity

True financial security comes with having liquid funds available at any time.  This next pillar is about having 1 year’s worth of a person’s income or more available to them for either good or bad reasons.

A good reason why a person may want this type of money available to them is to take advantage of a business or investment opportunity.  Most of the time when a person is presented with an investment opportunity a significant amount of capital is required upfront.  If a person has the money to be able to participate then they can do so, but most people are not in a financial position to take advantage of these opportunities when they come along.  

An example of a bad reason to use liquidity is in the case of a major interruption to a person’s income.  This may be due to an illness, sudden disability, job lay-off, or economic down-turn outside of a person’s control.  In this instance liquidity can help fulfill a gap of income and still maintain a comfortable life.  By the way, the number one cause of foreclosure in the United States is disability. 

Pillar 4: Pay-off your house

This is the point where it can really get exciting.  For most people, having their mortgage paid off is a far-off dream that may never come to fruition.  But, by focusing on strategies to effectively achieve the first three pillars of this system it can become a very realistic target. 

Most people define “having their mortgage paid off” as not having a mortgage on their house.  But, wouldn’t it also be true if a person had a $300,000 mortgage secured against their home and also had $300,000 in liquid assets?  After all, their personal balance sheet would show a $300,000 liability on one side and a $300,000 asset on the other. 

This topic raises some very interesting questions and opens up some powerful opportunities.  But, if a person has not yet addressed pillars 1 through 3 then does it even make sense to focus on down payments, principal payments, and home equity?  The bottom line is that an effective financial plan and strategy will do more for a person’s long-term financial well-being than most anything else. 

Would you like to share this model with others?  You may download this documents by clicking this link-evans-4-pillars-cash-flow-management-model-mti.

As always, I invite you to share comments below!