The Money Class Part 4

ADVICE FOR OWNERS WHO NOW WANT TO RENT.

I know that many of you who own a home are questioning whether it makes sense to sell and go back to renting. In the "What to Do if You Are Underwater" lesson later in the chapter I share strategies for homeowners who now have a mortgage that exceeds the current value of their home. But I also want to address those of you who have equity in your home but are now wondering if it makes more sense to sell and rent. Again, I am going to come back to the fact that you must shape and follow your own personal dream. If you are considering a move because of a life change-the kids moving out, you're ready to retire and downsize, or you recently ended a relations.h.i.+p-then by all means it makes sense to run the numbers and see if renting is right for you. But do not gloss over the potential drawbacks of renting as well. Think through the trade-offs and make an informed choice.

If your issue is that you just feel overwhelmed by the cost of the mortgage and maintenance and you know you can indeed save more by renting, then you are absolutely to stand in that truth. There is nothing wrong with changing your mind; if your new dream is to rent rather than own, then that is the right dream for you. Just promise me you will factor in the 8% to 10% cost of moving. That is not a reason to stay put, but if it adds up to more than you can cover from the gain on the sale, I want you to plan for how you will cover the costs. You may need to head back to chapter 2 chapter 2 to find ways to boost your savings for the next six months or year so you can cover the cost of the move. to find ways to boost your savings for the next six months or year so you can cover the cost of the move.

LESSON 3. THE NEW RULES OF BUYING A HOME THE NEW RULES OF BUYING A HOME.

For renters who are eager to buy now that prices have come down, and for owners who are looking to make a move, I have rules I want you to follow so your new housing dream will give you security, not stress.

SET A BUDGET THAT SATISFIES YOUR NEEDS.

Remember the credo of chapter 2 chapter 2? Live below your means but within your needs Live below your means but within your needs. Now is the time to embrace that phrase and make it a governing principle of your life. I do not want you listening to a mortgage lender who tells you what you will be allowed to borrow, nor do I want you to follow the advice of a real estate agent who insists the bigger, more expensive house is a better value. Listen only to yourself. This is your dream, and so it must be rooted in what makes sense for you. I want you to seriously think through how much s.p.a.ce you need. The size of new homes has increased about 35% over the past three decades, yet household size has declined. I want you to be comfortable, I want you to enjoy your house. But a smaller home that fits your needs means a more manageable mortgage, a lower property tax bill, lower utility costs, and likely less time and effort to maintain. And lower housing costs leave more income for your other important dreams, including funding your retirement or saving for a child's college education.

KNOW YOUR INCOME LIMITS.

Lenders are now back to calculating how big a loan they will offer you based on your income, a practice all but abandoned during the housing bubble. The two standard calculations are: - Your mortgage, property tax, and insurance (called PITI) should not exceed 25% of your gross (pre-tax) monthly income.

- Your PITI and all other debts should not exceed 36% of your gross monthly income.

There is leeway in those numbers; if you have other a.s.sets or make a big down payment you may be able to run past those limits. And in high-cost areas, the 36% debt-income ratio often is stretched past 40%.

My recommendation is that you never exceed the 25/36 rule. If you think that's impossible, then I ask you to return to another tenet from an earlier lesson: Sometimes when we feel stuck we must change our perspective Sometimes when we feel stuck we must change our perspective. If 25/36 seems out of your reach then you have two choices: Hold off purchasing until your finances make 25/36 doable, or shop for a less expensive home. The quickest way to buy an affordable home that meets the 25/36 test is to lower the price tag. That is the essence of living below your means but within your needs.

First-time homebuyer alert: Please do not think that you can afford a monthly mortgage that is equal to your current rent. There are many additional costs that come with homeowners.h.i.+p that can add 30% or more to your monthly base mortgage rate. In The Cla.s.sroom at my website you will find information on how to figure out the true cost of homeowners.h.i.+p and how to test whether you can honestly afford to buy. Go to Please do not think that you can afford a monthly mortgage that is equal to your current rent. There are many additional costs that come with homeowners.h.i.+p that can add 30% or more to your monthly base mortgage rate. In The Cla.s.sroom at my website you will find information on how to figure out the true cost of homeowners.h.i.+p and how to test whether you can honestly afford to buy. Go to www.suzeorman.com.

AIM TO MAKE A 20% DOWN PAYMENT.

Are you thinking that sounds crazy given that we all know you can get an FHA-insured loan with a 3.5% down payment? So why, you are wondering, should your dream of homeowners.h.i.+p be delayed by that 20% obstacle? I know all about the FHA program. I am well aware of what you can get these days. My job is to teach you what I think is best for your long-term security. In my opinion, if you cannot afford a 20% down payment, you cannot honestly afford to buy a home. During the 20002006 stretch, if sizable down payments had been required we would not have had such an inflated bubble and its painful deflation. Down payments below 20% also mean you must purchase mortgage insurance; whether through the FHA-insured program or private mortgage insurance, this adds to your housing costs.

A SPECIAL NOTE ABOUT FHA-INSURED LOANS.

Before the financial crisis, mortgages insured by the FHA accounted for about 5% of the new loans doled out in any given year. In 2010 the FHA insurance program accounted for about 30% of loans for home purchases. How come? Well, lenders are making it tougher to qualify for a conventional mortgage and are all too happy to steer clients into FHA-insured loans given the fact that the federal government is in fact insuring insuring that it will pay off the loan if the borrower runs into trouble. that it will pay off the loan if the borrower runs into trouble.

I have to say that I am not a huge fan of FHA-insured loans. The fact is, they perpetuate many of the problems that got us into this housing mess. For starters, until 2010, the FHA didn't require a minimum FICO credit score to be eligible for a mortgage. And it wasn't until last year that it set a FICO credit score floor. But that floor is a score of 500! If you can make a down payment of at least 10% and your FICO credit score is between 500 and 580, that's good enough for the FHA. And if you have a score above 580 you are eligible for an FHA-insured mortgage that requires just a 3.5% down payment. That said, many lenders that offer FHA-insured mortgages are applying their own FICO score rules, and require a FICO score of at least 620640. But any FICO credit score below 700 is in fact a sign that you have some financial issues to address. Yet 40% of FHA-insured loans in 2010 were given to borrowers with FICO scores below 680. Consider that for a regular conventional mortgage, most lenders these days won't give you the time of day if you have a FICO credit score that low.

At the same time, a 3.5% down payment just strikes me as dangerously low. When you put down 10% or 20% the simple truth is that you will think longer and harder about what you are doing. Putting so much of your own money on the line forces you to stand more solidly in your truth. And that large down payment gives you downside protection if, G.o.d forbid, anything were to happen and you needed to sell the home at potentially less than your current mortgage balance. Let's say you made a 20% down payment and values are 5% lower when you go to sell. Well, you still walk away with 15% equity; that's more than enough to cover your closing costs and the agent's fee. But if you put down just 3.5% to 5%, you will find yourself owing the bank money to move, or face the foreclosure or short-sale process. As I explain below, that's not a scenario you want to find yourself in.

I also want potential borrowers to understand the cost of an FHA-insured loan. At the time of the loan you will owe an up-front insurance fee equal to 1% of the loan amount, and then there is an ongoing annual insurance premium equal to 0.90% of your loan amount. You owe that ongoing fee until your equity in the home reaches 22%. As we discussed earlier, that could be many years, given that appreciation rates over the long term will likely be modest.

So am I against FHA-insured loans? It depends. If you are considering an FHA-insured loan because your FICO credit score is low due to your own self-induced overspending or poor payment habits, then I absolutely will not condone buying a home with an FHA-insured mortgage. Just because you can do something does not mean you should. And please don't hide behind the notion that because the federal government says it is okay, it is. Look, the federal government has its own agenda: By expanding the FHA-insured loan program, it is trying to keep the battered housing market from bigger losses. But your agenda is to stand in your truth and make financially sound decisions. If you can't get a conventional mortgage because of your own poor choices, then the only honest action to take is to wait until you repair your credit score, or save up enough for a bigger down payment so you can in fact qualify for a regular loan.

Now, that said, I think the FHA-insured mortgage can be a viable option for those of you who are rebuilding your life after divorce, or a financial setback such as a long layoff. Those are circ.u.mstances where a poor FICO credit score is not a sign of a lack of financial responsibility, but rather an indication that you have undergone a disruptive life event beyond your control. But even here I ask you to stand in your truth. I would feel so much better if you waited until you had the money to make a down payment of 10 to 20%. Being able to save that much is a sign that you have the strength and tenacity to make the right financial choices. And with a more sizable down payment you will be that much closer to the 22% home equity you need to have the 0.90% insurance fee dropped from your payment.

Special Buying Rules for Condos and Co-opsIf you are considering buying a condominium or cooperative, please be very very careful. In some of the most overdeveloped markets that have been hardest hit, condo prices can, at first glance, look like an incredible steal. But when you purchase a condo or co-op you are purchasing more than four walls; you are buying a piece of an entire development, and that means you have to make sure the development itself is a good investment. Here are the questions to ask:* What percentage of the units are owner-occupied as a primary residence? What percentage of the units are owner-occupied as a primary residence? Lenders and the FHA are becoming increasingly cautious about offering mortgages for properties that are in developments full of vacation or investment-property owners. And if a development is full of renters, that can impact your future resale value as well; unless it is a hot market for investment properties, you might have a hard time selling at a top price when everyone else around you is renting out their units. My advice: Stick with developments that are at least 90% owner-occupied. Lenders and the FHA are becoming increasingly cautious about offering mortgages for properties that are in developments full of vacation or investment-property owners. And if a development is full of renters, that can impact your future resale value as well; unless it is a hot market for investment properties, you might have a hard time selling at a top price when everyone else around you is renting out their units. My advice: Stick with developments that are at least 90% owner-occupied.* How many units have been foreclosed on in the past three years? How many units have been foreclosed on in the past three years? If the answer is more than 3%, that is a sign of potential trouble, if you ask me; if there are more foreclosures you will likely see your home's value drop. If the answer is more than 3%, that is a sign of potential trouble, if you ask me; if there are more foreclosures you will likely see your home's value drop.* What is the homeowners' a.s.sociation or condo fee for each of the past five years? What is the homeowners' a.s.sociation or condo fee for each of the past five years? You do know that in addition to your mortgage payment, you also will owe a monthly maintenance or common charges fee, right? I am asking because I am surprised at how many people come up to me so excited about a great condo deal, and then when I ask about the common charges they give me a blank stare. These monthly fees go toward paying the general maintenance costs of the development or building-landscaping, security, etc. And a portion of your monthly fee should also be set aside in a longer-term reserve fund that is tapped when the development needs to make an a.s.sessment for a major repair or upgrade, such as a new roof. I would be very wary of any development whose a.s.sociation fees have increased more than the general rate of inflation-about 3.5% or so. That's a sign that the development doesn't have a good grip on its costs, which would likely mean more big adjustments going forward. I also think you need to be extremely careful about buying into a development with many unoccupied units; if those units aren't sold or rented quickly it's likely the existing owners will be stuck with higher monthly fees. You do know that in addition to your mortgage payment, you also will owe a monthly maintenance or common charges fee, right? I am asking because I am surprised at how many people come up to me so excited about a great condo deal, and then when I ask about the common charges they give me a blank stare. These monthly fees go toward paying the general maintenance costs of the development or building-landscaping, security, etc. And a portion of your monthly fee should also be set aside in a longer-term reserve fund that is tapped when the development needs to make an a.s.sessment for a major repair or upgrade, such as a new roof. I would be very wary of any development whose a.s.sociation fees have increased more than the general rate of inflation-about 3.5% or so. That's a sign that the development doesn't have a good grip on its costs, which would likely mean more big adjustments going forward. I also think you need to be extremely careful about buying into a development with many unoccupied units; if those units aren't sold or rented quickly it's likely the existing owners will be stuck with higher monthly fees.* What percentage of current owners have not made their monthly condo/a.s.sociation fee payments in the past three months? What percentage of current owners have not made their monthly condo/a.s.sociation fee payments in the past three months? If it is more than 3% take that as a warning sign that everyone else-including you-may be asked to make up the shortfall. If it is more than 3% take that as a warning sign that everyone else-including you-may be asked to make up the shortfall.* How large is the reserve fund? How large is the reserve fund? All the owners, collectively, are on the hook for any big-ticket repairs or upgrades to the development. Ideally, you want to hear that the condo's roof is 15 months old, not 15 years! You must insist on reviewing the financial statements for the development, including how much money is currently set aside in the reserve fund. At a minimum, at least 10 percent of a condo a.s.sociation's annual operating budget should be set aside for the reserve fund. For older developments that are more likely to need maintenance, it would be great to see even more dedicated to the reserve fund. It's obviously your best bet to focus your sights on developments in good physical shape, but if you have your heart set on a unit in a building that will likely need a new roof or other capital repairs in the next few years, be sure the reserve fund can handle that cost. Otherwise you could be hit with budget-busting special a.s.sessments that can cost you thousands of dollars. All the owners, collectively, are on the hook for any big-ticket repairs or upgrades to the development. Ideally, you want to hear that the condo's roof is 15 months old, not 15 years! You must insist on reviewing the financial statements for the development, including how much money is currently set aside in the reserve fund. At a minimum, at least 10 percent of a condo a.s.sociation's annual operating budget should be set aside for the reserve fund. For older developments that are more likely to need maintenance, it would be great to see even more dedicated to the reserve fund. It's obviously your best bet to focus your sights on developments in good physical shape, but if you have your heart set on a unit in a building that will likely need a new roof or other capital repairs in the next few years, be sure the reserve fund can handle that cost. Otherwise you could be hit with budget-busting special a.s.sessments that can cost you thousands of dollars.Now, if all of that checks out, I then want you to do a full 360-degree inspection of your unit. Look, you are going to be living with neighbors quite near. So you better make sure you will be content amid all that closeness. Spend some time walking around the development and talk up as many residents as possible; are they effusive or complaining? You also want to do a noise check: If it's a multilevel unit, I would ask to have someone walk around the unit above you; I personally would never go near a place where I could hear my neighbor's every move. Same goes for any attached units nearby. Are the walls soundproof? And if you are highly sensitive to cigarette or cigar smoke, try to find out if neighbors you will be sharing ventilation systems with are smokers; in many buildings that smoke could end up wafting into your unit. And be sure to visit at a few different times, especially a weekend night. If you enjoy peace and quiet, it is better to know now if your neighbors tend to be more outgoing-and noisy-party types.

WHERE TO COME UP WITH THE DOWN PAYMENT.

As discussed in "Stand in Your Truth," the way to save for capital purchases is to create automated savings accounts so you can add to your dream funds every month. Set up a separate account for your down payment. The money should be kept in a stable bank or credit union account; money you expect to need within 10 years should never be invested in stocks.

DO NOT TOUCH YOUR RETIREMENT SAVINGS.

In the past I have given first-time buyers the option of taking money out of their retirement savings for a home down payment. There is indeed a special rule that allows first-time buyers to withdraw up to $10,000 from a traditional IRA for a down payment, and be exempt from the 10% early withdrawal penalty levied when you are younger than 59. (Though you still will owe income tax on the withdrawal.) Roth IRAs are another down payment source; you can always access money you contributed to a Roth without any tax or penalty, and first-time buyers can take $10,000 of earnings without paying the early withdrawal penalty. Income tax is only charged if the account is less than five years old.

However, I do not subscribe to that advice anymore. Given the struggles so many of you are having saving for retirement I am going to insist that you leave every penny of your retirement money invested for retirement. If that means you need to spend a year or two saving up for a down payment, that's the truth I am asking you to stand in. Remember, the New American Dream is not just about sensible homeowners.h.i.+p, but about retiring with security as well.

I also do not advocate borrowing large sums from your family for the down payment. This is primarily a lesson in personal accountability. I want you to be responsible for what likely will be your single biggest investment ever. For a 20% down payment I do not want your family chipping in more than one-quarter of that amount, or 5%. And it is your responsibility to make sure your family members are standing in their truth. They must never give you money if it compromises their own financial security.

MAINTAIN AN EIGHT-MONTH EMERGENCY SAVINGS FUND.

In late 2010, more than 40% of unemployed Americans had been out of work for at least six months. That statistic alone should make it obvious why I insist you have ample savings set aside so you can continue to cover your mortgage and other housing costs in the event of a layoff or furlough. In fact, mortgage lenders will be looking at your savings when evaluating your application. Without at least four or five months' worth of mortgage payments saved up you may find it hard to land a deal.

OPT FOR A 30-YEAR FIXED-RATE MORTGAGE.

As I write this in early 2011, a 30-year fixed-rate mortgage for a well-qualified buyer is below 5%. I can't tell you how seriously great that is. When you can lock in a low rate and you never have to worry about it changing, you must grab that deal. Yes, I know five-year and seven-year adjustable rate mortgages have even lower rates, but they also come with risk as well. Haven't we all learned the risks that come with adjustable-rate mortgages? Many of today's foreclosures came about because people took out adjustable mortgages during the bubble that they a.s.sumed they would be able to refinance out of before the rate adjusted. When that didn't pan out as expected the troubles began. And given that interest rates are currently at historic lows, the trend going forward is for rates to rise, not fall. All the more reason to lock in a safe-not-sorry 30-year fixed-rate mortgage.

TIP: Consider a 15-year mortgage if you are at least 45 years old. As I explain in the retirement chapter, I think one of the best retirement strategies is to get your mortgage paid off before you retire. So if you are purchasing a house today that you antic.i.p.ate you will retire in, and retirement is within 15 to 20 years, I want you to consider taking out a 15-year mortgage. Yes, that means your monthly payments will indeed be higher, but at today's super low interest rate-4.0% as of early 2011-a 15-year is incredibly affordable. If you have the income and savings to be able to handle the higher monthly payments you will save tens of thousands of dollars in total interest payments as well as arrive at retirement mortgage-free.

And if you are confident you can afford the higher required payments with the 15-year loan, it is the better strategy than just settling for a 30-year mortgage that you intend to pay off in 15 years. The interest rate on a 15-year mortgage is typically about a half a percentage point lower than the rate on a 30-year loan. That helps keep your overall interest costs lower. The website Bankrate.com has a calculator that will walk you through the math of a 15-year vs. 30-year mortgage. has a calculator that will walk you through the math of a 15-year vs. 30-year mortgage.

UNDERSTAND THE RISK OF DISTRESSED PROPERTY.

In most parts of the country, foreclosed homes and homes that are listed as short sales account for one-quarter or more of the homes for sale. These so-called distressed properties often sell for below-market rates, but you need to be extra careful if you are considering bidding on either type.

A short sale short sale is when a lender agrees to let a homeowner sell a home for less than the current balance left on the mortgage. The lender is essentially agreeing to take a loss on that shortfall. As a buyer you must understand that you have two sellers in a short sale: the homeowner who is listing the home, and the lender. When you make a bid, even if the seller accepts, you then must wait to hear if the lender agrees to the terms. That can take months. And if the seller has a second mortgage on the home the process becomes even more difficult; the sale can't go through without the approval of the second-mortgage lender, and that is not something that happens easily or quickly. is when a lender agrees to let a homeowner sell a home for less than the current balance left on the mortgage. The lender is essentially agreeing to take a loss on that shortfall. As a buyer you must understand that you have two sellers in a short sale: the homeowner who is listing the home, and the lender. When you make a bid, even if the seller accepts, you then must wait to hear if the lender agrees to the terms. That can take months. And if the seller has a second mortgage on the home the process becomes even more difficult; the sale can't go through without the approval of the second-mortgage lender, and that is not something that happens easily or quickly.

A foreclosure foreclosure is when a lender has already taken back possession of a home from a borrower. Sales of foreclosed homes can move much more quickly; once the bank puts the property on the market it is eager to make a deal. But I don't have to tell you about all the problems rocking the foreclosure market; as I write this in early 2011 we are dealing with revelations that many lenders may have foreclosed on homes without going through the proper steps. More troubling is the concern that many lenders lack the proper doc.u.mentation to prove they in fact have t.i.tle (owners.h.i.+p) of the home. What seems most likely is that this will clog the foreclosure process for months as banks-prodded by regulations and lawsuits-will have to scramble to prove their paperwork is in place. Given the turmoil in the foreclosure market I advise you to think very long and hard and ask yourself if you are up for navigating your way through the maze. It can take months. And you must work with a real estate agent with experience in foreclosures, as well as a real estate lawyer well equipped to review all doc.u.ments. You need legal proof that a t.i.tle search has been conducted and that you will indeed have free and clear t.i.tle to the property. is when a lender has already taken back possession of a home from a borrower. Sales of foreclosed homes can move much more quickly; once the bank puts the property on the market it is eager to make a deal. But I don't have to tell you about all the problems rocking the foreclosure market; as I write this in early 2011 we are dealing with revelations that many lenders may have foreclosed on homes without going through the proper steps. More troubling is the concern that many lenders lack the proper doc.u.mentation to prove they in fact have t.i.tle (owners.h.i.+p) of the home. What seems most likely is that this will clog the foreclosure process for months as banks-prodded by regulations and lawsuits-will have to scramble to prove their paperwork is in place. Given the turmoil in the foreclosure market I advise you to think very long and hard and ask yourself if you are up for navigating your way through the maze. It can take months. And you must work with a real estate agent with experience in foreclosures, as well as a real estate lawyer well equipped to review all doc.u.ments. You need legal proof that a t.i.tle search has been conducted and that you will indeed have free and clear t.i.tle to the property.

TIP: t.i.tle Insurance on Foreclosed Homes. If you are purchasing a foreclosed home and you antic.i.p.ate making sizable renovations to the property, ask your t.i.tle insurer for a policy that includes a special rider that would cover not just your purchase price, but also the future value after renovations as well. In the event the foreclosure doc.u.mentation mess escalates and your owners.h.i.+p is questioned in the future, you want to know at the very least that your t.i.tle insurance policy will provide ample reimburs.e.m.e.nt for the renovated value of your home. I recognize that there are some seriously great prices available on foreclosed properties, but I want you to be very careful if you decide to focus on foreclosed property. The buying process can be lengthy and full of pitfalls, and the current legal issues swirling around add a dose of uncertainty. Please stand in your truth: Maybe paying a slightly higher price for a home that is not a foreclosure is in fact the better deal for your family.

LESSON 4. WHAT TO DO IF YOU ARE UNDERWATER WHAT TO DO IF YOU ARE UNDERWATER.

The steep fall in home prices in many parts of the country means that many homeowners who purchased a home during the bubble-often with little or no down payment cus.h.i.+on-currently have a mortgage that is higher than the market value of their home. According to housing data firm CoreLogic, more than 20% of homes with a mortgage in the third quarter of 2010 were underwater. Arizona, California, Florida, Michigan, and Nevada have the highest concentrations of underwater homeowners.

In this lesson I want to address separate strategies for two very different types of underwater households: those that can't afford their mortgage and those that can. If you can't afford your mortgage and you are in fact underwater, I want you to stand in the truth that walking away may in fact be the right and honest move for you and your family.

If you are underwater and can still afford your home, the math and the ethical questions require a different strategy.

IF YOU ARE UNDERWATER AND CANNOT AFFORD YOUR MORTGAGE.

I need to start this lesson by telling you what I absolutely do not want you to do, ever: You are never to touch your retirement savings to keep up with a mortgage you can no longer afford. You must respect your retirement truth as much as your housing dream: You will need to have savings to support yourself in retirement. Using that money today to cover your housing costs raises the risk you will permanently doom your retirement dream.

I know this is such a painful truth to face, but it is the right truth. Please try to step back for a moment and think through the outcome of using retirement funds to cover a mortgage payment: All money withdrawn from a traditional 401(k) or IRA will be taxable, and there may be a 10% early withdrawal penalty as well. That reduces what you will have to put toward your housing costs. And whether the tapped funds are taxed or not, the more important issue is that they are being used at all. What's most upsetting for me is when families withdraw money from their retirement funds to cover a mortgage, and then when those savings are used up they still can't afford the mortgage. They depleted their retirement savings to do nothing more than delay the inevitable: They can't afford that mortgage, period.

And as I explain on this page this page in the retirement chapter, I do not recommend you ever take out a 401(k) loan. So please read that advice before you make this costly mistake. in the retirement chapter, I do not recommend you ever take out a 401(k) loan. So please read that advice before you make this costly mistake.

That brings us to the right strategies to pursue if you have a mortgage you can no longer afford. I am not going to sugarcoat anything here. The very sad truth is that banks have, on the whole, been incredibly unresponsive in working with homeowners who cannot afford their mortgages. The help that was promised, I'm sorry to say, did not materialize for so many of you. The federal government's programs have proven to be woefully ineffective, in large part because lenders are asked-asked, but not mandated-to partic.i.p.ate. So far, banks haven't shown much enthusiasm for helping. I mention all of this to make sure you understand the resolve and tenacity that is required to try to negotiate a deal with a lender.

There are four basic options for dealing with your predicament; I list them here in order of their appeal for distressed homeowners.

- Loan Modification: Your lender agrees to reduce your payments to an affordable level. Your lender agrees to reduce your payments to an affordable level.

- Short Sale: The lender agrees that you will sell your home for whatever it can get in today's market. If the sale price is less than the outstanding balance of your mortgage, the lender will forgive that amount. The lender agrees that you will sell your home for whatever it can get in today's market. If the sale price is less than the outstanding balance of your mortgage, the lender will forgive that amount.

- Deed in Lieu of Foreclosure: You hand the house back to the lender, and the lender agrees to not go through the foreclosure process. A lender will typically require you to attempt a short sale before considering a deed in lieu of foreclosure. You hand the house back to the lender, and the lender agrees to not go through the foreclosure process. A lender will typically require you to attempt a short sale before considering a deed in lieu of foreclosure.

- Foreclosure: The lender takes back your house and sells it. Depending on your state the lender may be able to sue you for any loss it incurs if the sale price is less than the outstanding mortgage balance. The lender takes back your house and sells it. Depending on your state the lender may be able to sue you for any loss it incurs if the sale price is less than the outstanding mortgage balance.

Please understand that the lender, not you, is in the driver's seat here. What you want is irrelevant; this is all about what a lender is willing to offer you. Let's walk through each option in detail.

Loan Modification If you can prove you have financial hards.h.i.+p, a lender may be willing to reduce your current monthly payment to a more affordable level. I want to stress that this does not mean your princ.i.p.al balance will be reduced. While that is possible, banks have been loath to offer this relief. What is more likely-if you can even win a modification-is that your interest rate will be reduced to lower your payment.

The federal Home Affordable Modification Program (HAMP) offers lenders incentives to reduce the mortgage payments for qualified borrowers. Some lenders may have their own modification programs as well. The bottom line is that you want to start working with your lender as soon as you have any inkling you are headed for trouble. You do not need to be behind on your payments to qualify for the HAMP program; if you can prove financial hards.h.i.+p, such as a drop in your income due to a layoff, or the fact that your mortgage payment is adjusting to a new, higher cost that will make it hard to pay the loan, you may be able to win a reduction.

HAMP Basics To be eligible for HAMP: - The mortgage must be for a primary residence that was obtained before January 1, 2009. Vacation homes and investment properties are not eligible.

- The mortgage amount must be $729,750 or less.

- You must be able to prove financial hards.h.i.+p: Either your mortgage has increased or your income has decreased.

- Your monthly mortgage payment (including property tax, insurance, and homeowners' a.s.sociation fees if applicable) must be more than 31% of your current gross income.

TIP: In the summer of 2010 the Treasury Department, which oversees HAMP, introduced a new variation specifically for households in which a layoff has made it hard to keep up with the mortgage payment. The Home Affordable Unemployment Program (HAUP) offers a reduced payment for a short period while the household looks for reemployment. As with all of these programs, lenders are not required to partic.i.p.ate, and so far it does not seem to be widely adopted. But please check with your lender to see if it may be willing to use HAUP to give you a temporary reduction in your mortgage cost. In the summer of 2010 the Treasury Department, which oversees HAMP, introduced a new variation specifically for households in which a layoff has made it hard to keep up with the mortgage payment. The Home Affordable Unemployment Program (HAUP) offers a reduced payment for a short period while the household looks for reemployment. As with all of these programs, lenders are not required to partic.i.p.ate, and so far it does not seem to be widely adopted. But please check with your lender to see if it may be willing to use HAUP to give you a temporary reduction in your mortgage cost.

If you meet all those criteria you may be able to win a mortgage reduction that brings your monthly payment down to 31% of your gross income. The HAMP website has a calculator that will show you an estimate of what your monthly payment could be if you win a modification: www.makinghomeaffordable.gov.

I need to be very honest here: To date this program has been a huge disappointment. Through the summer of 2010 only one-third of applicants who were given a "trial" modification were able to win a permanent modification. One of the issues was that the program initially enrolled partic.i.p.ants before verifying their eligibility. In many instances lenders disqualified people during the trial period if they could not doc.u.ment financial hards.h.i.+p or their payments did not exceed 31% of gross income. A change in the program-effective in June 2010-requires verification of eligibility before a trial modification begins. What this means is that you will know early on if you are a bona fide candidate for a modification. However, the reality has been that many eligible homeowners are often being strung along for months-the average modification trial period in 2010 was about fourteen months-only to be turned down for claims of faulty paperwork.

And what is particularly upsetting is that when you go into a trial modification you could be making matters worse, as you'll soon see.

The Risks of Asking for a Trial Modification When a lender offers you a trial modification, your monthly payment will be reduced. That's the good news. The bad news is that this will have a negative impact on your credit score. Why is this? Because even though the bank agrees to lower the payment, it must still report the fact that you are no longer paying the full amount due. So if you have been current on your mortgage and other payments, and you enter into a trial modification, be aware that your credit score is going to take a tumble. The hit your score takes will depend on your score prior to the modification. Unfair as it may be, a high score will actually fall more-possibly 100 points or so-while a lower score will not see as much impact.

The second risk is what happens if you are turned down for a permanent modification, a fact of life for more than two-thirds of borrowers who had gone through HAMP as of the summer of 2010. If you are deemed ineligible for a permanent modification, the lender can turn around and demand repayment for the difference between your regular payment and the trial payment.

Here's an example: Let's say you had a $2,000 monthly mortgage payment that was reduced to $1,500 during a 10-month trial period. Then the lender decides you do not qualify for the permanent modification. It can then demand that you repay the $500 monthly reduction you had for the 10 months. Suddenly you find yourself back at owing $2,000 to cover the monthly mortgage and and you have a $5,000 balloon payment you must pay p.r.o.nto. If you can't handle both of those costs, the bank then starts the foreclosure process. In late 2010 the Treasury Department said it was looking into the balloon payment issue. you have a $5,000 balloon payment you must pay p.r.o.nto. If you can't handle both of those costs, the bank then starts the foreclosure process. In late 2010 the Treasury Department said it was looking into the balloon payment issue.

In the meantime, I want anyone considering a modification to be very aware of what they may be walking into. Before you agree to a trial modification I recommend you get the lender to answer-in writing-the following questions: - Do I meet the financial requirements to be eligible for a permanent modification?

- When will you decide on making my modification permanent? (It is supposed to be three months, but the average wait time has been four times as long.) - If I am denied a permanent modification, will I owe any balloon payment? If so, how fast must I pay back that balloon payment?

I then want you to stand in the truth. Given the sorry statistics on how many homeowners in trial modifications are turned down for a permanent modification, I want you to ask yourself whether the better move-the one that allows your family to in fact move forward-is to walk away from the house.

TIP: Tax Break for Short Sales and Foreclosures Before January 1, 2013. Before the financial crisis, if you walked away from a mortgage and your lender forgave you the difference between the sale price and the mortgage balance, you still had a potential federal tax bill. The amount of the forgiven amount was reported as "income" given to you and you would owe tax on that income. But a special law pa.s.sed in 2008-the Mortgage Debt Relief Act-temporarily does away with this tax bill. Through December 31, 2012, any short sale or foreclosure in which the lender forgives any unpaid portion of your mortgage not covered by the sale price is exempt from the tax. The mortgage must have been taken out before January 1, 2009, for a primary residence, and the maximum loan amount covered is $2 million. For those of you who are considering a loan modification, I want you to be aware of the expiration date for this tax break. If you have any doubt whether you will qualify for a permanent modification, or whether even with the modification you will be able to hold on to the home, the wise move may be to let go of the home and have it sold/foreclosed before the end of 2012. If you wait longer and you ultimately need to give up the home, you may not be able to take advantage of this important debt forgiveness regulation.

Short Sale In a short sale your lender agrees to let you sell your home for a price that is less than the outstanding balance on your mortgage, and the lender will not require you to pay the difference. Lenders know they are likely to get a higher sale price through a short sale than if they have to foreclose on a home and incur all the costs of that process, including selling the house. That's their incentive for considering a short sale. But a lender will not extend a short sale option to anyone who merely doesn't want to pay their mortgage. Please respect the truth that your mortgage is a legal obligation; you promised to make a payment. If you no longer want to make the payment that is not nearly a good enough reason for the lender to agree to a short sale. You must exhibit a financial need for the short sale, such as a change in your household income, or an adjustable mortgage that has adjusted to the point of being unaffordable.

If your lender agrees to a short sale it will have the final say on accepting a buyer's offer. That is, the lender can turn down a buyer's offer if it decides it is too low, even if that means the lender will then start the foreclosure process on your home.

Deed in Lieu of Foreclosure In some instances, lenders may be willing to work out a deal for you to hand over owners.h.i.+p of the home to the lender without having to go through the formal foreclosure process. It is entirely up to a lender whether it wants to go this route, and typically this will be offered only if a short sale was not successful.

Foreclosure This should be your last-resort option if you must walk away from a home and you have been unable to work out a modification, short sale, or deed in lieu of foreclosure with your lender.

In a foreclosure the lender takes back owners.h.i.+p of the home and a.s.sumes responsibility for selling the property. In twenty-three states this process must go through the court system; in all other states there is no requirement for judicial review. In early 2011 we are in the midst of the latest twist in the housing fiasco: lenders pus.h.i.+ng through foreclosures while cutting corners in doc.u.menting the process. As noted above, in the most extreme cases there are now questions as to whether lenders can prove they in fact have t.i.tle to these properties.

The behavior of the banks and mortgage servicing companies has been awful. That is not to be debated. But I do not want any of you who are in foreclosure because you have not been able to pay your mortgage to think that this is some sort of reprieve and you will be able to win back your home. If you cannot afford your home, you cannot afford your home, regardless of the paperwork mess. That said, you may be able to use the debacle to your advantage; to the extent it slows down the foreclosure process that gives you more time to think through your next step. The healthiest move is to move out as soon as possible, but if you are not paying the mortgage, staying put while the foreclosure process plays out can give you a few more months-maybe even a year or more-to save money so you can secure a rental once you do move out. The fact that you are in foreclosure means your credit score has already taken a hit; so having more money to make a larger security deposit on a rental may be necessary to convince a landlord to rent to you.

Now, I am not blind to the controversy in suggesting that strategy. But if you have in fact done your very best to work out a solution-and despite your good-faith efforts (see the modification problems I just detailed above) you are still tossed into the foreclosure process-I have no problem suggesting you use the time it takes for the bank to formalize the foreclosure to save as much as you can.

Tax Breaks on Foreclosures As I mentioned above, through 2012 any foreclosures or short sales of a primary residence that result in a home being sold for less than the mortgage balance are eligible for an important tax break: The amount of the shortfall, which typically is treated as taxable income by the IRS, will not be taxed.

But that does not mean you are free and clear of all obligations.

In certain states, under certain circ.u.mstances, a lender or a collection agency can seek a "deficiency judgment" that would require you to repay the difference between the mortgage balance at the time of the foreclosure and the market value of the home. Please understand that just because you "walk away" from the home through a foreclosure, you could indeed still be on the hook for at least a portion of the unpaid balance of the loan. And depending on the state, you could be hit with a deficiency judgment four or five years after the foreclosure! What you may be liable for depends on what type of mortgage you have, and your state. If you have what is called a recourse recourse loan, that means the lender, in certain circ.u.mstances and in certain states, may have the right (recourse) to sue you for the unpaid portion of the mortgage. If your mortgage is nonrecourse that means the lender doesn't have the right to seek payment for the unpaid balance. loan, that means the lender, in certain circ.u.mstances and in certain states, may have the right (recourse) to sue you for the unpaid portion of the mortgage. If your mortgage is nonrecourse that means the lender doesn't have the right to seek payment for the unpaid balance.

The best investment you can make at this juncture is to talk to a real estate attorney with foreclosure experience so you can understand what may happen to you after after the foreclosure. Please don't a.s.sume that just because you live in one of the nonrecourse states, your loan or the specific nature of your mortgage protects you from a deficiency judgment. (Nonrecourse states that prohibit deficiency for most home mortgages are Alaska, Arizona, California, Minnesota, Montana, North Carolina, North Dakota, Oklahoma, Oregon, and Was.h.i.+ngton. Please note, other states impose restrictions on lenders' ability to seek deficiency judgments. As I said, retaining a lawyer well versed in your state's foreclosure laws is very important.) While nonrecourse means that you are generally protected from any deficiency judgments, you need to know if your actual mortgage is recourse or nonrecourse. And even if it is nonrecourse you could under some circ.u.mstances still be liable for a deficiency judgment. For example, only mortgages for a primary residence are generally protected. Any foreclosure on an investment property or HELOC loans is not protected from a deficiency judgment. And in some nonrecourse states, if the lender was granted the foreclosure through a judicial proceeding it can then seek a deficiency judgment. the foreclosure. Please don't a.s.sume that just because you live in one of the nonrecourse states, your loan or the specific nature of your mortgage protects you from a deficiency judgment. (Nonrecourse states that prohibit deficiency for most home mortgages are Alaska, Arizona, California, Minnesota, Montana, North Carolina, North Dakota, Oklahoma, Oregon, and Was.h.i.+ngton. Please note, other states impose restrictions on lenders' ability to seek deficiency judgments. As I said, retaining a lawyer well versed in your state's foreclosure laws is very important.) While nonrecourse means that you are generally protected from any deficiency judgments, you need to know if your actual mortgage is recourse or nonrecourse. And even if it is nonrecourse you could under some circ.u.mstances still be liable for a deficiency judgment. For example, only mortgages for a primary residence are generally protected. Any foreclosure on an investment property or HELOC loans is not protected from a deficiency judgment. And in some nonrecourse states, if the lender was granted the foreclosure through a judicial proceeding it can then seek a deficiency judgment.

I can't emphasize enough how important it is to sit down with a real estate attorney who can spell out the rules and regulations in your state. I want you to go into the process with eyes wide open. Sadly, some people who "walked away" are now finding they must declare bankruptcy after the fact to deal with a deficiency judgment they can't afford.

UNDERWATER BUT YOU CAN AFFORD THE MORTGAGE.

For those of you who are underwater on a mortgage but can still afford the payment, your decision involves more than financial issues.

I want to be absolutely clear about what I believe is the right thing to do. If you are 5%, 10%, even 20% underwater, and you can afford the mortgage, I cannot condone walking away. I don't care if rents are cheaper. That mortgage is a legal doc.u.ment; you do not walk away from it out of convenience. If you want out, then sell the home and use your savings to make up any difference between the sale price and your remaining balance. That is what I call being financially responsible.

I also hope that if you are only marginally underwater, you retain the perspective on what your home is. If your family loves that house, if it is the refuge and centerpiece of your family, and you can afford the mortgage, then don't get caught up in its current value. We are most likely through the worst of home price losses. Enjoy your home for the shelter it provides today, and over time-it might take ten or more years-you will likely see its value rebound.

Now, that said, I do indeed respect that some of you who bought at the peak of the bubble in the most inflated markets-Florida, Arizona, and Nevada among them-may now be 50% or more underwater. And in those instances I understand the rationale of walking away. For example, I have a dear friend who made a $140,000 down payment on a $700,000 home in Tampa, Florida, in 2007. She certainly met my stand-in-the-truth test of a 20% down payment. But since then, not only has the value of her home sunk to $150,000-that is what identical homes are selling for-but also her a.s.sociation fees have gone through the roof because so many of her neighbors have stopped their payments, or have already foreclosed. And she's actually lucky; at least her neighborhood remains safe; I know so many of you who are deeply underwater are now surrounded by empty homes. That's not just spooky, it is easy pickings for burglars. So I get it. My friend ended up walking away and having to declare bankruptcy-she had a recourse loan. There was no triumph in this. But there was relief from an awful situation where no one would work with her to come up with a modification.

The hard truth my friend stood in, and the hard truth some of you must face, is that it could be decades, if ever, until you will see home values return to their pre-crash levels in these hardest-hit areas, especially if your neighborhood and region is currently overwhelmed with foreclosures. In those instances you must dig deep and decide what is the right financial move for you.

HOW LOAN MODIFICATIONS, FORECLOSURES, SHORT SALES, AND DEEDS IN LIEU OF FORECLOSURE AFFECT YOUR ABILITY TO GET A MORTGAGE IN THE FUTURE.

When you do not fulfill your obligation to repay your original mortgage in full-even if the lender has agreed to a workout-your credit report will note the underpayment. According to FICO, the leading resource for credit scores derived from your credit report, a loan modification, short sale, deed in lieu of foreclosure, and foreclosure are all treated the same in terms of your credit score. One is no better, or worse, than the other. Once the underpayment shows up on your credit report it will remain there for seven years. How much it will hurt your score varies; if you had a high score before, it will have a larger impact; if your score was already low, it will have a smaller impact. The impact of this demerit declines over time; it will have less impact six months from now than it does today, and its impact three years from now will be less than two years from now. If you focus on the steps that help your credit profile-on-time payments, for example, and keeping your debt level low relative to your available credit-you can in fact repair a lot of the damage in less than seven years.

While FICO does not differentiate between the various types of loan workouts, mortgage lenders do. I know this might sound a bit crazy when we are talking about walking away from your house, but it is important to understand how your ability to buy another house in the future will be impacted by how you walk away from your current home.

As I write this in early 2011, the vast majority of lenders follow the rules laid down by Fannie Mae and Freddie Mac. These two agencies either guarantee or buy up most of the mortgages that lenders make; thus lenders are careful to make sure they follow the guidelines for what qualifies to be bought or guaranteed by either government agency.

If you go through a formal foreclosure, you may need to wait five years to qualify for a new mortgage that is backed by Fannie Mae. The wait can be less if you can doc.u.ment that the foreclosure was due to an "extenuating circ.u.mstance," such as a divorce or losing a job. But if you walk away through a short sale or deed in lieu of foreclosure, you may be eligible for a Fannie Maebacked mortgage in just two years if you have a 20% down payment, or four years for a 10% down payment. This rule presumes you are able to meet all other credit and income qualifications for the mortgage.

LESSON 5. HOW TO REDUCE MORTGAGE COSTS HOW TO REDUCE MORTGAGE COSTS.

Despite all the headlines this rash of foreclosures is getting, the truth is that the vast majority of homeowners can in fact afford to stay in their homes-and want to stay in their homes. But those of you who are in this category have a new dream to consider as well. Whereas borrowing as much as possible to buy the biggest home possible was a centerpiece of the old American Dream, for many of you, your new home dream is to get your mortgage paid off as quickly as possible, or to take advantage of the current low mortgage rates and refinance into a less costly loan.

WHEN IT MAKES SENSE TO PAY OFF A LOAN AHEAD OF SCHEDULE.

As I explain in great depth in the cla.s.s about planning for retirement in your 40s and 50s, I think one of the best retirement strategies to put in place is to have your mortgage paid off before you retire. So for anyone who is at least 50 years old and is absolutely sure they will stay in their home through retirement, I am all for accelerating your loan payments so you get the mortgage paid off. If you want to learn more about my reasoning and my recommendations for how to accomplish this, please see this page this pagethis page.

THE NEW REALITIES OF REFINANCING.