1. Get Connected – Every investor can do better by bouncing ideas off of other investors and the best way to find other investors is to join an investment group. Not only can you run your investment ideas by other people, but it also gives you a connection to other investors if you decide to sell your properties some day.
2. Budgeting - Setting this up before you buy a property is key. It stops you from over spending and ruining any chance you have of making a profit on a property you buy. If you aren’t sure about budgeting and want some help then look for local investment property specialists to help you.
3. Fast or Slow – Slow and steady wins the race. I’m sure you’ve heard that before and with real estate investing it couldn’t be more true. Getting sucked into buying to many properties to fast, whether it’s to rent or flip can get you into trouble. I’ll let you in on a little secret…there is always another deal coming. You’re never going to miss the “last good deal”. Statistically there will always be another one and you have to remember that.

It doesn’t get much simpler than that. Do your homework, keep things in perspective, and invest for the long haul to give yourself a decent shot at a long and profitable career investing in real estate, or anything for that matter.

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The Vanguard REIT Index Fund

Perhaps the best way to invest in the commercial real estate market is via Real Estate Investment Trusts, or REITS.  Investors in the Vanguard REIT Index Fund (VGSIX) have lost an average of 13.69% per year over the three year period ending 2/28/2010.  Despite the fact that the REIT index fund has almost doubled over the last year, it hasn’t been pretty for REIT investors for quite some time.

A Longer-Term Perspective

Looking at the fund’s recent performance, one might understandably be a bit wary of investing in this asset class.  Still, real estate has proven to be an effective diversified in the past and has a solid long-term track record.  The Vanguard REIT index fund, which tracks a modified version of the MSCI US REIT Index, has almost 14 years of history now.  Introduced on May 13, 1996, the fund has averaged 9.13% per year for the period ending 2/28/2010, a period that included one of the worst bear markets for real estate on record.  Furthermore, the fund has consistently been a decent (although not great) diversifier for a portfolio of U.S. stocks, with a correlation coefficient of between 0.5 and 0.8% with the Vanguard Total Stock Market Index Fund (VTSMX) for the vast majority of the period.

Almost as importantly, the REIT index fund has adequately met one of the primary objectives of almost any real-estate focused mutual fund:  providing a steadily growing stream of income for investors.  While its current yield of 4.31% is less than the asset classes historical yield, it is still well more than double the yield of the total stock market.  And as rents steadily climb as the economy slowly recovers, I believe REIT yields will someday regain a measure of their old luster.

So while it’s true the past few years haven’t been kind to real estate investors, the fundamentals of the asset class remain strong and what’s more, the long-term performance of real estate is still quite good even accounting for the recent bust!  That is to say, it’s probably as good a time as any to buy real estate provided you’re in it for the long term.

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As housing and mortgage laws are changing, getting stricter because of the increase in loan defaults, it is a very important first step to figure out exactly what you can afford before even beginning the home search. And above all else, never base what you can afford on what your mortgage broker tells you.  Chances are, he has no idea.

Calculating Home Affordability

Mortgage Percentages

The rule of thumb you’ll need to remember is that your monthly mortgage payments should not exceed 28% of your gross income before taxes. If your combined income is $60,000, your mortgage payment should not go over $1,400 a month. ($60,000/12 months = $5,000 x 28% = $1,400)

Total Housing Percentages

Following the 28% rule, you will also need to factor in with the mortgage the additional expenses of owning a home such as property taxes, insurance, and other monthly fees. This total amount should not exceed 32% of your gross monthly income. At $60,000, the total cost of housing each month should be no more than $1,600.

Debt Percentages

After the first two rules, debt will also be factored into the equation. You’ll need to have a solid understand of how much financial liability you have each month. This includes all of your monthly bills including credit card debt, student loans, vehicle notes, insurance, and the like. Total them up and compare against your gross monthly income. The amount should not exceed 40% of your gross monthly income. In our scenario, total monthly debt payments in excess of your housing expense should not be more than $400.

Interest Rates And Down Payments

You will need to calculate your total amount of your mortgage but the interest rate on the loan will be the deciding factor. Until you know what the rate will be, make a guesstimate based on your credit score and the current APR’s to find out exactly how much mortgage you can afford. To find formula for calculating the maximum amount for our scenario, let’s assume you take out a 30 year loan at a 6% fixed rate. For every $10,000 borrowed, your mortgage payments would be around $55. $1,400/$55 = 25.45 x $10,000 = $254,500.

After calculating the numbers, you will also have to factor in the amount of your down payment. Most lenders want to see 20% of the purchase price down. Anything less than 20% will bring an added expense of private mortgage insurance, or PMI, which is required when you have less than 20% equity in your home. PMI payments will decrease your debt expenses and the total amount of home you can afford.

Working through these calculations before shopping for a home or a mortgage will give you a better understanding of where to start looking and save you money for the long-run because you already know what you can afford.  And remember, the numbers above represent the maximum recommend purchase price.  You should of course try to purchase a less expensive home and under no circumstances should you purchase a more expensive one.

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What Is A REIT?

A Real Estate Investment Trust is an avenue that allows everyday investors to put money into commercial real estate, condos, apartments, or almost any other type of property.  REITs are required by law to distribute at least 90% of their income to shareholders as dividends.  In exchange for being required to pay out most of their income to shareholders, real estate investment trusts pay no corporate income tax.  The dividends, however, are taxable to investors as regular income.  Investors in REITs can buy or sell their shares like they would do with any other stock.

Which Type Is Right For Me?

There are actually three kinds of real estate investment trusts.

Equity REITs

Equity REITs are by far the most common form of Real Estate Investment Trusts.  Equity REITs invest in various types of income-producing commercial properties. The income is then shared in investor dividends. Profit will be based on numerous criteria including what type of property it is and how much income it generates.  Property management skill, property type, and geographical location are key determinants of returns in this segment of the market.  Shares of Equity REITs tend to appreciate only moderately over time:  most of the return comes from cash flow.

Mortgage REITs

Mortgage REITs are much less common than Equity REITS.  They either buy up pools of mortgages made by others or make mortgage loans directly.  As you might have guessed, they haven’t performed so well the last few years.  Mortgage REITs are estimated to make up only about 10% of all REITs.

Hybrid REITs

Hybrid REITs are quite rare.  A hybrid REIT is merely a REIT that invests both in actual real estate properties and mortgage loans.

REITs are a great way to achieve broad geographic diversification for a minimal initial investment.  It is possible to own real estate in all 50 states and dozens of foreign countries with just one or two funds.  It would take tens of millions of dollars to achieve that kind of diversification investing in properties directly, and that’s assuming you could actually figure out how to manage them efficiently.

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When Refinancing Your Home Makes Sense

The rule of thumb is that a mortgage refinance is generally only a slam dunk when you can lower your interest rate by two percentage points or more and if you plan to stay in your home for as long as it takes you be compensated for the cost of refinancing (learn how to calculate your payback period). For instance, if your mortgage payment drops by $250 a month and after adding in the cost of closing it takes you 24 months to start seeing the savings (a realistic number), you’ll need to stay in your home for at least 2 years to make refinancing worth the trouble. If you are planning to sell your home sooner than that, refinancing is not a wise financial move.

What To Look For In a Mortgage Refinance

First, you have to be realistic about where you stand financially.  Do you have a steady income?  Enough cash to cover closing costs?  Decent credit?  You will definitely want to check your credit report (find out how to get a free annual credit report) and order a copy of your credit score (I suggest using myFico.com for your score, but skip the credit monitoring services) to make sure you’re eligible for the best rates on a refinance loan. If your credit is not 720 or better, you should work on improving it before applying for a new loan.

If your credit is up to snuff, you’ll need to begin researching loan options. Never choose a loan based solely on the interest rate. There are many factors to consider including:

Mortgage Term

The length of time it will take to pay off the principal and interest of the loan is probably the most important decision you will make (see 15- vs 30-year mortgages). Mortgages with shorter terms will carry the lowest interest rates but higher monthly payments. The pro of a shorter term is a lower total amount of interest paid over the life of the loan.

Mortgage Interest Rate

Mortgages come with either a fixed- or a adjustable-rate flavors.  A fixed rate, of course, means the rate is fixed over the life of the loan and will never change.  Adjustable rate mortgages generally come with a fixed teaser rate for a pre-determined period of time, usually 3 to 5 years, after which the interest rate floats up and down depending on prevailing economic conditions. If you plan to remain in your home for a while, it’s usually best to stick with a fixed rate mortgage, as adjustable rates can and do jump dramatically over the coming years.

Mortgage Points Required

A mortgage point is equal to 1% of the total value of a mortgage loan.   To pay points on a mortgage is to pay 1% of the mortgage up-front at closing as a way to “buy down” the interest rate.  In exchange for getting some of their money up-front, most banks will agree to lower your interest rate somewhat in return.  Zero point mortgages do not have an up-front fee but can end up being more costly over the long run if it means paying a much higher interest rates instead.  You’ll need to calculate of a lower rate will justify the points costs.  Determining whether or not it’s in your best interests to pay points on a mortgage is simple math and depends primarily on the size of the interest rate discount and how long you plan to stay in your home.

You’ll want to shop around to find which mortgage offers will be most beneficial to you. When you do find a loan you’d like to apply for, be sure to know what you are signing. Read the contract thoroughly and be certain the savings over time will outweigh the expense of a refinance.   Do not feel pressed to make a quick decision. Refinancing a mortgage is generally be less time-consuming than the initial loan because most of the relevant financial information is readily available.   Whatever you do, don’t make the mistake of jumping on the first refinance offer you come across without considering the alternatives.

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What Is An Interest Only Mortgage?

With an interest only mortgage the borrower has the opportunity to pay monthly payments, for a predetermined period of time, on just their mortgage’s interest and not the principal. This time frame is usually between five to ten years; however, the borrower does have the option of paying down principal during the interest-only period. At the end of this period, the total amount of principal owed would not have been reduced one bit (unless you’ve been pre-paying principal, of course).

How Are They Structured?

Normally, an interest only mortgage is structured as a traditional 30-year mortgage with up to ten years of monthly payments on just the interest portion of the loan. As you might expect, the interest rate on these mortgages is usually much higher than comparable 30-year mortgages, however, since you aren’t paying on the principal, the total monthly payment is generally lower, at least at first.  After the interest-only period is over, there is generally a balloon payment due followed  by permanently-higher monthly payments. Few buyers plan on sticking around that long, however.  An interest only mortgage is almost always a last-resort option the buyer will opt to refinance out of at the earliest opportunity.

Advantages Of Interest Only Mortgages

Theoretically, the primary advantage of interest only mortgages is the lower monthly payment.  When times were good and home prices appreciating by the day it was possible to buy a property with no-money down, pay minimal monthly payments on an interest only mortgage while patiently waiting for values to go up, and then selling long before the interest-only period was up for a tidy profit.  Obviously, this trick only works in a bull market.

Another commonly-cited advantage of interest only mortgages is that they are more flexible than fixed-rate mortgages.  A family or borrower with fluctuating income may prefer the option of only making payments on interest during their months of leaner income. My opinion is that if you can’t afford a 30-year fixed mortgage, you can’t afford to own a home.

Disadvantages Of Interest Only Mortgages

With an interest only mortgage, there are a few issues borrowers need to be aware of. Do not be misled into believing these are low interest or low risk mortgages. They normally carry very high interest rates and are considered by most lenders to be very risky. Additionally, since most interest only mortgages are also ARMs, you could find yourself with an exorbitant monthly mortgage payment if rates move against you and you are for some reason unable to refinance (perhaps due to bad credit).

30-Year Fixed Vs Interest Only Mortgage

The primary difference between 30-year fixed and interest only mortgages is that 30 year mortgages amortize principal payments normally while interest only mortgages (surprise, surprise) do not.  Also, by definition 30-year mortgages are fixed-rate loans, meaning the interest rate will never change. Interest rates on most interest only mortgages, however, are adjustable, meaning they fluctuate up and down based on prevailing interest rates.

It would be unfair to say nobody should ever take out an interest only mortgage.  For some shrewd investors or perhaps some other ultra-specific situation, this type of mortgage might make sense.  But for 99.9% of borrowers, a fixed-rate mortgage is a far better deal.

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The Benchmarks

The benchmark many rely on to judge short-run mortgage interest rate fluctuations is the 5- year Treasury bill. When the 5-year bill rate go up, interest rates typically follow suit. Treasuries are backed by the United States government and are commonly considered among the safest investments on the planet, making them a benchmark for other bonds. Mortgages, however, are backed only by the value of the underlying real estate.  Therefore, investors demand a higher interest rate to compensate for the extra risk. If treasury rates go up, mortgage interest rates must go up as well to remain competitive.

In addition to the treasury benchmark, other factors will influence mortgage rates. Supply is one such factor. When loan originations increase dramatically over a short period of time, prices on mortgage-backed securities will tend to become somewhat depressed, so interest rates will have to go up a bit to compensate in classic supply-and-demand fashion. Inflation is also another factor that influences mortgage interest rates. If the market fears future inflation, interest rates will go up. During periods of low inflation (or even deflationary periods, which was a valid fear until recently), rates will typically drop.

The Fed’s Influence

The Federal Reserve also plays a role in determining your mortgage interest rate (thanks Ben!). When the Fed changes the Federal Funds Rate, interest rates on all manner of assets change in response. The general rule is that bad economic news will keep rates low while good news will jack up interest rates.

Personal Factors

Your own financial situation is a factor in the interest rate you will qualify for. Your credit score is used by lenders to determine how much of a credit risk you are (which is why it’s a good idea to get a free copy of your credit report). If your credit score is excellent (check your myFICO® credit score now), you will qualify for a lower rate. Not-so-good scores will likely raise your rates because lenders are taking on more risk by lending to you.

The size of your down payment will also be a factor. The more you put down on a property out of your own pocket, the more you have to lose (and presumably will be more committed to keeping current on your payments). The lender will also have a greater margin of error, since your equity cushion will absorb the brunt of the impact should real estate prices decline (it’s happened before, as we are all now aware).

How to Find the Best Mortgage Interest Rate

The best way to score the lowest rates for a mortgage is to be prepared. Get a copy of your credit report and see where improvements can be made. A higher score means better options. You should also commit to saving up at least 20% of the purchase price of your new home long before you consider pulling the trigger.

While interest rates are important, other factors such as the length or your mortgage term (30 years vs 15 years) and whether the rate is fixed or variable. Make sure you are never rushed into making a decision. Never sign on the dotted line until your questions are answered and you clearly understand the terms of the loan and most importantly of all, take your time. If you are in a hurry to get into a home, you may be more inclined to agree to poor terms.

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Even now, in the early stages of what I hope is a robust recovery, real estate is an investment few want to own.  Sure, there are a few savvy investors who view this as an opportunity to load up on quality properties at bargain prices, but by and large real estate seems to have lost its luster.  Just as everybody “knew” real estate was the quickest way to riches just a few years ago, today everybody “knows” real estate is a high-risk investment with more losses to come.

Real Estate’s Long-Term Performance Record

Likewise, everybody “knows” that anybody still exposed to real estate during the crash was wiped out.  And yet look at these returns for the Vanguard REIT Index Fund (VGSIX):

That’s right, over the last decade commercial real estate as represented by publicly-traded REITs has returned just over 10% per year, even including the recent crash.  Long-term buy-and-hold investors seem to have done just fine in all this.  It is the speculators and short-term traders who lost big.  Which camp do you belong to?

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These mortgages were severely abused throughout most of the decade, but that’s no reason to throw the baby out with the bathwater.  The average adjustable rate mortgage carries a lower initial interest rate than the average fixed-rate mortgage, at least before the first adjustment, potentially saving you thousands.  And if interest rates happen to fall, your payment could actually end up decreasing rather than increasing.  Of course, the opposite is true if rates go up.

Here are some situations where taking out an adjustable rate mortgage is okay and unlikely to cause you permanent financial harm.

When An Adjustable Rate Mortgage Could Make Sense

• You Can Afford The Worst-Case Scenario – This is rule #1, and by far the most important.  If you aren’t absolutely certain you can afford the worst-case scenario should things not work out as planned, you can’t afford an adjustable rate mortgage.  Period.  Fudging the numbers here could lead to disaster.
• You Have Excellent Credit And Ample Cash Reserves – If you have mediocre credit, you might be unable to refinance into a fixed-rate loan if events turn against you.  Ditto if you don’t have ample cash reserves to put up a sizable down-payment.  If your financial position is borderline, stick with the safety of a fixed-rate mortgage.  It’s simply not worth the risk.
• You Plan To Sell Before The Loan Readjusts – If your ARM is set to reset in 5 years and you plan to sell (or refinance) within 4 and are confident of your ability to do so, it probably makes sense to go with an adjustable rate mortgage assuming you can get enough of a rate discount to justify the trouble and refinancing costs.
• Interest Rates Are High And You Expect Them To Decline – This probably doesn’t apply right now, but in general, refinancing a fixed-rate mortgage is expensive (beware co-called “no cost refinance” loans).  If you think rates are heading south (not easy to predict), you can save yourself some refinancing costs by riding an adjustable rate mortgage down rather than having to refinance.  This is an admittedly risky endeavor, but if you have the ability to take on a bit of risk for a sizable return, why not give it a go?

When An Adjustable Rate Mortgage Is A Bad Idea

• It’s The Only Way You Can Afford To Buy – If you can’t afford a fixed-rate mortgage, you can’t afford to buy a home.  Period.  Stretching yourself so thin is a recipe for disaster.
• You Can’t Afford The Worst-Case Scenario – What if interest rates skyrocket?  If you can’t afford your loan’s maximum rate, you will probably lose your home.
• When The ARM Rate Doesn’t Offer Enough Of A Discount – I’m not sure there’s a fast rule here, but you should demand a sizable discount for the added risk of taking on an adjustable rate mortgage.  A discount of 0.5% probably isn’t worth the risk whereas a discount of 1.5% probably is.

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Why Bad Credit Mortgages Suck

Sub-prime mortgages are by now well-known by readers.  They cater specifically to borrowers with poor credit, a history of defaulting on debts, or a history of poor  personal financial management.  Often, bad credit mortgages charge upwards of 5% more than prevailing interest rates on regular mortgages.  They also usually sport at least one or two other unfavorable characteristics such as an adjustable rate or an interest-only period.

Naive buyers are often tricked into taking out sub-prime loans with phony arguments.  Among the most popular…

• Paying Rent Is Throwing Money Away – This one is repeated so often, you might begin to think it has merit.  It does not.  Renting isn’t throwing money away, it’s buying shelter.  It also limits risk since, as we now know, real estate prices don’t always go up.  The risk of taking a loss is born by the landlord, not the renter.  Think of renting as a cheap insurance policy.  Rent is often much less expensive than owning a comparable property, particularly during the heyday of the real estate bubble.  Renting a nice place to live is a far better financial decision than taking out a bad credit mortgage and paying twice as much in mortgage interest.
• Real Estate Always Goes Up – I was actually told this by my mortgage lender when I was purchasing my condo.  He was trying to convince me an interest-only mortgage was the way to go (no doubt because he got a larger commission).  Hilariously enough, his employer was one of the first to go out of business when the fit hit the shan.
• You Can Always Refinance – No you can’t, not in this environment.  If you took out a 10% interest-only mortgage in 2006 and your credit hasn’t improved dramatically since, chances are you’re still in it.  If you haven’t already lost your home, that is.
• It’s The American Dream – Excuse me, but I think it’s pretty ignorant to assume all or even most Americans share the same dream.  Let’s face it, owning real estate sucks.  You have to constantly fix things, pay property taxes, deal with insurance companies, and keep those pesky kids off your front lawn.  It’s not all that great.
• If You Don’t Buy Now, You’ll Be Priced Out Forever – Ha!  This was actually a very common argument a few years ago.

If you can’t afford a regular mortgage, you can’t afford a home.  Period.  Rent until your credit improves, save up some money, and put down 20%.  Responsibility is the new black.

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