Budgeting 101

Budgeting sounds really simple in practice: track your spending and make sure it’s less than your income. But if it were that easy, the average American wouldn’t have over $16,000 in credit card debt and we’d all have plenty saved for retirement. Budgets have gotten a bad rap as being synonymous with restriction, but if you’ve read my ‘About Me‘ you this is not a blog about extreme frugality or coupon clipping. Money is a limited resource so budgeting just comes down to choices… you can have anything, but not everything. Your budget shouldn’t scare you, it should empower you. Your goal is to be in charge of your money and not vice versa.

The first step is to ensure you have a good grasp on what your true take-home income is. Unfortunately, that salary that you negotiated for (you did negotiate right?!) isn’t what you get to take home with you. After taxes, social security, healthcare premiums, 401(k) contributions, etc. you may be bringing home a lot less bacon than what you expected. This is just another friendly reminder to ensure that your tax withholdings are up to date. If your taxes are under-withheld (i.e. you pay less than you owe) you’ll end up having to write a check that you may not have budgeted for. On the other hand, if you pay more than you owe and get a refund, you may be bummed to find out that you could have afforded that girls weekend you skipped after all.

Once you have a good idea of what you get after taxes and deductions comes the hardest part: doing some detective work on where that money goes. There’s no one way to do, but I think fewer and fewer people are balancing a checkbook as technology advances. Personally, I absolutely love Mint, but I know it’s not the only option out there. I’ve also tried Personal Capital and I’m currently testing out You Need a Budget (YNAB). I’m planning to compare and review them all in the near future so stay tuned. The most important thing is to pick a system and stick to it. The easiest expenses to nail down are those fixed costs that don’t change month to month; for example, you probably already know what you’re paying for rent, that Netflix subscription, and your gym membership. On the other hand, items like groceries, dining out, shopping, and your gas and electric bill may vary seasonally. Ideally, I’d take at least a 3-month look back and in a perfect world, I’d use a year. Why? You want to capture lumpy items such as increased spending for gifts around the holidays or maybe more travel in the spring, etc. to come up with an annual average.

Once you know what your income is and what you’re spending you’ve got a few questions to answer. Are you spending less than you’re making? If not, no sweat, just the fact that you’re starting to organize your finances is a step in the right direction. Your next task is to figure out where you can reprioritize your spending, which leads me to my next question which is much more objective: are you spending your values?

When I meet with clients they often want to know if their spending is “normal.” The problem with that question is that there is no right answer. What is important to one person may not matter for another. For example, travel may be incredibly important to Eliza and she may be willing to pack her lunch and skip a cable subscription in order to take a couple fabulous trips each year. On the other hand, Angelica may prefer to make her clothes last a few extra seasons in order to eat at the best restaurants in town and have that iced caramel macchiato every morning. Neither of those is better or worse than the other they are just different and a reflection of each person’s values. Now if you tell me travel is really important to you, but you haven’t taken a trip in a year and your detective work tells you that you’re spending a good chunk on a morning coffee it’s time to course correct. Or maybe you’ve decided that craft cold brew really is something you can’t give up. That’s totally fine so long as you know that it may be at the expense of that weekend trip to Sonoma. The choice is yours to make, and you’re in charge!

With all that said, I don’t necessarily think spending is a total free for all. If Eliza wakes up at age 65 with a passport full or stamps (hoorah!), but has zero savings and is going to have to work until age 90 and doesn’t have medical or disability insurance I’m not into that. I’m personally a fan of the 50/30/20 approach which dictates that no more than 50% of your after-tax take home pay goes to necessities, 30% goes to flexible or discretionary spending, and 20% goes to savings.

Necessities (50%)

Think your home, utilities, food, transportation and clothing for your job (notice I didn’t say for brunch), insurance, and minimum debt payments, etc. These are the things that you absolutely must pay for. As with everything, there’s wiggle room… you may be willing to rent a studio instead of a one bedroom so you can buy lunch at work rather than bringing it. But I also don’t think you should live here and eat all your meals at Saison. Or maybe you’d rather take Lyft to the office instead of the bus, but that means you’re grocery shopping at Trader Joe’s instead of Whole Foods (but actually I love TJs and think I would shop there even if I had been the Powerball Winner). Of course, this 50% is the maximum amount so by all means you could spend less on necessities and save more.

Discretionary (30%)

This is where the fun stuff comes in! Vacation, shopping, meals out, cough*Warriors games*cough. Now there are some items in this category that I would consider a gray zone or near necessities like a cell phone. You might need one for work, but you certainly don’t need a huge data plan so you can stream constantly (as Roberto likes to remind me whenever we get a friendly alert from Verizon). You’ll also notice I included meals out which I do treat differently than the necessity of groceries or grabbing a sandwich for lunch at work. Everyone may have a different view on how to delineate those wants vs. needs, but it’s up to you to create your own rules and follow them. This is the category where Roberto and I’s “allowance” or “fun money” comes in (if you haven’t read about how we merged our finances see here). The majority of our discretionary spending is on joint items that benefit us both: vacations, date night, entertainment, etc. But we also have an allotment that is ours to save or spend however we please. I have no idea what Roberto spends his on (jk jk I do, it’s totally watches), but mine goes to my gym membership which Roberto doesn’t categorize as a need since he just runs outside, getting my hair done, dinner and drinks with just my girlfriends, etc.

Savings (20%)

Last and most definitely not least is savings. Here’s the dealio: you should be saving for something for your future and in some cases this may mean saving yourself money on interest by paying down debt. I’m going to talk more about savings once we move past budgeting but it could be for anything from an emergency savings, to a down payment, to retirement, etc. This doesn’t mean that when your emergency savings is fully funded you get to spend this 20% either. Start saving for something else. Also, while the 50% and 30% recommendations for the categories above are intended to be the maximum, nobody is stopping you from saving more! So by all means skip the Uber, walk to work, and tackle your student debt if you’re able.

 So a few questions for you:

  • Are you spending your values?
  • Do you feel like you know what you spend?
  • What’s your favorite software/app for tracking your spending?

Tax To Do: Update Your Withholdings

Whew, can you believe the big T-Day was a month ago yesterday? I know you’re probably ready to forget about Uncle Sam for a while now that all the form gathering and check cashing (or writing!) is behind you, but I’ve got one more thing for you to cross off your list.

Bummed that you owed this year? Thrilled you got a big refund? I’d prefer you land right in the middle. You’ve probably heard that getting a refund is like giving the government an interest-free loan and I have to agree despite the fact that interest rates are practically zilch these days. Another reason I actually don’t want you to get a refund? I’d rather have you take a little more home each paycheck so you can incorporate the funds into your budget as opposed to getting a big check that is tempting to spend. Seventy percent of Americans received a refund last year (for their 2015 returns) and the average amount was almost $3,000. That’s another $250 per month you could use to pay down student debt, contribute to retirement, or save for an awesome vacation!

I know we’d both prefer that you didn’t have to write a big check either. If you underpay by too much you’ll not only have to cough up the taxes you owe but potential penalties in addition. It can throw your budget out of whack and I’d hate to see you dip into your savings for an expense you can plan for throughout the year.

I mentioned in my post on merging finances that I used to have this crazy master spreadsheet I used to track my finances. It’s practically office lore since it has been passed around between my coworkers over the years. I had set up the formulas so you could enter the number of hours worked and it would calculate regular and overtime pay. Once it had a pre-tax amount for each paycheck it would calculate deductions being taken out for your 401(k), healthcare, bus pass, federal taxes, state taxes, etc. so I could see the amount I would actually receive in my bank account after the deductions. One of the things you could do was change the number of withholding to see how it would affect the amount of taxes that were going to be taken out. From there I could compare my estimated withholding for the year vs. what I thought I’d owe. After playing around with the numbers I’d update my paperwork with payroll to ensure I’d be as close as possible come April. Sadly I stopped maintaining the spreadsheet when Roberto and I combined finances and our situation got a little more complicated.

Lucky for you, you do not need to be a spreadsheet freak to get your allowances straightened out. If you’re like me, your W-4 was one of many administrative forms you filled out on your first day and you may not have given it another thought since. This important piece of paper tells your employer how much to deduct for taxes from each paycheck, and if you find yourself getting or owing money it’s probably because this paperwork is out of date. You can follow the instructions in the W-4 to make your updates, but I prefer either the IRS Withholding Calculator or Turbo Tax’s more intuitive option to guide you along. You definitely do not need to do this multiple times a year like I used to do either. If you have a regular recurring paycheck I’d recommend checking your withholdings once a year as tax rates change. If you receive annual or quarterly compensation in the form of bonuses or commissions I’d suggest checking your numbers with each one of those payments since employers withhold taxes from bonuses differently than they do for regular compensation and that can often result in underpayment. If you have a more complicated situation such a stock options you’ll likely need to work with a CPA to come up with quarterly estimates. Of course, any major life changes such as a new job, getting married or having a baby always warrants a tax check-up as well.

Hope that helps you get your taxes in line for 2017… happy number crunching!

Your Bae and Your Bills

merging finances marriage joint
Documenting our first joint tax return… because I’m a nerd like that.

It’s Valentine’s Day and you know what that means… couples can’t wait to get home tonight, open up a bottle of wine, and get down and dirty… discussing their finances. Because what’s more romantic than talking about money, right? Figuring out how to split the bill can be awkward enough so how are you supposed to bring salaries, savings, student loans, credit scores, etc. into the mix.

It may be an uncomfortable conversation at first, but if you’re going to cohabitate or get married it’s a must. And given that money is frequently cited as one of the leading causes of stress in relationships it’s something I’d recommend doing sooner rather than later (and definitely before moving in or getting engaged). There isn’t one right way to merge your finances, but you’ve got to start by being honest about your own money habits and open to the fact that your partner’s finance style may differ from yours.

The way I see it there are three basic ways to combine your moola:

What’s Yours Is Mine

The Setup: All for one, and one for all. You combine all your accounts, debts, income, expenses, etc. Administratively, this is the least fussy and takes the least amount of work other than the upfront time of combining accounts and updating direct deposit/auto-debit. Set it and forget it.

Things to Consider: It’s easy and 100% transparent. No debating who pays for groceries and who pays the utility bill. On the other hand, if income isn’t equal, the higher earning partner may feel like it’s unfair to share everything. Or maybe your partner has credit card debt, and you don’t feel it’s your responsibility to assist in paying it off.

What’s Mine Is (Mostly) Mine

The Setup: To me, this means you essentially keep your finances separate. You maintain your separate accounts and find a way to split the bills. Maybe you each write a check for your half of the rent and divvy up other bills like groceries, cable, etc. with Venmo.

Things to Consider: Having your own accounts allows both partners autonomy but may require number crunching on an ongoing basis depending on how flexible you and your partner are. For example, if you ordered a movie on demand or the water bill is higher one month, are you having to recalculate who owes what with every bill variation?

A Little Bit of Both

This is where Roberto and I fall… somewhere in the middle. And between the extremes of combining everything and keeping everything separate, there are 1,001 other possibilities. You’ll likely end up with a combination of joint and separate accounts, and some of the variability will come from deciding how much goes into each “pot”.

One Joint Account

In this scenario, you maintain your separate accounts and use a joint account to cover shared expenses (however you define them). After tallying up the expenses you’re planning to split, you’ve got to decide exactly how you’re going to split them. If your incomes are similar you might choose to contribute equally to the joint account, but if one person earns more perhaps you’ll split expenses according to your income levels. A common way to do this is the percentage method. As an example, if one partner earns $40,000 annually and the other person earns $60,000, they’d split expenses 40/60. So if their joint expenses were $3,000 the higher earner would contribute $1,800 to the joint account and the other partner would contribute $1,200. Anything over and above that amount they would keep in their separate account.

One Separate Account

The opposite of the above is that you merge everything with the exception of one separate account. All your income is deposited to your joint account where your shared expenses are paid from. Each month, a set amount is transferred from the joint account to each person’s separate account as essentially an adult allowance. These funds are for discretionary or “fun” spending with the idea being that each individual can use their funds as they see fit without necessarily needing to clear the expense with their partner. For one person that could mean a $5 caramel macchiato each afternoon, while the other may prefer to save their funds for bigger ticket items like a watch or a purse. Just like the “One Joint Account” scenario, the tricky part is deciding what that allowance should be and if it should be the same for each person

My Bae and Our Bills

That thing I said about having different money habits than your partner. Couldn’t be truer for Roberto and I.  We have the same values around what things are important to save for and what we’re willing to splurge on, but the way that we handle our finances was (and still is!) pretty different. I’m always curious about what is working for other couples, so in the interest of sharing, I wanted to give you some insight on what has and hasn’t worked for us over the last couple years. But before I can tell you how our finances have changed since getting married, I think you’ve got to know where we were both coming from first.

My personal finance style has always been a little… obsessive. I check Mint.com about seven times a day. Before we got married, my paychecks were split between multiple accounts all calculated down to the penny for specific reasons in specific amounts. To ensure I wouldn’t owe anything or get a big refund come April 15th, I built a spreadsheet to calculate what my state and federal withholding should be and updated it multiple times a year (sorry payroll, but you’re welcome co-workers 😉). I can fully admit I have a problem, but it worked for me.

Roberto, on the other hand, is super laid back. To this day, I’m not really sure what his strategy was, but his bills got paid and whatever he was (or wasn’t doing) worked for him. He wasn’t spending half the time I was worrying and calculating, but to my amazement, it seemed like his “system” was working a-ok. He had a savings goal and would make transfers to that effect periodically, but other than that it was pretty laissez-faire. I would say he remains the “idea guy”, while I’m clearly captivated with the nitty gritty.  Which leads me to “the merge” (which reminds me of ‘The Purge’ which is fittingly unromantic).

Roberto and I’s income is different enough that it didn’t make sense for us to split our expenses down the middle. Given my penchant for calculating things to the penny, the percentage approach to contributing to one joint account seemed like a good option for us. So I tallied up our expenses and updated our direct deposit to reflect our calculated contributions. What was left of our individual paychecks went to our separate accounts. This setup was my idea and it seemed fair to me, but before long it gave Roberto a total headache. His income varies quarter to quarter and I was making him crazy trying to calculate and re-calculate our income and percentages every few months. He also didn’t think it made sense that he was “keeping” the income over and above his prescribed contribution to the joint account. He truly views everything as one pot so all the extra calculating just felt silly to him… were we saving up for separate vacations and homes or did we have the same goals? I still liked the idea of having separate accounts for “personal” spending, but I decided to give it a shot and see if I could let go of my double decimal addiction. And you know what? It’s worked out. The way we’re doing it certainly is not the only or the best way, but it’s what works for us given our income patterns and finding a happy medium between both of our money styles. The fact that we tried something only to discover it wasn’t going to work for us in the long-term is a testament to that fact that finances, like anything else in your relationship, isn’t a one-time conversation. But if you want to skip “the talk” tonight, I’ll forgive you 😘.

Like I said, I’m always interested to hear what method other people are using, so let me know what’s working for you!

Getting Your Giving On

I’ve been planning on doing a post on charitable giving for the Thanksgiving holiday for a while, but it feels even more poignant this week. I know I’m personally feeling the need to be more involved in my community and the causes I care about day-to-day as opposed to just every four years.

Since I’m focused on personal finance here on The Opening Belle, I’m taking a look at how to give money most effectively, but it’s not my intention to take away from the importance of donating your time as well. And while there can be tax benefits for donating to charity, I would certainly never recommend giving money solely for the write-off.

The Deduction Decision

You’ll only receive a tax deduction from your charitable gifts if your itemize your deductions, so let’s do a quick recap on standard vs. itemized deductions. Common types of itemized deductions seen on Schedule A of your personal tax return are qualified mortgage interest payments, real estate taxes, state income, etc., but you’d only claim these deductions if they exceeded your standard deduction (detailed below). If you don’t itemize, you’re not alone; less than 1/3 of people do!

For Tax Year 2016

Single: $6,300

Head of Household: $9,300

Married Filing Jointly: $12,600

Married Filing Separately: $6,300

Qualified Widow/Widower: $12,600

Who to Give To

To deduct your contribution, the receiving charity must qualify as a 501(c)(3) organization (don’t assume that all non-profits qualify!). You can typically find the IRS Not-For-Profit determination letter on the charity’s website (example), but to be sure you can confirm using the IRS’ Exempt Organizations Select Check.

Regardless of whether or not you can deduct your charitable contributions, you want to make sure that your hard-earned money is going towards organizations that are actually doing good. Charity Navigator and Charity Watch are great resources for ensuring that the charity of your choice has a good track record of managing donations. You can see what percentage of expenses are dedicated to actual support programs as opposed to overhead and even how much the charity’s CEO is being compensated.

What To Give

Cash Contributions

It’s best practice to keep a record of your gift whether that’s a bank or credit card statement, copy of the check, etc. regardless of the amount. Ideally, the charity will send you confirmation of your gift, and for gifts over $250 it’s actually required. The letter should detail the amount donated and whether you received any goods or services in return for the donation. An example: you pay $100 to attend a charity dinner. Your letter may indicate that they valued the meal at $40, so only $60 of your $100 ticket qualifies as a deductible donation. Of course, you’ll need to receive a copy of this gift confirmation before the April 15th tax deadline in order to claim the deduction on your return.

Non-Cash Contributions

I’m not the only one who read The Life-Changing Magic of Tidying Up right? Did you also get rid of everything in your home that didn’t “spark joy” this year? Roberto might argue that I pulled everything out of our closets, but never fully completed the purge phase. I digress.

If you’re donating non-cash goods like clothes or furniture, there is a different set of rules than there is for cash. First of all, the items must be in “good or better used condition” (you weren’t going to donate those holy socks anyway were you?). The one exception to that: individual items worth more than $500. I love this glam example from Nolo:

“Caroline donates a vintage French designer ball gown that belonged to her mother to her local symphony orchestra. The gown is over 30 years old and is in poor condition. Caroline hires an appraiser who determines that the rare item is worth $2,000, despite its poor condition. Caroline may deduct this amount, provided that she files Form 8283 with her tax return.”

For items worth less than $250, you’re required to get and keep a receipt detailing the name of the organization you donated to, the date and location of the gift, and a description of the item that was given. For items worth more than $250 but less than $500, you’ll need written acknowledgement (more than a receipt) detailing 1) a description of the item 2) whether any goods or services were received in return for the donation and 3) an estimate of the value of the goods or services received (if any). For items worth more than $500 but less than $5,000 or more you’ll need the aforementioned written acknowledgement as well as records on how the property was acquired, the date it was acquired, and the cost or basis of the item (you’ll also be required to file an extra form with your return). Lastly, if your gift is over $5,000 (a.k.a your vintage French designer balls gowns in great condition), you’ll need to get a qualified appraisal of the item in addition to the previously mentioned requirements.

Now that you know what the rules are for different item values, you have to do the tricky work of estimating the fair market value of your property i.e. what you could sell it for on eBay or at a thrift store. Determining this amount is important because it’s the amount you can deduct on your return, and the amount you’ll have to defend should you ever get audited. Larger charities such as Goodwill offer the ability to track and estimate the value of your donations throughout the year on their website. Another option is tax prep software such as ItsDeductible from TurboTax which allows you to track donations to various charities in one place. Of course, if you’re more of a pen and paper (or spreadsheet!) kinda person you can use this guide to value items and keep track yourself.

Donating stock or other securities is another type of non-cash contribution. Let’s say you tasted your first Starbucks Frappuccino in 8th grade and from that very moment you knew the coffeehouse chain was destined for success. You scraped together $100 of saved birthday money to buy 20 shares at $5 a share. Today those 20 shares are worth about $55 per share or $1,100 (what an enterprising 14 year old you were!). Assuming your federal long-term capital gains tax rate is 15% and your state capital gains tax rate is 8% you’d owe $230 in taxes if you sold the shares ($1,100 value – $100 cost = $1,000 gain x 23%). If you gift the shares to charity they get the full $1,100 value and you save yourself $230 in capital gains taxes. Assuming you itemize your deductions and are in the 25% federal income tax bracket you’d reduce your taxable income by $1,100 and save yourself an additional $275 in income taxes ($1,100 charitable deduction x 25% federal income tax rate). That’s a total of $505 saved in taxes, but your charity gets the full $1,100. WIN WIN! If you’re looking to unload shares that are at a loss, you’re better off selling them and giving the charity the proceeds and using the capital loss to offset some of your income. Important: notice how I said you bought those shares in 8th grade? That time period is a bit of an exaggeration, but donating appreciated securities is only advantageous if you’ve held the position for over a year. If you have a short-term gain, essentially only your basis (what you paid for the position) is deductible as opposed to the fair market value that you’re able to use for securities held over a year.

Your Time*

I said that I was focusing on monetary contributions, but I did want to mention that you can deduct most out of pocket expenses that are byproducts of giving your time. Just to be clear, if you volunteer for 3 hours and your salary is $20/hour, you cannot deduct $60 for your time. However, if you volunteer to deliver Thanksgiving meals to the elderly you can deduct the cost of gas for the miles you drive in the service of a qualified charity. In 2016 that’s 14 cents a mile. You can also deduct the cost of a uniform that you’re required to wear as part of your volunteer role. Of course this only applies to expenses you incur that aren’t reimbursed by the charity, and that aren’t personal in nature (i.e. miles driven for an In-N-Out lunch break or a red blouse for the American Red Cross that you can also wear to work).

Know Your Limits and Deadlines

Ah, there are always limits aren’t there? You can donate as much as you want, but the amount you’re able to deduct is limited so if you’re giving more than 20% of your Adjusted Gross Income (AGI), you need to be aware of the restrictions. The rules are complicated, but generally speaking your charitable deductions are limited to 50% of your AGI. However, that limit can be reduced to 20% or 30% of your AGI depending on the classification of the charity you give to and the type of property you donate. Your charity should be able to tell you which category they fall into, but the IRS’ Exempt Organizations Select Check search also provides those details. If you’ve contributed more than you’re allowed to deduct in any given year, you can “carryover” the disallowed amount to the next tax year for a maximum of five years.

Lastly, gifts must be made by December 31st to be deducted for that tax year. That doesn’t explicitly mean that the money needs to have left your account; if your check is in the mail or a charge on a credit card has been processed (even if you don’t pay the bill until the New Year) that counts. Tales from the trenches: don’t wait until the last minute especially if you’re donating securities. Unlike cash gifts, the date of a gift of stock (or other securities) is based on the date the charity receives the shares. These transfers can take longer than you might think, so please please please leave yourself plenty of time.

In Summary

  • You must itemize deductions in order to deduct charitable contributions
  • Give to the qualified charities (and those who have a good track record of managing donations)
  • Receipts and records: get them and keep them
  • Know the rules for donations of different kinds of property
  • Be aware of the limits on charitable deductions and when gifts need to be completed
  • Feel great for supporting your community!!!

Tis the Season…

nurses

Halloween is over, Starbucks’ holiday drinks are back on the menu (in green cups???), and I think we can all agree it’s the most wonderful time of the year… open enrollment season! Ok, ok, the holidays too, but before you go grabbing your eggnog latte let’s review some of the most common healthcare options out there.

What’s Open Enrollment?

Typically, you get just one chance to pick your healthcare plan for the year, and for most people the time to make that decision comes in the fall with plans becoming active on January 1st of the following year. Keep in mind that you can usually make adjustments to your plan mid-year if you undergo a life change such as the birth of a child, marriage, loss of a job, aging off your parents’ plan, etc. Before we go through the different types of plans that are usually offered, let’s review some quick healthcare vocab (keep an eye out for a glossary coming soon!):

Vocab Review

Premiums

The amount that you pay for your health care plan each month or pay period. This is the fixed cost you’d pay even if you never got sick or went to the doctor.

Deductibles

The amount that you pay out-of-pocket (on top of your premiums) before your insurance company starts to chip in. The Affordable Care Act, passed in 2010 and also known as “Obamacare”, now requires your insurance company to cover certain in-network preventive care costs such as flu shots, annual exams, etc. even if you haven’t met your deductible. Keep in mind that there can be multiple deductibles: ones for in-network expenses, out-of-network expenses, for each individual, and for your whole family. As a general rule, the higher your deductible is, the lower your premium will be.

Copayments and Coinsurance

Once you’ve met your deductible, you begin to pay copayments and coinsurance; in other words you begin sharing expenses with your insurance company. Copayments are fixed dollar amounts that you are responsible for i.e. you might be required you to pay $20 out-of-pocket for each doctor’s office visit with your insurance company covering the rest of the cost. Coinsurance is the percentage of costs you’re responsible for as opposed to a fixed dollar amount. In this case, you might be responsible for 20% of all medical costs once you’ve reached your deductible up to your…Read More

Do the Math… Do the Mortgage Math

When we were in college, my roommates and I listened to this song approximately 6,438 times each October. Switching up the words just a tad for this post so we can get ghoulish about your goals. In my last finance post, we talked about all the work that goes into getting ready to buy your first home. One of the big steps is figuring out what you can afford for your monthly payment, and a big driver of that is what type of mortgage you choose… so let’s talk options!

Fixed Rate vs. Variable Rate

Fixed Rate

When you get a fixed rate mortgage you lock in your interest rate from day one and don’t have to worry about it going up in the future. This means you’ll know exactly what your payment will be each month, and how much it will cost you over the life of your loan. This stability and predictability can be really helpful for budgeting, and if rates go up you’ll be glad that you chose a rate that won’t change. Sound like a sweet deal? It can be, and your lender will charge a premium (i.e. higher rate) for that peace of mind. A higher rate means a higher monthly payment, so it may be harder to qualify for the loan size you were hoping for. Another con is that if rates drop, you’ll have to refinance to get your rate lowered and there can be costs associated with that process.

Variable Rate

Variable rate loans usually offer lower rates than fixed rate mortgages (at least to start!), but your payment could change each month. Given the lower interest rates up front, it may be easier to qualify for a larger loan than you would with a fixed rate mortgage. With a variable interest rate loan, you’re hoping that rates stay the same or go lower because you’ll get to participate in those rate drops. On the other hand, if rates rise you don’t have the same protection that you would with a fixed rate loan. For example, your rate might be 3% to start, but have a ceiling of 10% i.e. your rate could more than triple!

Hybrid

Adjustable Rate Mortgages combine fixed and variable rate loans. Their rates are typically fixed for a set time period, before becoming variable. For example a 7/1 ARM would mean that your interest rate wouldn’t change for the first 7 years, but after that your rate could change every year. These loans can make sense if you only plan to be in your home for a set time period, which leads us to…

Loan Length

A 30-year fixed rate loan is as classic as Beethoven and the bread and butter of the mortgage industry. It’s probably what your parents have, but that doesn’t necessarily mean it’s not right for you too. When you’re purchasing a home, think about how long you’ll realistically be there. Is this the home you think you’ll be in for 30 years, or do you think your family might need an upgrade in the next decade? If this is your forever home, then it may make sense to lock in your rate for 30 years. If you’re buying a two bedroom, but know you want five kids, then perhaps a better option is an ARM that is fixed for 7-10 years. Knowing that you’ll likely move before your rate becomes adjustable allows you to take advantage of the lower rate up front.

Amortizing vs. Interest-Only

Something else to take into account is what makes up your mortgage payment. With a 30-year fixed rate loan a portion of each payment is comprised of both interest and principal. As you pay off principal over time, each payment is made up of less interest and more principal.  However, there are loans available that allow borrowers to pay only the interest on the outstanding balance of the loan. Interest-only loans will typically have a set amount of time where you’ll only be required to pay interest, before the amortization begins. These lower payments can be great for cash flow, but at the end of your interest-only period you’ll owe just as much as you did on the first day of your loan so it’s important to be disciplined about paying down principal as you’re able. Interest-only loans should be thought of as a cash flow management tool as opposed to a way to stretch for more debt. Most lenders will also require borrowers to have at least a 25% down payment for interest-only loans as opposed to 20% for an amortizing loan.

More questions? Let me know in the comments!

Homebuyer Homework

white-picket-fence-home
Donna Phelan/Intero Real Estate

We were in up Seattle this past weekend to visit my brother and sister in-law for a very exciting reason… they just bought their first home! We are so proud of them, and couldn’t wait to visit them in their new house. The whole family got together for a little housewarming celebration, and we had so much fun talking about all the memories our family is going to make in their new home.

While there are a lot of exciting parts to buying a home like decorating and designing to make it your own, today I want to talk about all the hard work that takes place before you set foot in your first open house.

Get Your Credit Right and Tight

Building good credit is so incredibly important as it determines how much debt you have access to and at what rates and terms. A 50 point difference in your credit score could cost you thousands of dollars over the life of your loan. The three credit reporting agencies (TransUnion, Equifax, and Experian) are required to provide you with your full credit report (not score!) annually, but my very favorite resource for monitoring your credit is Credit Karma. It’s a free service that gives you your TransUnion and Equifax VantageScore 3.0 (different than FICO, but a good guesstimate) and the nitty gritty on where you’re doing a good job managing your credit and where you can do better. They also have an awesome simulator tool that allows you see how different scenarios such as opening a new credit card or missing a payment might affect your credit. Your lender will be checking your credit score to ensure that if they lend you money you’ll pay them back, so make sure you’re educated on what they’ll find. I have so much more to say on credit, so look for a more in-depth post in the future on the secret sauce that makes up your credit scores.

Know What You Can Afford

A good rule of thumb is that no more than 36% of your pre-tax income should go towards your monthly debt payments, and ideally no more than 28% should be dedicated to your housing payment known as PITI (principal, interest, taxes, and insurance). The remaining 8% is reserved for other debt payments such as credit cards, student loans, car payments, etc. So if your pre-tax household income is $100,000 a year or $8,333 per month you wouldn’t want your home expenses to be greater than $2,333 per month. The national average for home insurance is $985 a year, and property taxes are typically 1-1.5% of the property value. Be sure to do your research on the rates in your area. The amount that you pay for principal and interest will depend on the type of loan that you choose. I’ll be doing a post on the different types of mortgage programs and their pros and cons next week so keep an eye out!

Save Save Save

Just being able to make your monthly loan payment isn’t enough. Another crucial component to buying a home is how much you’ve saved and what you can afford for a down payment. Most lenders will want you to have at least 20% of the purchase price to put towards a down payment. Before you start saving for your down payment, I think it’s important to have six months of living expenses saved (and your lender will too!). This is to give you some cushion and peace of mind that if you lost your job, had your hours decreased, got sick, etc.  you’d have savings to cover your mortgage, insurance, property taxes, etc. If you have a single-income household or your income is lumpy or commission based, consider saving up to a year’s worth of living expenses in your emergency or rainy day fund. Let’s assume that you’re spending $50,000 a year so you’ll want to have $25,000 in your emergency savings. That’s not all… there are also closing costs that you’ll have to pay for the home purchase, and you should plan on 0.5-1% of your purchase price.

Be a File Freak

Once you know your credit is up to snuff, how much you can afford, and have done the hard work of saving you’re almost ready to get house hunting! The last step is to get a pre-approval letter from a lender that is crucial for being a competitive buyer. This important letter indicates that the lender has reviewed your information and pre-approved you for a loan. A seller wants to know that if they accept your offer you’ll be able to come up with the funds, so having a lender essentially “vouch” for you gives them confidence. In order to get this letter your lender will require lots of documentation. They’ll typically ask for one month’s paystubs, two full years of tax returns, two months of bank statements, etc. so make sure you have all those items organized and ready to send out as you go through the process of selecting a lender.

Happy house hunting!!!