Fixed vs. Adjustable Rate Mortgages

There's been a lot of movement in the housing market, with prices falling in many metro areas around the country. Those of you thinking about jumping in the real estate market and buying a home, you might be able to get a good deal these days. But when figuring out what you can afford, you'll need to understand the basic difference between a fixed rate mortgage and an adjustable rate mortgage.

A fixed rate is exactly what is sounds like -- you lock in an interest rate for the duration of the loan, usually 30 years. The only way you can change the rate is if you refinance, which essentially means to get a new mortgage that will pay off your old mortgage.

An adjustable rate mortgage (ARM) will change to a different rate after a certain time period. You'll often find rates quoted for different types of ARMs, like 3/1 or 5/1. The critical piece is the first number: this is the number of years your rate is fixed before it adjusts to a new rate.

So which is better? Here's some key factors to consider:

• Length of stay: people who are very confident they plan to sell after two or three years may want to consider ARMs. Generally speaking, ARMs have lower rates, because lenders want to lure people into these products in the hope that rates might increase and the borrower accepts the new rate.
• Risk: Your risk tolerance is important to understand. There is a bit more risk to an ARM, even though the initial rate might be lower. What if you can't afford the new payment? What is you can't sell your home?
• Fees: You'll want to compare the closing fees on different mortgages in order to try and understand the true cost of the loan.
• Caps: ARMs sometimes have a cap on how much rates can adjust upward. This will give you a worst-case scenario of how much your monthly payment will be.

My personal recommendation for young borrowers: if it makes a lot of sense to buy a home, get a fixed rate mortgage unless you are sure you're going to move in 2-3 years, where an ARM might make more sense.

The mortgage market has been volatile recently, monitor mortgage rates at Bankrate and other independent sites to check the latest rates.

What's this 'credit crisis' about?

A number of you have e-mailed about the credit crisis, subprime mortgages, and other related topics asking what it all means.

A critical concept to understand that the media doesn't often talk about is the trend toward "securitization" of mortgages. In the old days, people would normally go to a local retail bank and meet with a loan officer to get a mortgage. This bank would then collect interest payments over the life of the loan. The loan officer would, in theory, carefully assess the risk of the loan in order to come up with an interest rate, because if the borrower defaulted, the bank would lose money.

That doesn't happen so much anymore. A whole new cadre of mortgage lenders (many of them now defunct) would loan money to prospective home buyers. But instead of keeping these loans on their books, they would group together these loans in a package and sell them. The borrower would make interest payments that would eventually go to the new owner of the loan.

When these lenders sold the loans, they no longer had any risk if the borrower defaulted. Perhaps this was one reason they aggressively marketed new mortgage products, that offered features like rates that would adjust after a few years or that required no downpayment. Riskier borrowers ("subprime" borrowers) were given loans, and for some reason, other financial institutions were buying these loans.

In the news, you may have heard of "write-downs" by many big banks. What this means is that the value of those loans they bought are not actually worth what they expected, since those riskier borrowers are defaulting.

The markets have been spooked by this. So what does this all mean for young borrowers? More to come in upcoming posts...

Need More Time to Do Your Taxes?

If you keep delaying the inevitable and haven't done your taxes yet, there is a backup option. For no penalty, you can file for an automatic extension using Form 4868 to get six extra months. A few caveats:

1) If you think you might owe money, pay it when you file this form. You are not getting an extension to pay, just to file. If you don't pay what you owe, you'll pay a penalty. You are better off paying a little bit in case you owe money and getting it refunded when you file.

2) You do not get an extension to contribute to your Roth IRA, so don't forget that before the 15th.

3) You won't get your stimulus package check from the government until you file this year. Most taxpayers will be getting $300, but you need to file a return to get your check.

See more information on filing extensions on the IRS website.

You're Getting a Tax Refund? You Messed Up.

Hopefully, many of you have already done your taxes by now and know whether or not you are getting a refund or not.

While it may seem that getting a refund is great, it actually means you overpaid during the year. You gave the government a free loan, and now they are paying you back. Wouldn't it have been better if you never gave them a loan at all?

If you are getting a substantial refund, it may be because you have some deductions, lowering your tax bill. If this is the case, you'll want to lower the amount your employer withholds from your paycheck. Talk to your HR administrator and ask to revise your W-4.

You'll want to increase your exemptions in order to reduce the amount of withholding from your paycheck. You'll end up getting bigger paychecks and earning money in your bank account rather than giving out a free loan.

Make Your 2007 Roth IRA Contribution

April 15th is the deadline for contributing to your Roth IRA for 2007. If you made less than $99,000 last year, those of us under 50 can contribute $4,000 of after-tax income. (If you made less than $114,000, you can still contribute, just not the full amount.)

Remember, your contributions to your Roth IRA can always be withdrawn. But you should try to avoid touching the money, since any interest or earnings are tax-free! They can be withdrawn when you retire, need a home down payment, along with some other special situations.

If you are a recent college graduate, you can expect your $4,000 to be worth about $70,000 when you retire -- all tax free. That means more money you can spend during your adult life, rather than having to save for the future.

If you don't have a Roth IRA, consider opening one through a mutual fund company, like Vanguard or Fidelity. If you don't know which fund to put your money in, contribute to a money market fund, balanced fund, or S&P 500 index fund. When you have time to make a more strategic decision, it will be easy to move the money.

You have two weeks to make this happen, so don't forget! Remember, you can always tap the money later if you absolutely need it, since your contributions can always be withdrawn.

If you're interested, check Investopedia or Wikipedia for more details on the specifics of a Roth IRA.

Yet Another Reason to Stop Using Your Debit Card

Banks have once again raised fees for overdrafts (writing a check for more than the balance of your bank account). These fees are becoming a critical part of how banks make money, so you'll need to show extra caution now.

So what does this have to do with your debit card? A debit card is just another way to use an electronic check. The industry is currently engaging in what many believe to be an unethical practice: letting your check clear which gives you a negative balance AND assesses you an overdraft fee.

For example, let's take this bank statement with a $12.46 starting balance:

01/15/2008 Beginning Balance $12.46
01/17/2008 Debit Card Use $14.00
01/17/2008 Overdraft Fee $35.00
01/17/2008 Debit Card Use $4.60
01/17/2008 Overdraft Fee $35.00
01/17/2008 Debit Card Use $5.75
01/17/2008 Overdraft Fee $35.00

Ending Balance: -$116.89

For just a few small purchases on your debit card, the bank was seeing each one as a check and sticking you with more than $100 in fees in one day!

How to avoid this:

1) Use credit cards
If you pay off your balance every month, use a credit card. Since a debit card often gets accepted, your credit card will get declined if something is wrong (over the limit, etc).

2) Get overdraft protection
Banks sometimes offer this protection for free -- it is simply a line of credit that gets tapped if you overdraw. The interest you pay on this is likely to be much lower than the overdraft fee.

3) Don't use banks that allow debit card purchases to clear when you have a negative balance
Drop them so that this unethical industry practice can end.

Saving: Roth IRA's vs. 401(k)'s

I have this friend who is so proud of herself these days. Beth told a group of us that she opened up an ING online savings account and put all her savings there which will earn more than triple what her checking account earns. After the oooh's and ahhh's subsided, the bubble-burster in me went in for the kill.

"So this is money you saved on top of your Roth IRA contribution?" Her clueless facial expression showed that she had no idea what I was talking about. She clearly had an old-fashioned conception of what it means to save.

After all, saving isn't any good unless you're saving money in a smart, savvy way.

A lot of the strategies for smart saving involve ways to lighten your tax burden. For many young people working today, their employer offers some sort of retirement savings plan -- for most of us, it's a 401(k). But the government has essentially created a huge tax loophole for people making less than $114,000: the Roth IRA.

Again, I'll refer you to my original post about the person figuring out how to pay of debt and save for a potential first home purchase. While his intention to open a money market savings account to accumulate money for a downpayment is good, he's not necessarily using the right mechanism.

After making sure you have a bit of emergency cash (for a natural disaster, Apocalypse, etc.), you should enroll in your employer's 410(k) program, especially if your employer "matches" your contributions. These matching programs reduce your tax burden AND give you extra compensation from your employer. Money that you put into your 401(k) will go in "pre-tax."

The disadvantage of a 401(k) is you won't be able to touch the money for a long time, and there are substantial penalties for doing so. When you withdraw, you'll also have to pay income tax on the proceeds.

A Roth IRA works a bit differently. Most of you will be able to contribute $4,000 this year. Your contributions come after taxes, and usually Roth IRA's have nothing to do with your employer. The beauty of the Roth is that all earnings are tax-free, and there a lot of circumstances that allow penalty-free early withdrawals (for example, you are always allowed to withdraw your contributions with no penalty.)

Other circumstances for penalty-free withdrawals from a Roth IRA include a first-home purchase, health expenses, and tuition.

For the vast majority of you, here's a quick list of how to allocate your savings:

1) Get the most out of your employer.
First, max out on your 401(k) contribution to the point where your employer "matches"

2) Take advantage of a Roth IRA.
After contributing enough to get the full employer matching funds, max out on your Roth IRA contribution for the year.

3) Save in taxes.
Contribute more to your 401(k) until you reach the employer or legal limit. Remember, you won't be able to touch most of this money for a while. If you're not willing to put it aside, you should be prepared to pay taxes on this amount and put it to good use.

In future posts, I'll offer some more details on how and when to start a Roth IRA.