Should You Leverage Your Home or Pay it Down Rapidly?

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There is a great debate within the inner-mortgage circles these days. Should we, as loan professionals, encourage clients to borrow as much money as possible? Or would consumers benefit more if we helped them to understand the advantages of 15-year amortization schedules and pre-paying principal? Let’s examine the pros and cons of both strategies.


Leveraging Your Property. In order to understand why you’d want to borrow as much as possible for your home purchase, you must first grasp the concept that equity has a zero rate of return. Here’s an example:

If Consumer “A” buys a home for $300,000, and puts 20% down, then they have $60,000 in equity. Over the next 5 years, the property appreciates $100,000 in value. Consumer “A” now has $160,000 in equity.

Consumer “B” buys a home for $300,000, and puts no money down. At the end of 5 years, that same home is now worth $400,000. Consumer “B” has $100,000 in equity, which is the same appreciation as Consumer “A”, a net $100,000.

As you can see, your down payment has nothing to do with your rate of return. What becomes important is how you choose to manage the $60,000 you didn’t use as a down payment. If you use it for frivolous activities, such as buying toys or going to Las Vegas, it would be more prudent for you to use that money as a down payment. Especially since this will enable you to obtain a lower interest rate.

However, if you were to invest the $60,000 in a vehicle that can out-earn the cost of that debt, then this could be a formula for success. This is why some lending professionals suggest putting as little down as you possibly can, maximizing your tax write-off, and investing the rest. This principle has been applied for many years in the life insurance game. The old saying goes, “Buy term and invest the rest.” The key component is taking the money you would have used as a down payment and creating an asset accumulation account. This account should earn a significant enough rate of return to enable you to pay your mortgage off entirely and achieve the ultimate goal of being debt-free.

Paying Your Home Down Rapidly. There are very few times over the course of my career that I have seen a client with zero debt and no financial difficulties. Choosing to pay off all of your debt can reduce stress and help you to gain freedom of cash flow for investment opportunities. A 15-year mortgage or a bi-weekly payment strategy provides structure. It can also put you on track to have your mortgage paid off within a set timeframe. Simply put, it contains built-in discipline.

It’s important, however, to understand that regardless of how rapidly you pay your home off, you’re not getting any greater rate of return on your investment than if you paid it off slowly.

Conclusion. So how does one determine which scenario is best? The choice depends entirely upon the individual. Savvy consumers who are disciplined, and are comfortable taking chances from an investment perspective, would do well with the first scenario. Over the course of time, it’s been proven that your rate of return over the long-haul will be far greater than the rate you’d pay for a mortgage in today’s rate environment. It’s important to seek the advice of a skilled investment advisor to ensure success with this strategy.

The second scenario is best for those who have a difficult time managing their money or who’ll sleep easier at night knowing they have a plan in place to pay their loan off more rapidly. Be sure that your budget can handle accelerated payments. When consumers “bite off more than they can chew” with a 15-year mortgage, they frequently end up having to refinance back into a 30-year schedule.

If you find this subject intriguing and would like to know more, I recommend that you read a book titled, Missed Fortune 101, by Douglas Andrew. It’s an outstanding read that is very simplistic and goes into far greater detail than I can cover in this column. Douglas is a financial planner who advises safe-structured investments such as whole life policies and tax-free fixed income instruments.

The Joys of Geocoding

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In my last post, I was asked what the accuracy of the locations in our generated Google Earth files are. Before I divulge that information, I’d like to explain some of the challenges of getting accurately geocoded data. (I’ll get on my soapbox and complain about the state of NWMLS data in my next post).

GPS Signal WiggleNow, in partial defense of realtors and the MLS, it is unrealistic to expect perfect data. For example, consumer-level GPS receivers aren’t always as accurate as one might think. This weekend I loaded up Microsoft Streets & Tips 2006 on my desktop computer, hooked up my GPS receiver, turned on GPS tracking , created a GPS trail, and walked away for an hour. An hour later, my map had a line drawing that resembled the type my 3 year old son likes to create. So even if a realtor was to use a GPS receiver, to get a latitude & longitude reading, it’s entirely possible that the measurement would be off by a house or two (or four).

Another problem, is that most digital maps are created with data sold by companies like TeleAtlas or NavTeq. The companies compile their data by driving around previously unknown streets & neighborhoods, with computers & GPS receivers (kinda like how that annoying guy in the Verizon ads, test their network). I should note that in-vehicle navigation systems are more accurate than GPS receivers alone, because the vehicle’s navigation system can also use the vehicle’s steeling wheel position and the speedometer to determine what your location is.

Unfortunately, by the time the Microsoft’s, Yahoo’s and Google’s of the world get their hands on the data, it is at least 3-6 months out of date (and probably closer to 12-18 months out of date by the time it gets on the web or published on a CD). This is a problem because about 25% of the properties in the NWMLS are new construction (where new construction is defined as a property that was built in 2005 or later). Since new construction is often located near new roads, the giants of digital mapping may be unable to help and are always in a position of playing catch up.

Then when the companies convert the raw data into digital maps, they end up using multiple sources of data, and interpolating it into one set of data they are going to use for a map. However, the data sources don’t always agree on where a point of interest is.

For example, Google Earth thinks the top of the Seattle Space Needle is at 47.620367° north latitude & 122.349005° west longitude. Meanwhile, Microsoft’s Virtual Earth, seems to think it’s located at 47.620336° north latitude & 122.348515° west longitude. Now, a few ten thousand-enths of a degree means the difference between the tip of the needle & one of the air conditioning units on the roof (a few yards). But if they can’t agree on where the top of the Space Needle is, it’s likely they aren’t going to agree on where 742 Evergreen Terrace is either. However, a few yards of error is better than a few miles of error (which is what can happen when I use raw NWMLS data)

Because of this, I have to geocode every single property in the database because I don’t trust the NWMLS data. So I to call Yahoo! Maps Web Services – Geocoding API to get a latitude & longitude for everything. Although Yahoo is far from perfect, at least it’s free and try’s harder than the MLS. So without further delay, here is the current geocoding precision of the points on our generated maps.

Geocoding Precision No. of properties Percentage
address 16341 80.20
street 1975 9.69
zip+4 43 .21
zip+2 343 1.68
zip 1644 8.07
city 25 .12
state 5 .02

In closing, I’d like to ask real estate professionals to be as complete and as accurate as possible when submitting listing data to their local MLS. I’d also like to state even if the MLS was accurate, it’s unrealistic to expect prefect geo-coding from imperfect data. If digital mapping companies and GPS technology can’t get it exactly right, a house or two off, is probably as accurate as you can realistically hope for given the current state of the art.

Robbie
Caffeinated Software

John Cook Interviews Redfin CEO: Redfin is "crazy-good"

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Dustin pointed out that John Cook over at the Seattle PI just published an interesting interview of Redfin’s CEO, Glenn Kelman (Direct link to the mp3).

Before I jump in, I should point out that I run ShackPrices.com, a site that is faintly a Redfin competitor. That said, that both Redfin and ShackPrices are much more worried about our customers and competitors with lots of money than we are about each other. I’ll try my best to stay unbiased.

Up to this point, Dustin has been under the impression that Redfin is very insular (He’s even gone so far as to say “arrogant”). I get the impression that Redfin has some interesting technologies, but they are still looking for their path; Glenn is doing a big marketing push on a site that has only had cosmetic changes (to real estate buyers) in the last year. Throughout the interview he raves about his site. I think he says exciting ten times and “crazy-happy” or “crazy-love” at least three times. If you check Redfin.com, their news bar clearly shows that they’re on a marketing push (it also shows they still don’t have an interface person who can tell them to use that valuable space more effectively).

Glenn then talks about how addictive (crazy-addictive?) he finds the Redfin site. Personally, I get much more excited by the technologies behind PropSmart and Trulia. Those sites seem to have added to cool aerial photos with some real focus on the user interface. Redfin gives you great information about individual houses and even shows you the lot line, but it doesn’t give you any medium- to big-picture information. Neighborhood and city pricing information is worth much more than a single house’s historical sales (and this is coming from the dude who has only historical sales on his site).

I think it is interesting how an interview can really bring out the best and worst in somebody by just letting them talk. More articulately than anyone else I’ve heard from Redfin, Glenn describes the company’s lack of focus. For instance, he talks about how every state is different and national websites can’t accommodate that. Next, he talks about how he’s going to expand down the West Coast and all over the country. He talks about how cool the site is and how technology is changing, but gives digital photos of houses as an example of this trend (that was cool 5 years ago!). Even in vegan-city Seattle, I want to know where’s the meat to go with this fluff? When asked what’s driving traffic to Redfin, Glenn says “because it’s an awesome site.” I think I would have gone with “aerial imagery, property outlines and past sales data.” And if they don’t add to that list, they risk becoming just-another-mapping-site.

A while back, Anna wrote this article that showed how Redfin wants it both ways with real estate agents… and it is interesting that while Glenn is new to the staff (he started in September), he inarticulately describes this same conundrum that Redfin faces.

He says,

we’re not trying to serve the real estate agents… sell people out to real estate agents… what we’re trying to do instead is serve the consumer directly…

But when pressed by John about how Redfin makes money, he says

How do we make money now? People sign up for a real estate agent… The real estate agent and Redfin share the fruits of that.

Which essentially means “by selling customer names to agents.” I’ll give him credit – I hate the housevalues model and find it to be really sleazy and maybe there really is something to be said for waiting until someone requests an agent. However, they are not, as he says, “trying to do something totally different.” Redfin is just leaving more money on the table and, possibly generating higher-quality leads. I’m going to read into this, though, and say that they don’t plan on working with agents for long – note his question to himself “How do we make money now?”

Dustin says “it is not hard to read between the lines that he’d really like to squeeze those agents out of the business if only it wasn’t for those “great” relationships he’s built up with a few of them.” I agree. Late in the interview he emphasizes how he wants to balance the business model:

… balancing our business model. We’ve got real estate agents that are partners, that we still value enormously, but we want to make sure we keep the focus on the home buyer and seller who is the customer.”

Word to agents: now that we have funding, you are not a priority.

This is my favorite part:

If you walked into Redfin, all you would see are engineers and a customer support person.

-Galen
ShackPrices.com

Insurance for house price change

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Last November, Slate magazine posted a piece on the housing market futures and options. The gist: you can hedge a drop in your house’s property values by buying derivatives that pay if the region’s property values drop a specific amount over a specific time period or even if predicted growth doesn’t materialize:

Next spring, however, investors might finally have a better hedging product. Just in time for the apparent top of the housing market, the Chicago Mercantile Exchange is introducing futures and options on housing prices in 10 cities for the second quarter of 2006.

It’s pitched to big institutions, but it would probably benefit individual investors immensely. That is, if they used it. Unfortunately, the individual home owners it would benefit the most didn’t have enough cash on hand to put money down on their house and are currently just paying interest, so they probably don’t have extra money to invest in hedges.

Also, as Ardell eloquently pointed out a while back, different sectors of the market can “pop” at different times and at different rates. Unfortunately, this could only protect against region-wide shifts:

These options will cover large markets—it will be tough to hedge the value of your own house, which depends so much on your particular neighborhood.

I liken it to buying an index fund (or mutual fund) instead of a single stock, although maybe insurance against extreme price swings is a better analogy; the effect is to reduce the upside and the downside of your investment. It doesn’t seem very exciting in the least so I’m putting this one in the “popular after the crash” basket, as it’s hard to plan for hard times when the good times have lasted so long.

So who’s buying on opening day? And can the market correctly predict housing prices over the next few years, or are investors so oriented toward a bubble popping that they can’t see the inherent strength of the market (or vice versa)?

Galen
ShackPrices.com

Good comments on the NYT For Sale By Owner article

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Thanks for the comments on my commentary here – they were interesting. I’m enjoying writing here and getting feedback from folks.

I found some more interesting thoughts on the New York Times article over on the Freakonomics blog. “Chubin,” one of economist Steven Levitt’s readers proposed a novel approach – the hourly realtor.

Lastly, the 6% commision model is little incentive for agents to get the highest price for the seller or lowest price for the buyer. I continue to think an hourly fee, based upon actual work provided, is the fairest of all. I just don’t think the public is ready to accept that model.

If consultants and lawyers can do it, why not real estate agents. Has anyone heard of agents trying this? Any reason this would be a non-starter from the gate? I don’t think it would take over the industry, but I could imagine some buyers and sellers really liking it. The comments are open…

The Future of MLS search is coming to Rain City Guide

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Greetings fellow Rain City Readers! I’m a software engineer that has been working with Dustin to develop a better MLS search. Before I get started into what I’m doing, I thought I’d discuss the why I’m doing it…

My saga began when I had the opportunity to develop an NWMLS search web site for a local realtor. After spending several weeks, cutting red tape, determining what forms I needed to fill out, figuring out whom at my realtor’s broker I needed to bother, signing my life away and finally getting access to an NWMLS database, I was at the point where I could get real work done. Anyway, after I had spent over 40 hours developing standard search features (search summary with thumbnails, property detail page) and a few interesting ones (like customized HTML e-mail with property photos, customizable photo not available photos on search results), I sent her my bill.

Then things went south. Despite the fact that my client was warned ahead of time that my time isn’t free, she apparently expected that I would be price competitive with “canned” solutions such as those offered by iHouse & Superlative. On the one hand, I can’t blame her. A consultant can’t compete with a commercial product, because a commercial product has a lot more customers to help finance its development than a lone consultant does. Just because those companies sell solutions for $50/month doesn’t mean it only costs them $50 to design, develop & test the software! It still costs those organizations thousands of dollars (or more) to bring these products to market! However, if you plan on distributing software to 1,000 customers, you can charge a lot less per customer, than if you are only distributing it to one.

Anyway, after this failed business opportunity, I decided to contact Dustin and regroup. I wanted to develop a unique MLS service that would’ve given my client a competitive advantage (and she was more interested in price than value) and after reading Rain City Guide it became obvious that Dustin would see the value in what I could do. Besides, I’d rather continue to improve the code I was working on than send it to the hard drive in the sky.

Dustin & I, both share the belief that the real estate industry is in for some very interesting times as the reverberations of the internet revolution continue to change our society and business models. Dustin’s enthusiasm for the ideas I’m trying implement is contagious and we essentially worked out a deal in which I’ll continue to develop compelling MLS technology in my spare time, I’ll use him and his Rain City readers as a sounding board for ideas and beta testers (both marketing & development feedback), and in a few months time, ideally, I would have developed a really unique service that technology savvy realtors would be willing to pay for.

One of the cooler things I’ve done is turn MLS search results in to Google Earth files. Just download the Google Earth application, visit our BETA listings search page, click on the Google Earth icon, and see your search results on a 3D globe. Eventually, we’ll do similar stuff with AJAX style Mapping (although, right now I’m focusing more on things that haven’t been done yet) and other applications.

Google Earth Application

Most realtors have “me too” & “same old thing” web sites. One of the things I want to do, is give realtors the ability of exploiting the MLS data in way that is valuable and compelling to their clients and strengthens & reinforces their name/brand to their prospects. Having customized RSS feeds of MLS data, having proximity searches to points of interest (how far is this house away from a gas station?), and take advantage of all the cool location/mapping technology that the 3 giants of the internet are developing (Microsoft, Google & Yahoo), are just some of the things that could be done, but aren’t really done yet.

One of the reasons for this state of affairs is that currently only software engineers with access to MLS data can do these things. Unfortunately, we live in world in which most realtors don’t have the skills & knowledge that software engineers have and most software engineers don’t have free access to the raw MLS data that most realtors do, so things are moving slower than they otherwise might be. Obviously, waiting for the HouseValue’s of the world to develop this technology is an option. However, their business model seems to be marginalizing the value of a realtor instead of enhancing it. I’d rather take the opposite tack, since I suspect that my future customers would prefer to use technology to improve their competitive advantage against all comers rather than having it used against them and risk turning themselves into a bunch of “me-too” commodity realtors paying somebody else for random sales leads. (which is probably one of the reasons you blog!)

Right now, you can take a gander at the humble beginnings of our grand vision at http://listings.raincityguide.com/search.aspx. Granted we still have a few bugs that need to be fixed, and many, many more features need to get implemented. However, it’s my goal to turn this into something that would provide a compelling value for my future clients (realtors & their customers) and I welcome any comments that would help me, help you.

Robbie
Caffeinated Software

FSBO will not take over the world

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And with a title like that, I might just eat my words. There was an interesting story in New York Times story about FSBO yesterday. It describes a (ugly!) FSBO online service in Madison Wisconsin that has grown immensely over the past few years. I feel a little like a curmudgeon when I say this, but I agree with the sentiments of the real estate agents quoted – FSBO sites don’t directly threaten the real estate brokerage industry. That said, the real estate agents are just as wrong about their own business if they think that margins won’t drop and market conditions won’t dramatically change over the coming 10 years.

As I see it, this is a great illustration of a large scale change that the real estate industry (and many other industries) is undergoing right now. Consumers today have vastly more information available to them, which means they rely less and less on a realtor to guide them through the process. Imagine (as I must) what it was like 15 years ago as a home shopper; you either drove around the entire city to see what was for sale or asked a realtor to essentially do it for you. The realtor held the cards and had the computer system with all the information. You, as shopper, really couldn’t make a short list of 5-10 houses you were really interested in without the help of a realtor. Today sites are springing up left and right to give consumers lots of information.

Today, home shoppers can (but don’t necessarily) figure out exactly what they’re looking for, sellers can get an approximate value of their house with free tools (like by site, ShackPrices.com) and in the end, are real estate agents really do not provide the same service they once provided. Supporting my assertion is Steven Levitt’s research that shows the extra amount that real estate agents make on sales of their own home versus the homes of their clients has dropped over the past 10 or so years (which I maddeningly can’t find a link to now); customers today can much more accurately assess the value of their home without a real estate agent.

Ms. Miller and Ms. Murphy, however, built a separate and alternative listing service – a parallel market, much like the Nasdaq, which rose in recent decades to challenge the New York Stock Exchange’s dominance and sparked competition that eventually reduced transaction costs for all stock investors.

This is an interesting, but misleading comparison, at least for the time being. Consumers can look up Nasdaq and New York Stock Exchange quotes from the same place and can buy those stocks from the same people. In fact, your broker will be happy to sell you stocks from either market. My real estate agent will not be happy to sell me a FSBO property and I certainly can’t look them up on Windermere’s web site.

These cracked me up:

To real estate agents, “for sale by owner” conjures up some cranky tightwad trying to sell an overpriced, ramshackle house. Agents utter FSBO as if there was something foul stuck to the bottom of their shoe. “It’s a commission-avoidance scheme,” said Sheridan Glen, manager of the downtown Madison office for Wisconsin’s biggest real estate broker, the First Weber Group.

Kevin King, executive vice president of the local Realtors’ association, runs the multiple listing service but says he pays no attention to FsboMadison. “It’s not important; I don’t follow it,” he said. “I don’t even know the people.”

First – commission avoidance scheme!? That’s like saying the classifieds are a low trade-in value avoidance scheme for cars. This looks much more like a agents-aren’t-worth-six-percent scheme. The problem seems to be that even the discount brokers aren’t doing a good job at covering the market; Madison effectively has a (usually) 6% commission market and a no commission market. The future is probably somewhere between, with most agents working on a flat fee model (Steven Levitt agrees).

Agents swear up and down that they’re worth every dollar they charge, but is that usually the case? Here’s a scenario: A friend of mine moved to Seattle last year and decided he wanted to buy a home with his girlfriend. They looked at a few places and decided they would buy a townhouse that wasn’t yet finished. They picked the place they wanted after doing much research on their own and then hired an agent to do the paperwork and cover the details. They effectively worked out a flat-fee agreement, which the agent was happy to sign.

FYI: the NYT article really struck a chord and has been the most emailed story for the past two days now.

Galen
ShackPrices.com

Seattle's jogging routes

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I like this site, although I really wish I could hit a “show all routes in my area” button. Still, if you’re looking for a new jogging route, take a look. Furthermore, if you’re wondering how to follow through on your “exercise more” resolution, this might be a good starting point.

Here are Seattle’s routes. Add your own if you are so inclined.

Galen
ShackPrices.com

Seattle running routes

Real estate is a smaller part of American's income than ever before… and rent is an even smaller part

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Yesterday, the New York Times reported that “Twenty Years Later, Buying a House Is Less of a Bite.” Two points on this:

1. It’s a macro-level article and points out that housing on the coasts is not necessarily a deal:

In high-profile places like New York and Los Angeles, home to many of the people who study and write about real estate, families buying their first home often must spend more than half of their income on mortgage payments, far more than they once did. But the places that have become less affordable over the last generation account for only a quarter of the country’s population.

2. They entirely ignore the fact that 20 years later, most things are cheaper. For instance: food, beer, wine, appliances, computers, telephone service, and so on. Some things, particularly services, have become more expensive, but the most important thing when you’re talking about the relative cost of houses, rent, is still cheap. An older article from the New York Times points this out:

In the Bay Area of California, a typical family that buys a $1 million house – which is average in some towns – will spend about $5,000 a month to live there, according to the Times analysis. The family could rent a similar house for about $2,500, real estate records show, and could pay part of that bill with the interest earned by the money that was not used for a down payment.

Seattle is not the Bay Area, but owning here is still much more expensive than owning in Dallas. I think this fits with anecdotes about buying rental properties. Twenty years ago, it was fairly easy to buy a rental property in the Seattle area and have the rent pay for repairs and the payments; you could earn equity for the cost of finding tenants. Today, the search to find a property like that is a challenge.

So will house prices plummet or flat-line this year? I don’t think anyone can say. A lot of people seem to be betting on increasing prices (they are still buying rental properties), however I believe that the stock market is beginning to bet against builders because they fear an over-supply of housing. My advice: If you have above 50/50 odds of staying in the same house for 10-20 years (unlike most Americans), you should definitely buy. If you can’t save money to save your life, maybe you should buy because your home could serve as a sort of inefficient savings scheme (again assuming you won’t sell right away). If you really value owning a home, buy one. Just don’t expect prices to continue increasing at the same rate as they have over the last 5 years. And don’t get an interest only loan!

-Galen
ShackPrices.com