By Terri Cullen
From The Wall Street Journal Online
Oct. 14, 2003 -- Barely 25, Tan Rezaei suddenly found himself on the verge of becoming a junior real-estate tycoon.
First, he gave up his $1,200-a-month rental this past spring for an "affordable" $230,000, two-bedroom condominium in Orange, Calif. About the same time, he came across a cheap $80,000 condo that he considered a great investment as a rental property.
But as Mr. Rezaei prepared to close on the two properties in the same week, reality came crashing down. "I had maybe $35,000 to my name, and about $12,000 in student-loan debt, so at the last minute I decided to bail out of the investment property," he says. He did close on the two-bedroom.
A year later, he's glad he didn't go for broke. "I have friends who stretched themselves too thin to buy their homes, and now some of them are struggling," he says.
Mr. Rezaei belongs to the fastest-growing segment of homebuyers -- the 25-and-under crowd. The number of homeowners who are below age 25 nearly doubled to 1.5 million in 2002, from 792,000 a decade earlier, U.S. census data show. The National Association of Realtors says a surge in younger buyers has driven down the median age of a first-time homebuyer to 31 in 2001, from 36 in 1993.
It isn't just historically low mortgage rates pushing the trend, says Susan Wachter, professor of real estate at the Wharton business school in Philadelphia. Hefty down payments aren't as critical to lenders as they once were.
"Over the last five years there's been a down-payment revolution," she says. The advent of credit-scoring and data-mining techniques have made it much easier for lenders to gauge risk. "The changes have freed lenders from relying on what had been the best predictor of risk, and the biggest hurdle to young buyers -- a big down payment," she says.
But, as many young people have discovered, buying a home and being able to afford one are two different things. Responding to the siren song of low mortgage rates and breakneck home-price appreciation, some younger workers are leaving themselves financially vulnerable by taking on an enormous amount of debt well before they've reached their peak earning years.
If you're intent on making such a significant investment so early in life, you may need to modify some tried-and-true financial-planning rules in ways that will help minimize your long- and short-term risks. Here are some things to consider.
Shore Up Your Finances
Odds are, at this stage you're likely carrying student-loan debt, a car loan, credit-card debt or some combination of the three. Adding a down payment, closing costs, monthly mortgage payments, real-estate taxes and home maintenance costs to the mix can lead to an overwhelming financial load.
So put down that home-shopper circular and start shoring up your finances.
First, determine whether you're carrying too much debt to afford a home. This SmartMoney.com calculator can help. If your debt load is big -- but not a deal breaker -- the next step is to "manage" your debt in such a way that it garners you the best possible credit score when you apply for a mortgage. Lenders track your borrowing habits through credit-reporting agencies, and come up with a "credit score" that gauges how risky it is to lend to you. The higher the score, the better the mortgage deal.
How to manage debt? If you're carrying a number of student loans and haven't consolidated yet at one low rate, get on it. Student-loan consolidation rates have never been lower, and the interest is tax deductible. If you have a lot of credit-card debt, shop around at the Online Journal's Bankrate center here or a site like CardWeb.com to find the lowest-rate card available. Consolidate your debt on that card and begin aggressively paying it down.
Finally, do yourself a favor and take good care of that clunker you've been driving. Though zero-percent financing deals may give you the urge to splurge on your first new car, the longer you can avoid monthly car payments and costly insurance coverage, the better.
If you haven't taken on any student-loan or credit-card debt at all, now is the time to start building your credit history. Lenders will want you to show a pattern of responsible borrowing before they extend to you the best mortgage rates, so apply for a credit card and begin making and repaying small purchases over a few months before you apply for a mortgage.
Defining 'Affordable'
If you feel ready to move ahead, the next question is, how much can you afford?
The single-biggest mistake younger homebuyers typically make is letting industry professionals tell you how much home you should buy, says Keith Gumbinger, an analyst with HSH Associates, financial publishers in Butler, N.J.
"Younger buyers typically rely too much on their realtors for guidance, and they don't ask enough questions," he says. "They need to ask things like, 'What's a typical mortgage for my financial circumstances?' 'How long am I going to be in this home?' and 'How high could my mortgage payment go if rates increase?' "
Affordability also doesn't mean just what you can afford right now. People in their 20s and 30s are much more likely to find themselves in between jobs than older homeowners, so you have to factor that into your decision-making process. Buying a lot of house on the assumption that your income level will be higher in a few years can leave you in a precarious financial position if you -- or your significant other -- suddenly find yourself out of work.
"Young buyers are in a good position in that they've got their peak earnings years ahead of them," says Brad Bond, a certified financial planner in Pittsburgh. "But we're in a different economic environment right now, and you can't assume sharp increases in salary over the next few years -- or even guarantee that you'll have a job at all."
Online financial calculators can give you a rough idea of how much house a person -- in general --can afford. Remember that the resulting figure is a borrowing limit -- meaning, the very highest amount you could borrow, not what you as a younger person should -- and aim at purchasing a home that would require you to borrow less.
The Equity/Debt Equation
Coming up with the cash for the down payment is the next hurdle. It's increasingly common for young homeowners to buy with no money down. One good option for younger cash-strapped borrowers is a so-called 80/20 piggyback loan -- a loan that combines a first mortgage for 80% of the home's price with a second one for 20% of the selling price.
You'll pay a slightly higher interest rate than a traditional loan -- typically a half percentage point or slightly more -- but you'll avoid paying costly private mortgage insurance, which can add hundreds of dollars to your monthly mortgage.
Adjustable-rate mortgages also are a favorite of young borrowers, HSH's Mr. Gumbinger says. While fixed-income mortgages typically are the best bet for older homeowners who plan on staying put for a while, ARMs can be a lower-cost alternative for 20- and 30-somethings who are likely to sell their homes and trade up in a few years.
Mr. Gumbinger notes that 5/1 hybrid ARMs, which are fixed for five years and then covert into 1-year ARMs for the remainder of the 30-year term, are popular among younger borrowers. "A 5/1 hybrid today is at 4.83%, that's just $790 bucks a month for $150,000 loan," he says. "That weighs favorably against a 6%, 30-year fixed mortgage, which would be around $899 a month."
The very real danger here is the threat of rising interest rates. But odds are if you're single or a DINK (double income, no kids) at this age, you may not stay in your first home long enough to face the dreaded adjustable rate.
Don't Sacrifice the Future
Okay, you've dealt with your student loans, credit-card debt, your car and have still managed to move into your new home. Now you start to worry. What about retirement? What about college savings? What about …. Help!
While budgeting in long-term savings may seem like an unaffordable extravagance for young homeowners, waiting even a few years to get started can dent your retirement savings.
The beauty of compounding is best illustrated by this eye-opening scenario that financial planners like to trot out when they're courting young clients: A 25-year-old starts saving $1,000 a year for retirement for 10 years, then he stops and never contributes another dime. His twin brother doesn't start saving until he's 35, but he continues to contribute $1,000 a year from then on until his retirement at 65. Who wins? The early bird, of course. Assuming an annual return of 8%, the brother who started saving early would have $157,435 by age 65, compared with just $122,346 for his twin.
Saving $1,000 a year is doable for most young workers, especially if socked away in small, bite-sized chunks and especially if that money is invested in an employer-sponsored retirement account. For a worker at a marginal tax rate of, say, 25%, every $100 you invest in your employer's tax-deferred plan is actually taking just $75 out of your pocket.
That said, monthly mortgage payments and a crushing debt load may make it impossible to reach that elusive benchmark of saving 10% of your annual income. So don't. Give yourself a break -- at least until your debts are under control -- and commit to saving at least enough in your employer-sponsored plan to get matching contributions (typically 2% to 3% of your annual income). This way, you double your savings without breaking the bank.
What about college savings? If you're a young married couple with a little one on the way, you can probably skimp on college savings until the preschool years -- but not much longer. As with retirement savings, the longer you wait, the greater the amount you'll need to sock away each month, and more likely it will be that you won't have enough to foot the bill when the time comes.
In the interim, consider setting up a tax-advantaged college-savings account like a 529 plan and drop some not-so-subtle hints to friends and family members that when it comes to birthday or holiday gifts for baby, nothin' says lovin' like cold hard cash.
