Being the frugal fella you are, you have spare cash each month and you need to decide what to do with it. You probably have several options: pay down the mortgage, pay down student loans, invest in a retirement account, pay off credit card debt (credit card debt? but you’re a frugal fella, right?), or put it under a mattress. Whether you’re earning interest or paying interest, these can still be compared to find the most qualified suitor for your cash. Let’s take a look at some numbers, however accurate they may be, for each of these sinkholes:

• Pay down the mortgage: 5% (mortgage interest rate)
• Pay down student loans: 4% (student loan interest rate)
• Invest in a retirement account: 9% (rate of return)
• Pay off credit card debt: 12% (credit card interest rate)
• Put it under a mattress: 0% (rate of return)

Now, if you subscribe to the idea that you should put your extra cash in the one with the highest rate, this would lead you to believe you should pay down the credit card. Most people would stop there.

But let’s look at PMI. First things first: lenders are required by law to remove PMI once the balance of the mortgage reaches 78% of the original value of the property (given your payments are current). Technically they are able to remove PMI prior to 78% but that’s another story and we’ll play conservatively. Let’s say we purchased our home for $200,000 and so far we’ve paid the mortgage down to $165,000. 78% of $200,000 is $156,000 so we’re $9,000 from being free of PMI. We pay $100/month for PMI and our mortgage interest rate is 5%.

We may or may not have a full $9,000 to pay down our mortgage but, regardless, assuming so will more easily allow us to determine if this is where we should sink our cash. If we had the full $9,000, what would be the cost of putting it under our mattress versus paying down the mortgage? 5% of $9,000 is $450. This is the amount of annual interest we would save if we paid down the mortgage. Another way to look at it: this is the amount we would pay on annual mortgage interest if we stashed the $9,000 under our mattress instead. Now add PMI. PMI in our example is $100/month so over a year this tallies up to $1,200! Now let’s add the interest and the PMI together and we arrive at $1,650. This is the true opportunity cost/gain for the $9,000 with regard to the mortgage.

Now let’s calculate our opportunity cost/gain in the form of a percentage so we can compare it with our other candidates. $1,650 / $9,000 = 18.3%! The option of paying down the mortgage just went from 5% to 18% which is even higher than the massive credit card interest rate of 12%! Run the numbers for your own situation and see what you come up with.

Not So Fast

Before sinking all your extra funds into your mortgage to remove PMI, consider the following:

Pay-off cliff. PMI is somewhat of a different beast from interest. If we paid $1000 on our example mortgage we would immediately save ourselves from paying $50 each year on interest. On the other hand, the $1000 wouldn’t save us from paying the same amount in PMI until we paid all $9,000 that’s needed to get to the 78% PMI removal “cliff”. This causes some interesting effects. For example, the farther you are from the pay-off cliff the lower your opportunity cost/gain will appear for paying down the mortgage. Keep this in mind when paying down the mortgage as paying down $8,999 in our example is going to do you much less good than $9,000. Don’t run and pass out right before you reach the cliff.

Tax deductions. At least through 2011, mortgage interest and private mortgage insurance (PMI) is tax deductible though starts to phase out once your gross income reaches $100,000. Roughly, this means if your tax bracket is 25% then your opportunity cost/gain for the mortgage interest and PMI should be reduced by 25%. In our case, the 18.3% would more accurately be reflected as 13.75%.

Mind over math. Not all people feel you should pay down debts with the highest interest first. Dave Ramsey and other smart people like him believe that paying down debt is as much of an emotional game as it is mathematical. To get the emotional drive from quick, up-front wins, Dave recommends paying down debts with the lowest balance first–not necessary the highest interest.

Liquidity. Home equity is not a very liquid asset. In other words, if you lose your job and your kids are going to starve, it’s difficult to sell the house to feed their faces. Liquidity is itself of value and may be a great reason to store some savings elsewhere.

Vet your options. I’ve kept things pretty simple but life is good at throwing curve-balls. Make sure you understand the benefits of putting your money in each of your options. If your employer is offering a 401(k) match, that’s likely a 50% to 100% immediate return (keep vesting in mind) that should not be turned down. Likewise, there are tax advantages and implications all over the place. Be smart. My main goal of this article is to keep you from sweeping PMI under the rug and instead mathematically incorporating it into your financial decisions.

Understand the lingo.
In real estate, if you don’t understand the lingo, you risk locking yourself into something you didn’t really understand.  In today’s society, most people would call this “being taken advantage of”.  I call it being irresponsible and unprepared.

Here’s my list of lingo items I feel each home buyer should know and understand.  Each are linked to their respective Wikipedia articles, though you can find numerous resources online through any search engine like Google that I would recommend checking out.

• Mortgage Broker
• Mortgage Banker
• Realtor/Real Estate Broker (vs. not using a realtor)
• Foreclosure
• Short-sale
• PMI
• FHA vs. conventional loans
• Piggyback loan
• Mortgage points
• Origination fee
  
• Good faith estimate
• Assessment vs. appraisal
• Inspection
• Balloon payment
• Title insurance
• Property insurance
• HOA
• CC&R

If you know what those mean and how to act upon them, I’d say you’re ahead of the game and well-prepared.

Determine if you need a realtor.
I’m not going to go through all the reasons you should or should not have a realtor; I just want to bring up the idea that it may not be in your best interest to have a realtor, especially if you already know the area and are willing to put forth the effort to research the local real estate markets, understand legalities, and schedule the inspection, appraisal, etc.  Usually when you purchase a house, your realtor gets paid by the seller.  While you may initially think there’s no down-side to having a buyer’s realtor agent, do realize that some sellers will offer some fairly deep discounts if you come without an agent.  Most agents will require you to sign paperwork stating essentially that you will not go house-hunting without them.  Understandably, they don’t want to be cut out of the deal after they have put forth effort to help you.  Remember it’s easy to get a realtor, but difficult to get rid of one.

Determine how much you can afford.
Crack open Excel and crunch numbers.  In our case, I had just recently changed jobs, we were weeks away from having our first child, and weeks away from my wife quitting her job to be a stay-at-home mom.  And I’m supposed to know how much we can spend each month on a house?   It’s not easy, but you have to do your best.  Write down all your expenses that you can think of including outstanding debt payments, saving for retirement, saving for your children’s college fund (if you choose), and saving for an emergency fund.  Subtract all these expenses from your net income (how much you take home each month).  Don’t assume that this is how much  you can then spend on your house.  Give yourself a healthy padding for unexpected expenses, change in jobs, etc.  Ask yourself some questions: What would happen if our car broke down and needed to be replaced?  What would happen if I suddenly broke my back and needed a couple months off work?  What would happen if I lost my job?  If you can answer these questions and still feel comfortable with your estimates, you’re on your way.

Consider a short-sale or foreclosure.
Since you’re likely currently renting, you may have flexibility in your contract.  If so, hunker down and go for a short-sale or foreclosure.  They take time and patience but can be immensely worth it.  There are plenty of options out there currently and ripe for the pickins.

Go house hunting.
Research the area in which you’d like to buy the house.  Use online websites such as City-Data.com, Homefair, and Zillow to learn more about potential buying areas.

Create a wishlist of everything you would like in a house.  Sit down and make your MoSCoW lists (must, should, could, won’t haves).  If you’re using a realtor, review these with him/her.  It’s the realtor’s job to take this list and find houses that match.  If they don’t know what you’re looking for, you’ll waste a lot of time.  Be upfront with them on what you do/don’t like about the houses you see.  Take photos and notes of all the houses; you’ll have a hard time remembering them if you don’t.

Be patient but realistic when trying to find the perfect house.  There are always new houses available for sale to choose from, but it’s likely you’ll never find your perfect house.  When you find a match, don’t be afraid to pull the trigger, especially if it’s a short-sale.  Laws may vary by location, but usually you can submit offers on as many short-sales as you’d like.  Even if one is accepted, you can still turn it down.  With houses that are not short-sales however, you are under contract if your offer is accepted and cannot back out under most circumstances without a penalty.

In our case, we looked at approximately 15 houses in person and ended up buying the second house.  We looked at many, many more online to drill down to the ones we actually wanted to visit.

Make the banker/broker work for your money, especially if you have good credit.
Do not just go to one broker and call him your broker.  Go to several and ask a lot of questions.  Send their good faith estimates (ask for digital copies) to each other and have them try to beat the others.  Never feel bad for asking questions and doing things on your own terms.  In the end, you’re the one stuck with your mortgage and it’s likely you’ll never talk to your broker or realtor again after you sign your life away.

Don’t feel pressure to go with a realtor family member or friend.  Unless you really trust him/her, I’d actually suggest against it.  The safety of having someone you know doing your work can easily be offset by higher interest rates (honesty and friendship do not always mean least expensive) or bad feelings if a mistake is made or expectations aren’t met.

Get an inspection.
An inspection may be a few hundred dollars, but they can save you thousands.  Even if the inspection doesn’t turn up a faulty foundation or a roof that needs to be replaced, it can still highlight items that may be safety hazards or can be used for bargaining with the seller.

Lock in your interest rate.
Despite some popular beliefs, you’ll very likely have no idea whether mortgage interest rates will go up or down.  You could wait and hope they go down (called floating the rate).  Or you can take what’s currently available and ensure you get that rate (called locking the rate).  By locking the rate, you’re guaranteed you will get the interest rate you locked if you complete the home purchase within a given period of time (usually 30 days).   This ensures the interest rates don’t jump way up out of your budget range right before you sign the closing documents.  If such were the case, you could end up losing a house you really like and paying a fat penalty for backing out.  On the other hand, if you don’t lock or wait to lock you might get a lower rate.  You weigh the risks involved and make your decision.  There’s no clear-cut answer on whether the rates will go up or down and you’ll drive yourself crazy trying to foresee the future.  Unless you’re up for a risky ride, be safe and lock your interest rate as soon as possible.

Read everything.
Recently a news story portrayed a woman who speculated in the housing market by purchasing a handful of condos in Florida with hopes that their values would soon rise as they had done in the past.  She said she didn’t read the paperwork because so many of her friends were doing the same thing and they were all making big money.  After the mortgage crisis, she reported she had lost a lot of money in her real estate purchases and was treated unfairly because she didn’t know what she was getting into.

Wrong.  If you don’t read the paperwork, you have nobody to blame but yourself. If you don’t understand it, find someone who does or sign it knowing that you are the one opting out of understanding it.

Enjoy the ride.
While buying a house may be stressful, it should also be fun.  It’s not every day you can throw down a John Hancock on something worth thousands of thousands of dollars.  It’s now your house and you can do almost anything you want with it.  Don’t like a wall?  Knock it down.  Don’t like the color?  Paint it.  It’s great to own a house as long as it’s financially smart.  Figure out what’s financially smart and go have fun.

So who’s to blame?  Oh, there’s plenty to go around alright. Jimmy Carter? Ronald Reagan? Bill Clinton? George Bush? Franklin Raines? Jamie Gorelick? Chris Dodd? Barney Frank? Phil Graham?  The plethora of banks?  Wall street?  Predatory lendors?

Let me share a reader’s comment I found online while reading Bankruptcy, not Bailout, is the Right Answer that I believe encompasses the mindset of many American citizens:

Perhaps you should spend less time criticizing individuals for taking chances at success, and instead focus your unwarranted hostility at the corporations that took advantage of those people. It is perhaps quite easy for you to be so smug, when it may not be you that would rely on such a system in the first place.

Americans are struggling every day, and instead of acknowledging that and trying to understand the situation – you refer to them as “stupid”. I beg to differ, these individuals are losing everything because of corporate, and government, greed… not stupidity.

I would suggest that in the future you spend less time attacking the people that are suffering, and place a little more focus on the cause of the problem.

Within the scope of your mindset it was not Hitler and the Nazi regime that was responsible for the Holocaust, but the Jewish people for being Jewish.

When will we start accepting responsibility for our own actions?  When will we start to understand that being a Jew in the Holocaust is different than borrowing more than we can afford?  Who’s fault is this mess?  Sure, the Community Reinvestment Act of 1977 allowed credit-unworthy citizens to take out loans over their heads at sub-prime levels.  Yes, Jimmy Carter was the one who signed it, Bill Clinton was the one who enforced it, and George Bush didn’t do anything about it.  Fannie Mae, Freddie Mac, and banks throughout the country did indeed enhance the problem due to greed and lax oversight.  Does this excuse us from the responsibility of wisely managing our own money?

Let me illustrate.  If every bank around the country said, “Hey, come on in.  You qualify for a gabajillion dollars and here it is!  It’s a 30-year mortgage locked in at today’s mortgage rates. Nah, don’t worry about your credit.  Here’s the check.  Enjoy your new home!”  Today’s market, in my view, proves the average American would spend more of that gabajillion dollars than he/she could actually afford.  But who’s fault is it?  The lender’s fault, of course!  How dare they put a gabajillion dollars in front of my nose!  Take it or leave it, that’s what’s happened.  That’s our society.

Over the last couple weeks I’ve spent about ten hours talking to lenders so I can buy a home.  I’ve spent many more hours researching mortgages online and understanding the terminology.  The majority of my time spent has been looking for answers to my questions.  I ask questions because it’s my fault if I don’t understand what I’m getting into.  It’s my responsibility to figure out how much can I afford.  When the lender says I qualify for a gabajillion dollars, it’s my responsibility to only take what I can pay back.  Regardless of government policy, greedy banks, or what my neighbor owns, my loans are my responsibility.