Weighing financial considerations

You’ve probably already heard some arguments regarding the supposed financial benefits of owning a home. These benefits include the notion of buying and owning a home for the tax breaks, as well as the thought that paying rent is analogous to throwing your money away.

The biggest homeownership costs are mortgage interest and property taxes, and in the United States, these costs are generally tax-deductible. The tax breaks are already largely factored into the higher cost of owning a home, however, so you should never buy a home just because of the tax breaks.

Renting isn’t necessarily like throwing your money away. In fact, renting can have several benefits, including the following:

• Renting sometimes costs less (sometimes much less) than owning. In the mid-2000s, in some parts of the country, renting a given property cost about half as much as owning that same property (a monthly comparison even after factoring in the tax benefits of owning).
• You may be able to save more toward your personal and financial goals if you can rent at a relatively low cost. You can invest, for example, in other financial assets such as stocks, bonds, and funds (and may be able to do so through tax-favored accounts).
• Renting has potential emotional and psychological rewards. You usually have more flexibility to pack up and move on as a renter. You may have a lease to fulfill, but you may be able to renegotiate it if circumstances require you to move. As a homeowner, you have some major monthly payments to take care of. To some people, this responsibility feels like a financial ball and chain. After all, you have no guarantee that you will be able to sell your home in a timely fashion or at the price you desire if you want or need to move.

Renting does have at least one big drawback: exposure to inflation (cost-of-living increases). As the cost of living increases, unless you live in a rent-controlled unit, your landlord can keep increasing your rent. By contrast, if you’re a homeowner, your largest monthly expense — the mortgage payment — doesn’t increase, assuming that you buy your home with a fixed-rate mortgage. Your property taxes, homeowner’s insurance, and maintenance expenses are exposed to inflation, but these expenses are usually much smaller in comparison with your monthly mortgage payment.

Considering costs and your time frame

You face significant costs when buying and selling a home. My analysis suggests that you probably need at least three to five years of low to moderate appreciation to recoup your transaction costs. Some of the expenses you face when buying and selling a home include the following:

• Agent’s commission: Real estate agents generally charge a commission of 5 percent to 7 percent of the purchase price. Even if the seller is technically paying the commission out of the proceeds that he or she receives from selling a home, both the buyer and seller of a home are effectively paying commissions because those costs are built into the home’s sale price. (You may be able to reduce these costs somewhat by doing the selling yourself, but a buyer may offer less, knowing that you’re not having to pay commission.)
• Inspection fees: When you buy a property, you should hire a professional to thoroughly check it out. Good inspectors can help you identify problems with the plumbing, heating, electrical systems, foundation, roof, pests like termites, and so on. Property inspections typically cost at least a few hundred dollars up to $1,000 for larger homes.
• Moving expenses: Moving costs vary wildly, but you can count on spending hundreds to thousands of dollars. Costs increase with the distance you have to go and the amount of stuff you have, of course.
• Mortgage costs: The costs of getting a mortgage include such items as the points (up-front interest — about 1 percent to 2 percent of the loan amount), application and credit report fees, and appraisal fees.
• Title insurance: When you buy a home, you and your lender will want to protect yourselves against the small probability that the property seller doesn’t actually legally own the home that you’re buying. Title insurance protects you financially from unscrupulous sellers. Although title insurance costs vary by area, 0.5 percent of the purchase price of the property is about average.

On top of all these transaction costs of buying and then selling a home, you face maintenance expenses — repairs, cosmetic work, and so on — during your years of home ownership. To cover the typical transaction and maintenance costs of homeownership, the value of your home needs to appreciate about 15 percent over the years that you own it for you to be as well off financially as if you’d continued renting. Counting on that kind of appreciation in case you need or want to move elsewhere in a few years is risky.

Some people invest in real estate even when they don’t expect to live in the home long, and they may consider turning their home into a rental if they move within a few years. Doing so can work well financially in the long haul, but don’t underestimate the responsibilities that come with rental property. See the section “Investing in Investment Real Estate” later in this chapter.

Deciding when to buy

If you’re considering buying a home, you may be concerned about whether home prices are poised to rise or fall. No one wants to purchase a home that then plummets in value. And who wouldn’t like to buy just before prices zoom higher?

It’s not easy to predict what’s going to happen with real estate prices in a particular town or neighborhood over the next few years. Ultimately, the economic health and vitality of an area drive the demand and prices for homes in that area. An increase in jobs, particularly ones that pay well, increases the demand for housing, and when demand goes up, so do prices.

If you buy your first home when you’re in your 20s or 30s, you will likely be a homeowner for many decades. Over such a long time, you will surely experience numerous ups and downs. But you’ll probably see more ups than downs, so don’t be too concerned about trying to predict what’s going to happen to the real estate market in the near term and whether prices may fall a little. You should do a basic rent-versus-buy comparison, of course, to see whether the properties you’re considering offer decent value or not. A silver lining of the late-2000s decline in home prices is that homes were more affordable than they had been in a long time and offered better value versus renting in many areas.

That said, at particular times in your life, you may be ambivalent about buying a home. Perhaps you’re not sure whether you’ll stay put for five years. Therefore, part of your home-buying decision may hinge on whether current home prices versus the costs of renting in your local area offer you a good value. The state of the job market, the number of home listings for sale, and the level of real estate prices compared with rent are useful indicators of the housing market’s health.

Trying to time your purchase has more importance if you think you may move within a few years. In that case, avoid buying in a market where home prices are relatively high compared with rental costs. If you expect to move so soon, renting generally makes sense because of the high transaction costs of buying and selling real estate.

Getting your financial house in order

To qualify for a mortgage, you need good credit and a stable, reliable source of employment income. Mortgage lenders will tell you the maximum amount that you’re qualified to borrow. Just because they offer you that maximum amount, however, doesn’t mean you should borrow that much.

Buying a home without considering your other monthly expenditures and long-term goals may cause you to end up with a home that dictates much of your future spending. Have you considered, for example, how much you need to save monthly to reach your goals? How about the amount you want to spend on your current lifestyle?

If you want to continue your current lifestyle, you have to be honest with yourself about how much you can really afford to spend as a homeowner. First-time home buyers in particular run into financial trouble when they don’t understand their current spending.

Buying a home can be a wise decision, but it can also be a huge burden. Also, you can buy all sorts of nifty things for a home. Some people prop up their spending habits with credit cards — a dangerous practice. So before you buy a property or agree to a particular mortgage, be sure you can afford to do so and that it fits with your overall plans and desires.

Determining your down payment

When deciding how much to borrow for a home purchase, keep in mind that most lenders require you to purchase private mortgage insurance (PMI) if your down payment is less than 20 percent of your home’s purchase price. PMI protects the lender from getting stuck with a property that may be worth less than the mortgage you owe, in the event that you default on your loan. On a moderate-size loan, PMI can add hundreds of dollars per year to your payments.

If you have to purchase PMI to buy a home with less than 20 percent down, keep an eye on your home’s value and your loan balance. Over time, your property should appreciate, and your loan balance should decrease as you make monthly payments. After your mortgage represents 80 percent or less of the market value of the home, you can get rid of the PMI. Doing so usually entails contacting your lender and paying for an appraisal.

I’ve never liked interest-only loans, which entice cash-strapped buyers with lower monthly payments because all the initial payments go toward interest. These loans typically have higher interest rates and fees than conventional mortgages do, and they cause some buyers to take on more debt than they can handle. (After a certain number of years, the payment amount jumps higher when the principal and interest begin to be repaid together.)

What if you can afford to make more than a 20 percent down payment? How much should you put down then? (This problem is rare; most buyers, especially first-time buyers, struggle to get a 20 percent down payment together.) The answer depends on what else you can or want to do with the money. If you’re considering other investment opportunities, determine whether you can expect to earn a higher rate of return on those other investments versus the interest rate that you’d pay on the mortgage. (Forget about the tax deduction for your mortgage interest. The interest is deductible, but remember that the earnings from your investments are ultimately taxable.)

All investments come with risk. If you prefer to put down just 20 percent and invest more money elsewhere, that’s fine. Just don’t keep the extra money (beyond an emergency reserve) under the mattress, in a savings account, or in bonds with a lower yield than your mortgage’s interest rate. Invest in stocks, real estate, or other growth investments. Otherwise, you don’t have a chance of earning a higher return than the cost of your mortgage; therefore, you’d be better off paying down your mortgage.

Doing lenders’ calculations

Mortgage lenders calculate the maximum amount that you can borrow to buy a home. All lenders want to gauge your ability to repay the money that you borrow, so you have to pass a few tests.

For a home in which you will live, lenders total your monthly housing expenses. They define your housing costs as

Mortgage payment + Property taxes + Insurance

Note: Lenders don’t consider maintenance and upkeep expenses (including utilities) in owning a home, but of course, you will incur these expenses as a homeowner.

Understanding your housing options

If you’re ready to buy a home, to help focus your search, you should make some decisions about what and where to buy. Here are the most common types of housing you will encounter:

• Single-family homes: If you grew up in the suburbs, you probably saw plenty of single-family homes, even if you didn’t live in one. This type of home is a detached house on a piece of land. Lots may be small or large, but the land is 100 percent yours, and the house is separate from other neighboring properties.
• Condominiums: These properties typically are apartment-style units that are on top of and adjacent to one another. Many condo buildings were originally apartments that were converted to condos through the sale of ownership of separate units. When you purchase a condominium, you purchase a specific unit as well as a share of the common areas (the pool, landscaping, entry and hallways, laundry room, and so on).
• Townhomes: Townhomes are attached or row homes. A townhome is essentially a cross between a condominium (because it’s attached, sharing a roof and some walls) and a single-family house (because it has its own yard).

• Cooperatives: Cooperatives (or co-ops) resemble apartment and condominium buildings. When you buy a share in a cooperative, you own a share of the entire building, including some living space. Unlike in a condo, you generally need to get approval from the cooperative association if you want to remodel or rent your unit to a tenant. In some co-ops, you must even gain approval from the association to sell your unit to a proposed buyer.

  Co-ops generally are much harder to obtain loans for and to sell, so I don’t recommend that you buy one unless you get a good deal and are certain you can obtain a loan.

With the exception of single-family homes in the preceding list, the other types of housing are shared housing. This type of housing generally gives you more living space for your dollars. This value makes sense, because a good chunk of the cost of a single-family home is the land on which the home sits. Land is good for decks, recreation, and children’s playgrounds, but you don’t live “in” land the way you do in your home. Shared housing maximizes living space for the housing dollars that you spend.

Another possible benefit of shared housing is that in many situations, you’re not personally responsible for general maintenance. Instead, the homeowners’ association (which you pay into) takes care of it. If you don’t have the time, energy, or desire to keep up a property, shared housing can make sense. Shared housing units may also give you access to recreation facilities, such as a pool, tennis courts, and exercise equipment.

From an investment perspective, shared housing isn’t best. Single-family homes generally appreciate more than shared housing does. Part of the reason for that is that shared housing is easier to build and to overbuild, and the greater supply tends to keep prices from rising as much. On the demand side, single-family homes tend to attract more potential buyers. Most folks, when they can afford it, prefer a stand-alone home, especially for the increased privacy.

If you can afford a smaller single-family home instead of a larger shared-housing unit and don’t balk at maintaining a home, buy a single-family home. Shared housing makes more sense for people who don’t want to deal with maintenance and who value the security of living in a larger building with other folks. (Recognize that you may not like or even feel comfortable with everyone living in a given shared housing complex.) Shared-housing prices tend to hold up better in developed urban environments. If possible, avoid shared housing units in suburban areas, where the availability of developable land makes building many more units possible, thus increasing the supply of housing and slowing growth in value.

Researching communities

You may have an idea about the type of property and location that interests you or that you think you can afford. Even if you’ve lived in an area for a while and think that you know it well, be sure to explore different types of properties in a variety of locations before you start to narrow your search.

Thinking that you can know what an area is like from anecdotes or from a small number of personal experiences can be a mistake. Anecdotes and people’s perceptions often aren’t accurate reflections of the facts. Check out the following key items in an area you’re considering:

• Amenities: Ideally, you don’t spend all your time at work, slaving away to make your monthly mortgage payment. I hope you have time to use parks, recreation facilities, and so on. Walk and drive around the neighborhoods you’re interested in to get a sense of these attractions. Most real estate agents enjoy showing their favorite neighborhoods. Talk to folks you know in the areas you’re considering. Visit those cities’ and towns’ websites.
• Catastrophic risks: Are the neighborhoods in which you’re considering buying a home prone to floods, tornadoes, mudslides, fires, or earthquakes? Although homeowner’s insurance, with proper supplements, can protect you financially, consider how you may deal with such catastrophes emotionally. Insurance addresses only the financial pain of a home loss. You can’t eliminate all risks, but you can get educated about catastrophic risks. The U.S. Geological Survey (www.usgs.gov) has maps that show earthquake risks, and the Federal Emergency Management Agency (www.fema.gov) has flood-risk maps. Insurance companies and agencies can also tell you what they know about risks in particular areas.
• Crime: Cities and towns keep all sorts of crime statistics for neighborhoods, so use them! Call the local police department, or get local crime data online at sites like www.neighborhoodscout.com.
• Development: Check with the planning office in towns that you’re considering living in to find out what types of new developments and major renovations are in the works. Planning people may also be aware of problems in particular areas.
• Property taxes: What will your property taxes be? Property tax rates vary from community to community. Check with the town’s assessment office or with a good real estate agent.

• Schools: If you have kids, you care about this issue a lot. Unfortunately, many people make snap judgments about school quality without getting the facts. Visit schools, talk to parents and teachers, and discover what goes on at the schools.

  Consider school quality even if schools aren’t important to you, because they can affect the resale value of your property.

Checking out and valuing a home

Over many months, you may see dozens of homes for sale. Use these viewings as an opportunity to find out what specific homes are worth. Odds are that the listing price isn’t what a house is actually worth. Property that’s priced to sell usually does sell. Properties left on the market are often overpriced. The listing prices of such properties may reflect what an otherwise greedy or uninformed seller and his or her agent hope that some fool will pay.

Of the properties that you see, keep track of the prices they end up selling for. (Good agents can provide this information.) Properties usually sell for less than the listed price. Keeping track of selling prices gives you a good handle on what properties are really worth and a better sense of what you can afford.

After you set your sights on a home you like, thoroughly check out the surroundings. Go back to the neighborhood in which the property is located at different times of the day and on different days of the week. Knock on some doors, and meet your potential neighbors. Ask questions. Talk to property owners as well as renters. Because they don’t have a financial stake in the area, renters are often more forthcoming with negative information about an area.

After you decide where and what to buy, you’re ready to try to put a deal together. To do so, you need to understand mortgages, negotiations, and inspections. I cover these issues and many more in the latest edition of Home Buying Kit For Dummies (Wiley), which I cowrote with Ray Brown.

Understanding real estate investment’s appeal

Many people build their wealth by investing in real estate. Some people focus exclusively on property investments, but many others build their wealth through the companies they started or through other avenues and then diversify into real estate investments.

Real estate, like all investments, has its pros and cons. Investing in real estate is time-intensive and carries risks. Do it because you enjoy the challenge and because you want to diversify your portfolio. Don’t take this route because you seek a get-rich-quick outlet. Here are some of the reasons why people pursue real estate investments:

• Ability to add value: Perhaps you can fix up a property or develop it further and raise the rental income and resale value. Through legwork, persistence, and good negotiating skills, you may also be able to make money by purchasing a property below its fair market value.
• Appreciation and income: You can make money from investment real estate through appreciation and from rental income in excess of your expenses. The appreciation of your properties compounds without taxation during your ownership. You don’t pay tax on this profit until you sell your property, and even then, you can roll over your gain into another investment property to avoid paying tax. The federal tax rate on gains from property held more than one year (known as long-term capital gains) are taxed a reduced rate — currently, a maximum of 20 percent (and possibly an additional 3.8 percent if you’re a high income earner subject to the Obamacare investment income surtax). You also seek to rent out your investment property at a profit based on the property’s rental income in excess of its expenses (mortgage, property taxes, insurance, maintenance, and so on). Over time, your operating profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than your expenses.
• Leverage: Real estate is different from most other investments because you can generally borrow up to 75 percent of the value of the property to buy it. Thus, you can use your down payment of 25 percent of the purchase price to buy, own, and control a much larger investment; this concept is called leverage. You hope, of course, that the value of your real estate goes up; if it does, you make money on your original dollars invested as well as on the money that you borrowed. Leverage can also work against you when prices decline.
• Limited land: There’s a limited supply of buildable, desirable land, and as the population grows, demand for land and housing continues to grow. Land and what you can do with it are what make real estate valuable.
• Longer-term focus: One problem with investing in the stock market is that prices are constantly changing. Because all you need to do is tap your phone app, click your computer mouse, or call a toll-free phone number to place your sell or buy order, some stock market investors fall prey to irrational snap judgments. While the real estate market is constantly changing, short-term, day-to-day, and week-to-week changes are invisible (although some real estate–pricing websites are calculating updated prices, of questionable accuracy, more often). If prices do decline over months and years, you’re much less likely to sell real estate in a panic. Preparing a property for sale and eventually getting it sold take a good deal of time, and this barrier to selling quickly helps you keep your perspective.

Sizing up real estate investment options

If you think you’re cut out to be a landlord and are ready for the responsibility of buying, owning, and managing rental real estate, you have numerous real estate investment options to choose among.

Some investors prefer to buy properties, improve them, and then move on. Ideally, however, you should plan to make real estate investments that you hold for many years, perhaps into your retirement years. But what should you buy? Following is my take on various real estate investments.

Conducting real estate investing research

In the following sections, I explain what to look for in a community and area where you seek to invest in real estate. Investing in real estate closer to home is best because you’re probably more familiar with the local area, allowing you to have an easier time researching and managing the properties.