Chapter 10

Investing in a Home

In This Chapter

Using homeownership to meet financial goals

Deciding whether to rent or buy

Determining how much you can afford

Finding the best properties to purchase

For most people, buying a home in which to live is their first, best, and only real estate investment. Homes may require a lot of financial feeding, but over the course of your life, owning a home (instead of renting) can make and save you money. Although the pile of mortgage debt seems daunting in the years just after your purchase, someday your home’s equity (the market value of the home minus the outstanding mortgage debt) may be among your biggest assets.

And, yes, real estate is still a good investment despite its declines in the late 2000s in many areas. Like stocks, real estate does well over the long term but doesn’t go continuously higher (see my website at www.erictyson.com for up-to-date, long-term graphs of housing prices in different parts of the U.S.). Smart investors take advantage of down periods; they consider these periods to be times to buy at lower prices just like they do when their favorite retail stores are having a sale.

Considering How Home Ownership Can Help You Achieve Your Financial Goals

Even though your home consumes a lot of dough (mortgage payments, property taxes, insurance, maintenance, and so on) while you own it, it can help you accomplish important financial goals:

• Retiring: By the time you hit your 50s and 60s, the size of your monthly mortgage payment, relative to your income and assets, should start to look small or nonexistent. Lowered housing costs can help you afford to retire or cut back from full-time work. Some people choose to sell their homes and buy less-costly ones or to rent the homes out and use some or all of the cash to live on in retirement. Other homeowners enhance their retirement income by taking out a reverse mortgage to tap the equity that they’ve built up in their properties.
• Pursuing your small-business dreams: Running your own business can be a source of great satisfaction. Financial barriers, however, prevent many people from pulling the plug on a regular job and taking the entrepreneurial plunge. You may be able to borrow against the equity that you’ve built up in your home to get the cash you need to start your own business. Depending on what type of business you have in mind, you may even be able to run your enterprise from your home. (I discuss small-business issues in Part IV.)
• Financing college: It may seem like only yesterday that your kids were born, but soon enough they’ll be ready for an expensive four-year undertaking: college. Borrowing against the equity in your home is a viable way to help pay for your kids’ educational costs.

Perhaps you won’t use your home’s equity for retirement, a small business, educational expenses, or other important financial goals. But even if you decide to pass your home on to your children, a charity, or a long-lost relative, it’s still a valuable asset and a worthwhile investment. This chapter explains how to make the most of it.

The Buying Decision

I believe that most people should buy and own a home. But homeownership isn’t for everybody and certainly not at all times in your adult life.

The decision of if and when to buy a home can be complex. Money matters, but so do personal and emotional issues. Buying a home is a big deal — you’re settling down. Can you really see yourself coming home to this same place day after day, year after year? Of course, you can always move, but doing so, especially within just a few years of purchasing the home, can be costly and cumbersome, and now you’ve got a financial obligation to deal with.

Weighing the pros and cons of ownership

Some people — particularly enthusiastic salespeople in the real estate business — believe everybody should own a home. You may hear them say things like “Buy a home for the tax breaks” or “Renting is like throwing your money away.”

As I discuss later in this chapter, the bulk of homeownership costs — namely, mortgage interest and property taxes — are tax-deductible. However, these tax breaks are already largely factored into the higher cost of owning a home. So don’t buy a home just because of the tax breaks. (If such tax breaks didn’t exist, housing prices would be lower because the effective cost of owning would be so much higher. I wouldn’t be put off by tax reform discussions that mention eliminating home-buying tax breaks — though the odds of these reforms passing are slim to none.)

Renting isn’t necessarily equal to “throwing your money away.” In fact, renting can have a number of benefits, such as the following:

• In some communities, with a given type of property, renting is less costly than buying. Happy and successful renters I’ve seen include people who pay low rent, perhaps because they’ve made housing sacrifices. If you can sock away 10 percent or more of your earnings while renting, you’re probably well on your way to accomplishing your future financial goals.
• You can save money and hopefully invest in other financial assets. Stocks, bonds, and mutual and exchange-traded funds (see Part II) are quite accessible and useful in retirement. Some long-term homeowners, by contrast, have a substantial portion of their wealth tied up in their homes. (Remember: Accessibility is a double-edged sword because it may tempt you as a cash-rich renter to blow the money in the short term.)
• Renting has potential emotional and psychological rewards. The main reward is the not-so-inconsequential fact that you have more flexibility to pack up and move on. You may have a lease to fulfill, but you may be able to renegotiate it if you need to move on. As a homeowner, you have a major monthly payment to take care of. To some people, this responsibility feels like a financial ball and chain. After all, you have no guarantee that you can sell your home in a timely fashion or at the price you desire if you want to move.

Although renting has its benefits, renting has at least one big drawback: exposure to inflation. As the cost of living increases, your landlord can keep increasing your rent (unless you live in a rent-controlled unit). If you’re a homeowner, however, the big monthly expense of the mortgage payment doesn’t increase, assuming that you buy your home with a fixed-rate mortgage. (Your property taxes, homeowners insurance, and maintenance expenses are exposed to inflation, but these expenses are usually much smaller in comparison to your monthly mortgage payment or rent.)

Here’s a quick example to show you how inflation can work against you as a long-term renter. Suppose that you’re comparing the costs of owning a home that costs $160,000 to renting a similar property for $800 a month. (If you’re in a high-cost urban area and these numbers seem low, please bear with me and focus on the general insights, which you can apply to higher-cost areas.) Buying at $160,000 sounds a lot more expensive than renting for $800, doesn’t it? But this isn’t an apples-to-apples comparison. You must compare the monthly cost of owning to the monthly cost of renting. You must also factor the tax benefits of homeownership in to your comparison so that you compare the after-tax monthly cost of owning versus renting (mortgage interest and property taxes are tax-deductible). Figure 10-1 does just that over 30 years.

As you can see in Figure 10-1, although owning costs more in the early years, it should be less expensive in the long run. Renting is costlier in the long term because all your rental expenses increase with inflation. Note: I haven’t factored in the potential change in the value of your home over time. Over long periods of time, home prices tend to appreciate, which makes owning even more attractive.

The example in Figure 10-1 assumes that you make a 20 percent down payment and take out a 7 percent fixed-rate mortgage to purchase the property. It also assumes that the rate of inflation of your homeowners insurance, property taxes, maintenance, and rent is 4 percent per year. If inflation is lower, renting doesn’t necessarily become cheaper in the long term. In the absence of inflation, your rent should escalate less, but your homeownership expenses, which are subject to inflation (property taxes, maintenance, and insurance), should increase less, too. And with low inflation, you can probably refinance your mortgage at a lower interest rate, which reduces your monthly mortgage payments. With low or no inflation, owning can still cost less, but the savings versus renting usually aren’t as dramatic as when inflation is greater.

Recouping transaction costs

Financially speaking, I recommend that you wait to buy a home until you can see yourself staying put for a minimum of three years. Ideally, I’d like you to think that you have a good shot of staying with the home for five or more years. Why? Buying and selling a home cost big bucks, and you generally need at least five years of low appreciation to recoup your transaction costs. Some of the expenses you face when buying and selling a home include the following:

• Inspection fees: You shouldn’t buy a property without thoroughly checking it out, so you’ll incur inspection expenses. Good inspectors can help you identify problems with the plumbing, heating, and electrical systems. They also check out the foundation, roof, and so on. They can even tell you whether termites are living in the house. Property inspections typically cost a few hundred dollars up to $1,000 for larger homes.
• Loan costs: The costs of getting a mortgage include items such as the points (upfront interest that can run 1 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 need to protect yourselves against the chance — albeit small — that the property seller doesn’t actually legally own the home that you’re buying. That’s where title insurance comes in — it protects you financially from unscrupulous sellers. Title insurance costs vary by area; 0.5 percent of the purchase price of the property is about average.
• Moving costs: You can transport all your furniture, clothing, and other personal belongings yourself, but your time is worth something, and your moving skills may be limited. Besides, do you want to end up in a hospital emergency room after being pinned at the bottom of a staircase by a runaway couch? Moving costs vary wildly, but you can count on spending hundreds to thousands of dollars.
• Real estate agents’ commissions: A commission of 5 to 7 percent of the purchase price of most homes is paid to the real estate salespeople and the companies they work for.

On top of all these transaction costs of buying and then selling a home, you’ll also face maintenance expenses — for example, fixing leaky pipes and painting. To cover all the 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 had continued renting. Fifteen percent! If you need or want to move elsewhere in a few years, counting on that kind of appreciation in those few years is risky. If you happen to buy just before a sharp rise in housing prices, you may get this much appreciation in a short time. But you can’t count on this upswing — you’re more likely to lose money on such a short-term deal.

Some people invest in real estate even when they don’t expect to live in the home for 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, which I discuss in Chapter 11.

Deciding How Much to Spend

Buying a home is a long-term financial commitment. You’ll probably take out a 15- to 30-year mortgage to finance your purchase, and the home that you buy will need maintenance over the years. So before you decide to buy, take stock of your overall financial health.

If you have good credit and a reliable source of employment, lenders will eagerly offer to loan you money. They’ll tell you how much you may borrow from them — the maximum that you’re qualified to borrow. Just because they offer you that maximum amount, however, doesn’t mean that you should borrow the maximum.

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 retirement goals? How about the amount you want to spend on recreation and entertainment?

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 homebuyers 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. And you can buy all sorts of nifty things for a home. Some people prop up their spending habits with credit cards — a dangerous practice.

Don’t let your home control your financial future. Before you buy a property or agree to a particular mortgage, be sure that you can afford to do so — be especially careful not to ignore your retirement planning (if you hope to someday retire). Start by reading Chapter 3. After reading the following sections, you can also check out Chapter 12, where I cover mortgages and financing options in greater detail.

Looking through lenders’ eyes

Mortgage lenders calculate the maximum amount that you can borrow to buy a piece of real estate. 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 reside, lenders total your monthly housing expenses. They define your housing costs as

Mortgage payment + property taxes + insurance

A lender doesn’t consider maintenance and upkeep expenses (including utilities) in owning a home. Although lenders may not care where you spend money outside your home, they do care about your other debt. A lot of other debt, such as credit cards or auto loans, diminishes the funds that are available to pay your housing expenses. Lenders know that having other debt increases the possibility that you’ll fall behind or actually default on your mortgage payments.

If you have consumer debt (for example, credit cards, auto loans, and so on) that requires monthly payments, lenders calculate another ratio to determine the maximum that you can borrow. Lenders add the amount that you need to pay down your other consumer debt to your monthly housing expense.

Consumer debt is bad news even without considering that it hurts your qualification for a mortgage. This type of debt is costly and encourages you to live beyond your means. Unlike the interest on mortgage debt, consumer debt interest isn’t tax-deductible. Get rid of it — curtail your spending and adjust to living within your means. If you can’t live within your means as a renter, doing so is going to be even harder as a homeowner.

Determining your down payment

When deciding how much to borrow for a home, 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 take 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.

As I’ve said in the earlier editions of this book, I have never been a fan of interest-only loans, which entice cash-strapped buyers with lower monthly payments, because all the initial payments go toward interest. These loans typically have worse terms (interest rate and fees) than conventional mortgages and cause some buyers to take on more debt than they can handle. After a number of years, the payment amount jumps higher when the principal and interest begin to be repaid together.

What if you have so much money that you can afford to make more than a 20 percent down payment? How much should you put down then? (This problem doesn’t usually arise — 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.

During the past century, stock market and real estate investors have enjoyed average annual returns of around 9 percent per year. So if you borrow mortgage money at around 5 to 6 percent, in the long term you should come out a few percent ahead if you use the money you would have put toward a larger down payment to invest in such growth investments. You aren’t guaranteed, of course, that your investments will earn 9 percent yearly. (Remember that past returns don’t guarantee the future.) And don’t forget that all investments come with risk. The advantage of putting more money down and borrowing less is that it’s essentially a risk-free investment (as long as you have adequate insurance on your property).

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 that pay less interest than your mortgage costs you in interest. Invest in stocks, real estate, or a small business. Otherwise, you don’t have a chance at earning a higher return than the cost of your mortgage, and you’d therefore be better off paying down your mortgage.

Selecting Your Property Type

If you’re ready to buy a home, you must make some decisions about what and where to buy. If you grew up in the suburbs, your image of a home may include the traditional single-family home with a lawn, kids, and family pets. But single-family homes, of course, aren’t the only or even the main type of residential housing in many areas, especially in some higher-cost, urban neighborhoods. Other common types of higher-density (“shared”) housing include the following:

• Condominiums: Condominiums are generally apartment-style units that are stacked on top of and adjacent to one another. Many condo buildings were originally apartments that were converted — through the sale of ownership of separate units — into condos. When you purchase a condominium, you purchase a specific unit as well as a share of the common areas (for example, the pool, landscaping, entry and hallways, laundry room, and so on).
• Townhomes: Townhome is just a fancy way of saying attached or row home. Think of a townhome as a cross between a condominium and a single-family house. Townhomes are condolike because they’re attached (generally sharing walls and a roof) and are homelike because they’re often two-story buildings that come with a small yard.
• Cooperatives: Cooperatives (usually called 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 for the sale of your unit to a proposed buyer. Co-ops are generally 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 can easily obtain a loan.

All types of shared housing in the preceding list offer two potential advantages:

• This type of housing generally gives you more living space for your dollars. This value makes sense because with a single-family home, a good chunk of the property’s cost is for the land that the home sits on. Land is good for decks, recreation, and playing children, but you don’t live “in” it the way you do with your home. Shared housing maximizes living space for the housing dollars that you spend.
• 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.

So why doesn’t everyone purchase shared housing? Well, as investments, single-family homes generally outperform other housing types. Shared housing is easier to build (and to overbuild) — and the greater supply tends to keep its prices from rising as much. Single-family homes tend to attract more potential buyers — most people, when they can afford it, prefer a standalone 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 shudder at the thought of maintaining a home, buy the single-family home. Shared housing makes more sense for people who don’t want to deal with building maintenance and who value the security of living in a larger building with other people. Keep in mind that 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 values.

If shared housing interests you, make sure that you have the property thoroughly inspected. Also, examine the trend in maintenance fees over time to ensure that these costs are under control. (See Chapter 11 for specifics on how to check out property.)

Finding the Right Property and Location

Some people know where they want to live, so they look at just a handful of properties and then buy. Most people take much more time; finding the right house in a desired area at a fair price can take a lot of time. Buying a home can also entail much compromise when you buy with other family members, particularly spouses.

Be realistic about how long it may take you to get up to speed about different areas and to find a home that meets your various desires. If you’re like most people and have a full-time job that allows only occasional weekends and evenings to look for a house, three to six months is a short time period to settle on an area and actually find and successfully negotiate on a property. Six months to a year isn’t unusual or slow. Remember that you’re talking about an enormous purchase that you’ll come home to daily.

Real estate agents can be a big barrier to taking your time with this monumental decision. Some agents are pushy and want to make a sale and get their commission. Don’t work with such agents as a buyer — they can make you miserable, unhappy, and broke. If necessary, begin your search without an agent to avoid this outside pressure. See Chapter 12 for additional information on working with an agent.

Keeping an open mind

Before you start your search for a new home, you may have an idea about the type of property and location that interests you or that you think you can afford. You may think, for example, that you can only afford a condominium in the neighborhood that you want. But if you take the time to check out other communities, you may find another area that meets most of your needs and has affordable single-family homes. You’d never know that, though, if you narrowed down your search too quickly.

Even if you’ve lived in an area for a while and think that you know it well, look at different types of properties in a variety of locations before you start to narrow down your search. Be open-minded and make sure that you know which of your many criteria for a home you really care about. You’ll likely have to be flexible with some of your preferences.

After you focus on a particular area or neighborhood, make sure you see the full range of properties available. If you want to spend $200,000 on a home, look at properties that are more expensive. Most real estate sells for less than its listing price, and you may feel comfortable spending a little bit more after you see what you can purchase if you stretch your budget a little bit. Also, if you work with an agent, make sure that you don’t overlook homes that are for sale by their owners (that is, properties not listed with real estate agents). Otherwise, you may miss out on some good prospects.

Research, research, research

Thinking that you can know what an area is like from anecdotes or from a small number of personal experiences is a mistake. You may have read or heard that someone was mugged in a particular area. That incident doesn’t make that area dangerous — or more dangerous than others. Get the facts. Anecdotes and people’s perceptions often aren’t accurate reflections of the facts. Check out the following key items in an area:

• Amenities: Hopefully, you don’t spend all your time at work, slaving away to make your monthly mortgage payment. I hope that you have time to use parks, sports and recreation facilities, and so on. You can drive around the neighborhood you’re interested in to get a sense of these attractions. Most real estate agents just love to show off their favorite neighborhoods. Websites for cities and towns detail what they have to offer and where you can find it.
• Schools: If you have kids, you care about this issue a lot. Unfortunately, many people make snap judgments about school quality without doing their homework. Visit the schools and don’t blindly rely on test scores. Talk to parents and teachers and discover what goes on at the schools.

  If you don’t have (or want!) school-age children, you may be tempted to say, “What the heck does it matter about the quality of the schools?” You need to care about the schools because even if you don’t have kids, the quality of the local schools and whether they’re improving or faltering affects property values. Consider schooling issues even if they’re not important to you, because they can affect the resale value of your property.

• 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.
• Crime: Call the local police department or visit your public library to get the facts on crime. Cities and towns keep all sorts of crime statistics for neighborhoods — use them!
• Future development: Check with the planning department in towns that you’re considering living in to find out what types of new development and major renovations are in the works. Planning people may also be aware of problems in particular areas.
• Catastrophic risks: Are the neighborhoods that you’re considering buying a home in susceptible to major risks, such as floods, tornadoes, mudslides, fires, or earthquakes? Although homeowners insurance can protect you financially, consider how you may deal with such catastrophes emotionally. Insurance eases only the financial pain of a home loss. All areas have some risk, and a home in the safest of areas can burn to the ground. Although you can’t eliminate all risks, you can at least educate yourself about the potential catastrophic risks in various areas.

  If you’re new to an area or don’t have a handle on an area’s risks, try a number of different sources. Knowledgeable and honest real estate agents may help, but you can also dig for primary information. For example, the U.S. Geologic Survey (USGS) puts together maps that help you see potential earthquake risks by area. The USGS maintains offices all around the country — check your local phone directory in the government White Pages section (or visit the agency online at www.usgs.gov). The Federal Emergency Management Agency (FEMA) provides maps that show flood risk areas. (Call FEMA at 800-358-9616 or check its website at www.fema.gov.) Insurance companies and agencies can also tell you what they know about risks in particular areas.

Understanding market value

Over many months, you’ll look at perhaps dozens of properties for sale. Use these viewings as an opportunity to find out what specific homes are worth. The listing price isn’t what a house is worth — it may be, but odds are it’s not. Property that’s priced to sell usually does just that: It sells. Properties left on the market are often overpriced. The listing price on such properties may reflect what an otherwise greedy or uninformed seller and his agent hope that some fool will pay.

Of the properties that you see, keep track of the prices that 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.

Pounding the pavement

After you set your sights on that special home, thoroughly check out the surroundings — you should know what you’re getting yourself into.

At different times of the day and on different days of the week, go back to the neighborhood in which the property is located. Knock on a few doors and meet your potential neighbors. Ask questions. Talk to property owners as well as renters. Because renters don’t have a financial stake in the area, they’re 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. I cover issues common to both home and investment property purchases — such as mortgages, negotiations, inspections, and so on — in Chapter 12.