Seeing the benefits of renting

Although owning a home and investing in real estate generally pay off well over the long term, renting has its advantages. Some of the financially successful renters I’ve met include people who pay relatively low rent, either because they live in modest housing and/or have roommates, or they live in a rent-controlled building. Some young adults live with a family member who provides them with a great deal on rent, which can have benefits. If you can consistently save 10 percent or more of your earnings, which you may be able to do through a low-cost rental, you’re probably on track to achieving your financial goals.

Renting has the following pros:

• You can avoid worrying about or being responsible for fixing up the property. Your landlord is responsible.
• You have more financial and psychological flexibility. You may not be sure that you’ll stay with your current employer or chosen career, and you may change direction in the future and not want the financial overhead that comes with a mortgage. And if you want to move, you can generally do so a lot more easily as a renter than you can as a homeowner.
• You can have all your money in financial assets that you can tap into more easily. Some people enter their retirement years with a substantial portion of their wealth tied up in their home, a challenge that you don’t face when renting over the long haul. Homeowners who have equity (the difference between the market value of the property and the debt owed on it) tied up in a home at retirement can downsize to a less-costly property to free up cash and/or take out a reverse mortgage on their home equity.

Considering the long-term costs of renting

When you crunch the numbers to find out what owning rather than renting a comparable place may cost you on a monthly basis, you may discover that owning isn’t as expensive as you thought. Or you may find that owning costs more than renting. This discovery may tempt you to think that, financially speaking, renting is cheaper than owning.

Be careful not to jump to conclusions. Remember that you’re looking at the cost of owning versus renting today. What about 10, 20, or 30 years from now? As an owner, your biggest monthly expense — the mortgage payment — doesn’t increase, assuming that you have a fixed-rate mortgage (for an explanation of fixed-rate and other types of mortgages, see the “Understanding your mortgage options” section later in the chapter). Your property taxes, homeowner’s insurance, and maintenance expenses, which are generally far less than your mortgage payment, should only increase with the cost of living. And remember that as a homeowner you build equity in your property; that equity can be significant by your retirement.

When you rent, however, your entire monthly rent is subject to inflation. (Living in a rent-controlled unit, where the annual increase allowed in your rent is capped, is the exception to this rule.)

Completing your rental application

When you’re in the market for a rental, you’ll probably complete an application. You’ll be asked to provide such information as your name, current address, date of birth, occupation, employer, banking information, credit history, current landlord and rental terms, and a couple of references.

Here are some tips to keep in mind as you’re completing your rental application:

• Put your best foot forward. Just as a good résumé helps you interest an employer and land a job, your rental application helps you secure a place to live. So, it’s important to fill it out accurately and completely. Does that mean you need to list everything on it, including less-than-flattering information? As with your résumé, tell the truth but remember the advertising value of the document.

  With regards to other sources of income, you’re under no obligation to detail alimony, child support, or your spouse’s annual income unless you want that information considered in your application.

• Recognize that you’re authorizing the release of personal and confidential information. Rental applications generally have a section requiring your signature, stating, “I authorize an investigation of my credit, tenant history, banking, and employment for the purposes of renting a house, apartment, or condominium from this owner, manager, brokerage, finder, agent, or leasing company.”
• Consider the length of the lease commitment. Most landlords prefer tenants who are stable renters and who remain for long periods of time (years, not months). Especially if you may want to move to buy a place or relocate for a future job, having a one-year lease that goes month to month after the first year is a good compromise. If you don’t expect to stay much more than a year or two, that’s probably better left unsaid. Remember, landlords generally want long-term tenants.
• Remember lease agreements are negotiable. Landlords will present you with a standard lease form and hope that you simply accept and sign it, which many people do. Legal agreements don’t make for scintillating reading and are often intimidating for non-lawyerly types! Please take the time to read the proposed lease agreement so that you know what you’re potentially agreeing to. Ask questions about things you don’t understand. And please remember that you can and should negotiate, especially if your local rental market is a bit slow or you’re considering a lease that seems a tad expensive for what it is. Ask if there are any promotions (for example, free month’s rent).
• Rent where you might like to buy. If you’re getting close to wanting to buy your own home, try renting in (or at least near) the area in which you think you’d most like to buy. What better way to test out whether you’ll actually enjoy living in an area?

Deciding to buy

Before you determine whether you want to actually buy a home, you want to figure out how long you plan on living in the home.

Financially speaking, buying a home begins to make more financial sense if you anticipate being there for three to five years or more. Buying and selling a property entails a lot of expenses, including the cost of getting a mortgage (points; application and appraisal fees), inspection expenses, moving costs, real-estate agents’ commissions, and title insurance. To cover these transaction costs plus the additional costs of ownership, a property needs to appreciate about 15 percent during the tenure of your ownership.

If you need or want to move in a couple of years, counting on 15 percent appreciation is risky. If you’re fortunate and you happen to buy before a sharp upturn in housing prices, you may get it. Otherwise, you’ll lose money on the deal.

Comparing the costs of owning versus renting

Some people assume that owning costs more than renting, but owning doesn’t have to cost a lot. Owning may even cost less than renting in some geographic areas, especially with the opportunity to buy at lower prices that may occur after a decline in home values (usually around the time of a recession). After the 2008 financial crisis and decline in home values throughout the country, there were attractive values in many areas through and beyond the early 2010s for example.

Buying seems a lot more expensive than renting if you compare your monthly rent (from hundreds of dollars to more than $1,000, depending on where you live) to a property’s purchase price, which is usually a much larger number — perhaps $100,000 to $250,000. But you must compare the expenses the same way. When you consider a home purchase, you’re forced to think about your housing expenses in one huge chunk rather than in a monthly rent check.

To make a fair comparison between ownership and rental costs, figure what it costs on a monthly basis to buy a place you desire versus what it costs in monthly rent for a comparable place. Remember that mortgage interest and property tax payments for your home are generally tax-deductible subject to certain limitations. The worksheet in Table 7-1 enables you to do a monthly rent versus buy cost comparison.

Now compare Line 9 in Table 7-1 with the monthly rent on a comparable place to see which costs more — owning or renting.

Considering your overall financial health

Before you buy a property and agree to a particular mortgage, take stock of your overall financial health (especially where you stand in terms of retirement planning). Don’t trust a lender when he tells you what you can “afford” according to some formulas the bank uses to figure out what kind of a credit risk you are.

To determine how much a potential home buyer can borrow, lenders look primarily at annual income; they pay no attention to some major aspects of a borrower’s overall financial situation. Even if you don’t have money tucked away in retirement savings, or you have several children to clothe, feed, and help put through college, or you want to financially help your elderly parents, you still qualify for the same size loan as other people with the same income (assuming equal outstanding debts).

Calculating how much you can borrow

One general rule says you can borrow up to about three times your annual income when buying a home. But, the maximum that a mortgage lender will loan you depends on interest rates. If rates fall, the monthly payment on a mortgage also drops. Thus, lower interest rates make real estate more affordable.

To determine how much they’re willing to lend you, lenders start by totaling up your monthly housing expenses for a given home. They define your housing costs as

mortgage payment + property taxes + homeowner’s insurance

Lenders typically loan you up to about 35 to 40 percent of your monthly gross (before taxes) income for the housing expense. (If you’re self-employed, take your net income from the bottom line of your federal tax form Schedule C and divide by 12 to get your monthly gross income.)

Lenders also consider your other debts when deciding how much to lend you. These debts diminish the funds available to pay your housing expenses. Lenders add the amount you need to pay down your other consumer debts (such as auto loans and credit cards) to your monthly housing expense. The total monthly costs of these debt payments plus your housing costs typically can’t exceed 40 to 45 percent.

Accumulating your down payment

You generally qualify for the most favorable mortgage terms by making a down payment of at least 20 percent of the property’s purchase price. In addition to saving money on interest, you can avoid the added cost of private mortgage insurance (PMI) by putting down this much. To protect against their losing money in the event you default on your loan, lenders usually require PMI, which costs several hundred dollars per year on a typical mortgage. (PMI compensates the lender in the event that it has to take over the property and the property ends up being worth less than the outstanding mortgage on it.)

Many folks, especially folks in their 20s, don’t have enough cash on hand to make a 20 percent down payment on a home to avoid paying PMI. Here are a number of solutions for coming up with that 20 percent faster or for buying with less money down:

• Minimize your spending. See Chapter 5 for ideas.
• Consider lower-priced properties. Smaller properties and ones that need some work can help keep down the purchase price and, therefore, the required down payment.
• Find financial partners. Draft a legal contract to specify what happens if a partner wants out, divorces, or passes away.
• Seek reduced down-payment financing. Some property owners or developers may be willing to finance your purchase with 10 percent down, although you can’t be as picky about properties because not as many are available under these terms — many need work or haven’t been sold yet for other reasons.
• Check out the USDA’s Single Family Housing Guaranteed Loan Program. Another way to buy a home with no down payment and a low interest rate in “rural” areas is via the USDA’s Single Family Housing Guaranteed Loan Program (https://www.rd.usda.gov/programs-services/single-family-housing-guaranteed-loan-program). These properties are not limited to what one would typically think of as “rural” areas (think more broadly about non-urban areas) and while there are income limits, many young people qualify.
• Get family assistance. If your parents, grandparents, or other relatives have money dozing away in a bank or similar low-interest account, they may be willing to lend (or even give) you the down payment.

For more home-buying strategies, get a copy of the latest edition of Home Buying Kit For Dummies (Wiley), which I coauthored with real-estate guru Ray Brown.

Understanding your mortgage options

Three major types of mortgages exist — those with a fixed interest rate, those with a variable or adjustable rate, and those that are a combination of the two.

• Fixed-rate mortgages: These are usually issued for a 15- or 30-year period and have interest rates that don’t change over the life of the mortgage. Because the interest rate stays the same, your monthly mortgage payment amount doesn’t change. With a fixed-rate mortgage, you have no uncertainty or interest-rate worries.

• Adjustable-rate mortgages (ARM): In contrast to a fixed-rate mortgage, an adjustable-rate mortgage (ARM) carries an interest rate that varies over time. Thus, the size of your monthly payment fluctuates. Because a mortgage payment makes an unusually large dent in most homeowners’ checkbooks anyway, signing up for an ARM without understanding its risks is dangerous.

  So why would anyone want an ARM? Some home buyers are attracted to the potential savings, especially during the first few years of an adjustable loan, when the interest rate is typically lower than it is on a comparable fixed-rate loan.

• Hybrid mortgages: This type of mortgage combines features of both the fixed- and adjustable-rate mortgages. For example, the initial rate may hold constant for three to five years and then adjust once a year or every six months thereafter.

Deciding which mortgage type is best for you

You should weigh the pros and cons of each mortgage type and consider these issues to determine whether a fixed or adjustable mortgage is best for you. Think about the following questions to make that determination:

• How much risk can you handle with the size of your monthly mortgage payment? You can’t afford much risk, for example, if your job and income are unstable and you need to borrow a lot or you have little slack in your monthly budget. If you’re in this situation, stick with a fixed-rate loan. If interest rates rise, how will you afford the monthly payments — much less all the other expenses of home ownership? And don’t forget to factor in reasonably predictable future expenses that may affect your ability to make payments. For example, are you planning to start a family soon? If so, your income may fall while your expenses rise (as they surely will).

  If you can’t afford the highest allowed payment on an adjustable-rate mortgage, don’t take it. You shouldn’t accept the chance that the interest rate may not rise that high — it might, and then you could lose your home! Ask your lender to calculate the highest possible maximum monthly payment on your loan. That’s the payment you’d face if the interest rate on your loan were to go to the highest level allowed (the lifetime cap).

• How long do you plan to keep the mortgage? The savings on most adjustables is usually guaranteed in the first two or three years, because an adjustable-rate mortgage starts at a lower interest rate than a fixed one. If rates rise, you can end up giving back or losing the savings you achieve in the early years of the mortgage. In most cases, if you aren’t going to keep your mortgage more than five to seven years, you’re probably paying unnecessary interest costs to carry a fixed-rate mortgage.

  You may want to look into a hybrid loan. These loans may make sense for you if you foresee a high probability of keeping your loan seven to ten years or less but want some stability in your monthly payments. The longer the initial rate stays locked in, the higher the rate.

Get a written itemization of charges from all lenders you’re seriously considering so you can more readily compare different lenders’ mortgages and so you have no surprises when you close on your loan. And to minimize your chances of throwing money away on a loan for which you may not qualify, ask the lender whether you may not be approved for some reason. Be sure to disclose any problems you’re aware of that are on your credit report or with the property.

Some lenders offer loans without points (upfront interest) or other lender charges. Remember: If lenders don’t charge points or other fees, they have to make up the difference by charging a higher interest rate on your loan. Consider such loans only if you lack cash for closing or if you’re planning to use the loan for just a few years.

Avoiding negative amortization and interest-only loans

As you make mortgage payments over time, the loan balance you still owe is gradually reduced, a process known as amortizing the loan. The reverse of this process — increasing your loan balance — is called negative amortization. You want to steer clear of negative-amortization mortgages.

Some ARMs allow negative amortization. Your outstanding loan balance can grow even though you’re continuing to make mortgage payments when your mortgage payment is less than it really should be.

Taking on negative amortization is like paying only the minimum payment required on a credit-card bill. You keep racking up greater interest charges on the balance as long as you make only the artificially low payment. Doing so defeats the whole purpose of borrowing an amount that fits your overall financial goals. And you may never get your mortgage paid off! Even worse, the increased interest you start to accrue on the unpaid interest added to your mortgage balance may not be tax-deductible because it doesn’t qualify as interest incurred as part of the original purchase (what the IRS calls the acquisition debt).

The only way to know for certain whether a loan includes negative amortization is to ask. Some lenders aren’t forthcoming about telling you. You find negative amortization more frequently on loans that lenders consider risky. If you’re having trouble finding lenders who are willing to deal with your financial situation, be especially careful.

Some loans cap the increase of your monthly payment but not of the interest rate. The size of your mortgage payment may not reflect all the interest you owe on your loan. So rather than paying off the interest and some of your loan balance (or principal) every month, you’re paying off some, but not all, of the interest you owe. Thus, the extra unpaid interest you still owe is added to your outstanding debt.

Also tread carefully with interest-only mortgages, which are loans in which you pay only interest in the beginning years. Don’t consider interest-only loans if you’re stretching to be able to afford a home, and consider one only if you understand how they work and can afford the inevitable jump in payments.

Getting your mortgage approved

When you’re under contract to buy a property, having your loan denied after waiting several weeks can mean you lose the property as well as the money you spent applying for the loan and having the property inspected. Some property sellers may be willing to give you an extension of time needed to close on the property’s purchase, but others won’t, especially if the local real estate market is strong. So you want to make sure you get your mortgage approved.

Here’s how to increase your chances of having your mortgage approved:

• Get your finances in shape before you shop for real estate. You won’t know what you can afford to spend on a home until you whip your personal finances into shape. Do so before you begin to make offers on properties. This book can help you. If you have consumer debt, pay it down.
• Clean up credit-report problems. If you think you may have errors on your credit report, get a copy before you apply for a mortgage. Chapter 4 details how to obtain a free copy of your credit report and correct mistakes.
• Get prequalified or preapproved. When you get prequalified, a lender speaks with you about your financial situation and then calculates the maximum amount it’s willing to lend you. Preapproval is much more in-depth and includes a lender’s review of your financial statements. Just be sure not to waste your time (and money) getting preapproved if you’re not really ready to get serious about buying.
• Be upfront about problems. You may be able to stop potential loan rejection by disclosing to your lender anything that may cause a problem before you apply.
• Work around low/unstable income. When you’ve been changing jobs or you’re self-employed, your income may be down or unstable. Making a larger down payment is one way around this problem. You may try getting a cosigner, such as a relative. Be sure to have a written agreement, including who’s responsible for payments.
• Consider a backup loan. You certainly should shop among different lenders, and you may want to apply to more than one for a mortgage. Disclose to each lender what you’re doing; the second lender that pulls your credit report will see that another lender has already done so.