CHAPTER
16

Owning Versus Renting a Home

In This Chapter

• Deciding whether to rent or buy
• The good and bad about taxes
• Qualifying for a mortgage
• Understanding different types of mortgages
• House hunting
• Insuring your home

There’s speculation that millennials simply are not interested in home ownership, that they want to live in cities, rent apartments that require minimal upkeep, and just enjoy life.

Not so, claims the online real estate site Trulia. A recent survey revealed that 93 percent of millennials someday plan to buy a home. While millennials are delaying both marriage and buying their first homes—factors attributed to the Great Recession, a job market many claim has not fully recovered from said recession, credit problems, and alarming amounts of student debt—statistics indicate that most will eventually embrace both institutions.

The Mystique of Owning a Home

People aspire to own their own home for many reasons. They get tired of paying rent every month, or they outgrow an apartment and decide to get a house instead. Maybe they think a house would be a good financial move, or maybe they just like the idea of having a house. They imagine having friends over for summer deck parties or picture the family gathered around the Thanksgiving table. For whatever reason, each year, many people buy homes for the first time, and many more people plan to buy in the future. If you’re among either of those groups, you’re considering a move that will affect your life, and your finances, for a very long time.

Only you can decide whether owning a home is right for you. The implications of home ownership extend well past the financial ones, so you’ll have to examine the whole picture and then make a decision. If it’s not the right time to consider home ownership, don’t feel bad. You can revisit the topic when it makes more sense.

Advantages of Renting

The first thing to remember is that having a home requires a great deal of responsibility. There are always things to be done, sometimes at considerable expense, and houses require constant attention and upkeep. If you think you don’t want to deal with the never-ending concerns that come with owning a house and you live in an area where rents are affordable, consider renting.

Rental agreements vary widely, but many usually stipulate that the homeowner is responsible for most repairs. You might be responsible for routine upkeep like cutting grass and shoveling the sidewalks, if that; but if the heater breaks down or the garbage disposal goes, you’ll just need to contact the homeowner or leasing company about the problem.

Another reason to think about renting is if you know—or suspect—your life situation will be changing soon. None of us can know what will happen in our future, but if you think you’ll be transferred in 6 months to a year, it’s not a good time to think about buying a home. The same thing applies if your marriage is on shaky ground, or if your job security is threatened, or if you’ve just learned you’ll need an advanced degree to keep your job.

Renting instead of buying may provide financial advantages at this point of your life. Assuming you’d be paying less to rent a place than you’d have to pay on your mortgage each month, you could use the difference to contribute to a specific financial goal, such as paying off student loans, investing, saving for future travel, or building an education fund. Renting also means you won’t face the burden of property taxes, which can be significant.

If you live in an area where rents are sky high and affordable rental homes are at a premium, you’ll have to work harder to find something you can afford. The cost of renting a home has increased dramatically during the past decade, and salaries have not kept up.

Economists are worried about this trend, as it doesn’t seem to be about to change. Ideally, you should spend no more than 30 percent of your income on rent. Increasingly, however, renters are paying 35, 40, or even 50 percent or more for rent. This not only makes it more difficult to live, it also limits your chances of being able to save money to use for a down payment so you can buy your own home.

In Washington, D.C., for instance, more than a quarter of all median-wage earners—those earning more than low-income workers but not as much as high-paid workers—spend more than 50 percent of their total incomes for rent each month, according to a recent study by New York University’s Furman Center for Real Estate and Urban Policy.

For many people, renting a home is the way to go. If you live in an area where rental prices are very high and you’re spending a disproportionate amount of your salary to live there, you might need to get creative and consider looking for roommates, moving to where rents are less expensive, or looking for a smaller place.

Advantages of Buying

If rents are affordable in your area, renting definitely has advantages, but there also are some very good reasons why you should consider buying a house.

There are all of those intangible things, like becoming a part of a community and having a stake in its well-being. Then, there are some important financial reasons why buying instead of renting can be a good thing. Instead of handing over money to someone else, you build up equity in your house as you pay off your mortgage. You have something that’s yours, not simply a place where you pay to live.

Owning a home also gives you good tax advantages. When you buy a house, Uncle Sam gives you a little housewarming gift and lets you deduct three of the biggest owning-a-home expenses from your federal income tax: the interest on your mortgage, your property taxes, and your primary mortgage insurance. Other, one-time deductions also are available to you, such as the points you pay at closing, but interest and property taxes and primary mortgage insurance (PMI), which protects the lender in the event that you default on your mortgage, are the long-term biggies.

These deductions are great news for homeowners. When paying the mortgage bill every month starts to seem like more than you can bear, remember that, come April, you’ll be happily filling out Schedule A (Form 1040), “Itemized Deductions,” which is a part of your federal income tax return. If you itemize deductions, the interest you pay on your loan, the property taxes you pay on your home, and your PMI all lower your tax liability. That’s a good thing!

Tax deductions can be itemized and subtracted from your adjusted gross income if they’re greater than the standard deduction the tax laws allow. The deductions and personal exemptions are subtracted from your income before you figure out how much tax you have to pay on it. If your total income is $45,200 but you have $8,500 in deductions and personal exemptions totaling $4,050, you’ll pay tax on only $32,650 ($45,200 – $8,500 – $4,050 = $32,650).

When you become a homeowner, you get the privilege of taking some pretty hefty deductions. If you haven’t itemized your deductions before buying the house, be sure you find out all the deductions you’re entitled to before you pay this year’s taxes. Deducting your mortgage interest, property taxes, and PMI can take quite a large chunk out of your income.

Points usually are the responsibility of the buyer, but a seller who really wants to sell can sometimes be convinced to assume responsibility for paying some or all of the cost of the points. If you can convince the seller to pay the points, you win in two ways: you don’t have to pay the points, and you can still deduct them from your income tax. If you and the seller split the points, you still get to deduct the total amount.

In addition to deducting mortgage interest and points, you can deduct some of the property taxes and other expenses that are finalized at settlement. Some of the expenses you pay at settlement can be deducted from your income tax, and some of the other expenses are considered capital expenses when you sell your home.

Property tax rates vary significantly but usually run somewhere about 1.5 percent of the value of your property. Because paying property taxes can be prohibitive, many lenders require that homeowners pay money into an escrow account to cover the cost of the taxes when they come due. An escrow account is a special account used to hold money designated for a particular purpose, such as property taxes.

In most areas, you pay local property taxes (also known as your school tax), county taxes, and sometimes some oddball taxes from your municipality. Taxes can vary, depending on the quirks, wishes, and wealth of the municipal boards that impose them.

The majority of property taxes you pay go toward funding your local school district. A portion also goes to the borough or township where you live, and some goes to your county. You normally pay your taxes to a local tax collector, who distributes them to the proper places.

You can be assessed for your taxes once a year, twice a year, or even more often. Property taxes have gotten so high in some areas that officials are allowing residents to pay their taxes quarterly to relieve the burden of huge lump sums.

Many property owners and legislators agree that property taxes are not an equitable means of raising money to support public education and other services. Elderly people whose children graduated from high school 40 or 50 years ago still pay property taxes if they own homes. And people who don’t own property enjoy the same services without having to pay the high taxes. Property tax is an issue in almost every state, and movements are underway in many states to reform the tax.

The really annoying thing about property taxes is that the municipality imposing them can raise them by reassessing your home. Every now and then, municipal governments declare a major property reassessment. When that happens, look out. At that point, the municipality probably has reached its upper allowable tax limit and is looking for a way to make more revenue. If it can’t increase your tax rate, it can reassess the value of your home. You can challenge your assessment by filing an appeal, which can be approved or denied.

Obviously, other expenses besides taxes are involved with owning a home, and you can expect to pay various taxes in addition to your property tax. You might be charged additional taxes for streetlights, fire hydrants, trash collection, sewage, water, and the like. Unfortunately, these taxes are not tax-deductible.

All this means you have to be careful when breaking down your expenses for your tax return. The bank might pay $2,000 to your municipality for your taxes, but only $1,550 of the $2,000 is deductible on your taxes. It’s a good idea to keep copies of all bills and the payments you make so you have them handy when tax time comes around.

Enlisting Help

Buying your first house—or any house—is a big decision, and you’re going to need some help. Some people insist on doing it themselves, but that’s not advisable, especially for first-time buyers.

First, you should secure the services of a good, reputable real estate agent who can walk you through the process of finding and purchasing a home. A good agent can be your best friend when you’re searching for the home of your dreams.

You also might want to identify a mortgage broker to help you locate and obtain the mortgage that makes the most sense for you. You have to pay for a broker’s services, but if you don’t have time to shop around for the best mortgage, or if you feel intimidated by it all, it might be worth your while to hire one. If you apply for a mortgage and are turned down, you should call a broker.

Be sure to check the qualifications of anyone you hire to help you in the process of buying a home.

Qualifying for a Mortgage

Because hardly anybody has a couple hundred thousand dollars available to hand over for a home, we rely heavily on mortgages when purchasing homes.

A mortgage is a loan you get from a bank or other lender. You borrow the difference between the cost of the house and the money you have for a down payment and agree to pay it back over a specified period of time and at a specified rate of interest.

On one hand, mortgages are great because they provide a means for buying a house. On the other hand, they can be financially crippling if they’re not managed properly.

To get a mortgage, you have to meet certain criteria. During the financial crisis and recession, we saw what happens when people get loans for houses and are unable to pay them back. About 5.5 million U.S. homes were lost to foreclosure between the end of 2007 and the end of 2015.

The lending industry pulled back tremendously in response, and for a while, getting money loaned to do anything was extremely difficult. New rules to ensure borrowers will be able to repay their mortgages went into effect in January 2014. Hopefully, this will even out the lending field by assuring banks their money will be returned and making it easier for qualified buyers to get mortgages.

To determine how much you’d be able to get for a mortgage, you need to consider a few things. First, think about how much money you have available to put down. Then consider how much you earn and what your expenses are. These factors will help you figure out how much you can afford to borrow.

The real estate research firm RealtyTrac estimated that a typical millennial would need 12½ years to save enough money for a 20 percent down payment on a home.

There’s good news, however. In 2015, the federal government reduced the cost of mortgage insurance and the minimum amount of money needed for a down payment for first-time homeowners who qualify for a government-backed mortgage such as through the Federal Housing Administration or from the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac).

If you qualify for a Fannie Mae or Freddie Mac mortgage, you may be able to get a minimum down payment of only 3 percent, down from 5 percent previously. Not everyone supports these home-buying incentives, but they are the government’s response to the lowest rate of home ownership in the United States in 20 years. Only about 65 percent of all Americans owned homes in 2015, and only about 36 percent of people under 35 owned.

If you don’t qualify for a government-backed mortgage, you’ll probably need a larger down payment. The bigger the down payment you make, the less your monthly mortgage payment will be. This can work in your favor in two ways: you can lower your monthly payments and have more money to invest or for other purposes, or you could afford a more expensive house with a bigger down payment because you’ll be financing less of the cost of the home. For example, if you buy a $175,000 home and make a $10,000 down payment, you have to finance $165,000. But if you have $35,000 for a down payment, you could buy a $200,000 home and only have to finance the same amount as you would have on the less-expensive home with a smaller down payment.

Your Income and Expenses

To determine how big a mortgage you probably can get, look at how much money you make before taxes. This amount is your gross income. The recommended guideline is that you should spend no more than 28 percent of your gross monthly income on your mortgage payment.

The mortgage payment includes the principal, interest, real estate taxes, homeowner’s insurance, and PMI if applicable. The principal of a mortgage is the amount loaned. If you borrow $200,000, that amount is the principal, and you are obligated to repay a portion of that mortgage amount each month. You pay principal every month based on the unpaid balance of the mortgage. The interest is the fee the lender charges you to use its money.

When you’re thinking about applying for a mortgage, you must pay close attention to all your expenses as they relate to your income. Although the recommended maximum for your mortgage payment is 28 percent of your gross monthly income, the historical maximum for your total monthly debt is 36 percent of your income. That means all your debt other than a mortgage—such as your car payment, credit card bills, student loans, child support payments, and other bills—should total no more than 8 percent of your gross income.

You need to take a realistic look at your gross income and all the expenses you’ll be faced with once you’ve bought a house. Then consider your down payment, and you’ll be able to determine how much you can afford to borrow. Many good mortgage calculators are available online, or you can get an app such as Quicken Loans’ Mortgage Calculator to help you.

Getting the Right Mortgage

You’ll find many different kinds of mortgages. They vary tremendously in time needed to pay them back, the frequency of payments, and other factors. Much good information about mortgages is out there, and it’s important that you take time to research.

The two most common types of mortgages are fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs).

Fixed-Rate Mortgages

With more than three quarters of the people who get mortgages choosing FRMs, they’re the most common type. They’re also the easiest to understand: you agree to pay a certain amount of interest on your mortgage for as long as you have it. If you pay 4 percent interest the first month, you’ll pay 4 percent interest the last month as well. The rate doesn’t change, and neither does your monthly payment. You receive a schedule of payments, and you know exactly how much you must pay each month. So if you like to know precisely how to plan your long-term budget, you’ll probably like FRMs. It removes the guesswork.

The interest rates a lender charges on a mortgage or another type of loan depend on inflation and the state of the general economy. Interest rates are controlled by the Federal Reserve, through the interest rates this federal agency charges to banks. If the Fed charges banks high interest, your mortgage rate will be high; if rates are low, a mortgage you take out should have a low rate.

The problem with FRMs is that if the interest rates drop dramatically, you’re still stuck paying the higher rate. You can refinance your mortgage to take advantage of low rates, but this process requires time and involves significant expense.

Still, there are reasons why more people have FRMs than any other kind. They’re easy to keep track of, for example, and you can count on making a specific payment each month.

Let’s have a look at how a FRM compares with one that has an adjustable rate.

Adjustable-Rate Mortgages

ARMs are different from FRMs because the interest rate doesn’t stay the same for the entire term of the loan. Because of that, your monthly mortgage payment varies as well. Homebuyers generally are attracted to ARMs because they offer some initial savings like no points and a lower beginning interest rate.

With ARMs, you generally agree to pay a fixed interest rate for a certain amount of time, after which your rate and monthly payment may start to fluctuate. The interest rates for ARMs are tied into various indexes that determine how they’ll rise or fall. The indexes used for the interest adjustment are based on the current interest rate scenario evident at the time the ARM rate is adjusted. Your lender will specify what index is used to determine your rate.

Most ARMs also include annual caps, so your interest rate can’t keep increasing forever. However, you could end up paying hundreds of dollars more on your monthly payment down the road than you do initially if the interest rates rise dramatically. On the other hand, if interest rates stay low, an ARM can be a good deal.

The initial savings of an ARM over a FRM can be tempting. But don’t get sucked into an adjustable-rate deal, especially when interest rates are low, unless you fully understand how it works and are willing to take the risks. Get all the information you can about different types of mortgages before you decide what type is best for you.

Finding Your Dream Home

An important rule to remember when you’re house hunting is to keep an open mind. Don’t refuse to look at homes anywhere outside of the three-block area you have your heart set on because you’re sure to miss out on some good properties. The house of your dreams might be just on the other side of the street you’ve set as your boundary, or on the other side of town, or the county.

Real estate prices vary tremendously, based in large part on the location of the home. You might be able to afford a townhouse in the “in” neighborhood or a much larger single home in another area. It’s a matter of getting your priorities and your finances straight.

You’ll find many different kinds of homes, and you should think about what makes sense for you at this point of your life. Don’t be pressured into thinking you must have the house of your dreams at this age. You’ll have time to upgrade later.

Types of Homes

Let’s consider some different styles of homes.

Single home This is a freestanding home. It can be a one-story ranch or a three-story mansion, and it often has more land than some of the other options.

Double house In this structure, two homes are side by side and share a common wall. Each dwelling in a double home can be quite large, and each half often includes some property. Double homes generally are less expensive than single homes and can be a good value.

Townhouse Townhomes, sometimes called row houses, are attached to the homes on either side. They are generally less expensive than singles, unless they’re in an extremely trendy area. Townhouses offer advantages such as security, community, and financial value. As with double homes, only you know how you feel about living in close proximity with your neighbors.

Duplex Another example of non-single-family housing, a duplex holds one complete living unit above another complete living unit. Duplexes are popular investment properties, and the owner often lives either upstairs or downstairs and rents the other unit.

Condominium When you buy a condominium, you own everything from the walls in and part of everything else in the community. That means you normally have shared costs for maintenance and other expenses. Condos are great for people who have no time, skill, or interest in the upkeep involved with the exterior of a single home and property.

Apartment We normally think about renting apartments, but they also can be purchased, particularly if you live in a large city. An apartment is a living unit contained within a larger building with other living units.

Location, Location, Location

In addition to thinking about what type of home you want, you need to consider its location. People choose the neighborhoods they live in for many different reasons, such as the quality of the schools, proximity to shopping or work, safety, and property size.

Regardless of why you choose the neighborhood you do, be sure to check it out thoroughly before buying a home there.

Protecting Your Investment

Your home is probably the biggest investment you’ll ever make. And it holds the people and things most important to you. To protect your home, you must buy homeowner’s insurance. You’ll probably need to show proof of insurance before obtaining a mortgage as well. Home-owner’s insurance includes personal property coverage for the contents of your home and liability insurance for the damage that could occur to other people who visit and to their property.

In the event of a fire or other catastrophe, homeowner’s insurance can’t replace your wedding videos and the coffee table that belonged to your great-grandmother, but it can at least enable you to rebuild your home and make a new start. It can’t protect your emotional investment in your home, but it can protect your financial one.

Homeowner’s insurance is designed to repair or replace your primary residence if it’s damaged or destroyed. Coverage usually is based on the sale price of the home when purchased, but remember that the sale price includes the value of the land. If your entire property is valued at, say, $275,000, but your house would cost only $200,000 to rebuild, you don’t need homeowner’s insurance based on the entire value.

The part of your homeowner’s insurance that covers your house (the structure, that is) is called dwelling coverage. Dwelling coverage isn’t based on how much you paid for your house or how much money you borrowed to buy it. It’s based on how much it would cost you to rebuild your house if it were completely destroyed, known as the replacement value.

The cost to rebuild is normally based on the square footage of your home, the type of home you have, and when it was built. If you have an older home with lots of details, such as a wooden staircase, stained glass above the doors, or ornate plaster work, your insurer is likely to tell you that sort of detail could not be matched if your house had to be replaced. You can expect to pay more for your homeowner’s insurance if you have a lot of extras in your home, such as ceiling fans, spas, French doors, propane fireplaces, and so forth.

We can’t stress enough how important it is for you to closely examine your insurance policies and know exactly what coverages you have and don’t have. It can be financially devastating to assume you’re covered for something, only to find out after a catastrophe that you’re not.

The Least You Need to Know

• Buying and renting each come with advantages and disadvantages.
• It’s important to get a real estate agent you trust professionally, as well as one you like and can work with effectively, when you’re house hunting.
• If you want to buy a house, you need to figure out how much you’ll be able to pay by calculating how much you have for a down payment, how much you earn, and what your expenses are.
• Mortgages come in a variety of flavors, but the main decision you’ll need to make is whether to get a fixed- or adjustable-rate mortgage.
• When you start looking for a house, remain open-minded on the type of structure and location.
• Insuring your home and its contents is crucial. Do your homework, and be sure you have adequate protection for your home and your possessions.