Financially purchasing a home is usually the largest purchase you make in your life. Off the books, it is often an emotional decision. Putting down roots, deciding which town or city is the right one for you and what that might represent based on your background and your life experience. It is something I help clients with regularly and get asked frequently, so I hope you find this information helpful!
Are you throwing money away by paying rent?
The most common argument for buying is that clients feel like they are throwing away money paying rent. If they owned the home they would be building equity, they often tell me. This argument is valid and at its core and if it was that simple, we should all go out and buy houses now. But it is not that simple, homeownership comes with many costs in addition to the mortgage.
There are many ongoing costs homeowners have to pay that will continue to move higher over time excluding the mortgage. Those include taxes, insurance, routine maintenance and upkeep (50 Cent was paying $70,000 a month for one of his homes!). Most specialists recommend budgeting 1% of the value of your home to cover routine expenses annually. Larger unexpected repairs such as replacing a water heater or fixing a roof can quickly deplete savings or strain household finances.
If you rent, on the other hand, you don’t have to worry about any of those expenses. You just pay your rent and renters insurance, the rest is the landlord’s responsibility.
What is home equity?
The question above talks about “building equity” instead of “throwing away rent” each month. For most people, to buy a home you need to need to pay a downpayment between 3%-20% of the purchase price and a bank will lend you the remaining amount in the form of the mortgage. You then pay monthly mortgage payments to the bank to chip away at this loan. As you pay that loan you gain ownership of your house which is also called equity. Home equity can be a useful tool for financial prosperity through appreciation of the home, using it for leverage or potentially creating income.
How long are you planning to live in the home?
In addition to the ongoing costs of ownership, real estate transactions are very expensive. Not including the downpayment, closing costs such as brokers fees, appraisal fees, inspection fees, attorney fees, title insurance, mortgage origination fee, and others are not cheap. Generally, they range between 2-3% of the purchase price. If you are considering purchasing a home it is recommended that you plan to stay in that home for upwards of three years. This does vary geographically, the more expensive area real estate, the longer you would need to live in the home to offset the purchase costs.
That minimum time period allows you to rebuild savings, start to pay down the mortgage and essentially spread those upfront costs out over the time period. Additionally, if you sell the home to quickly the home might not have appreciated enough to offset the transaction costs, and if you sell in less than 2 years you are subject to capital gains taxes which would further deplete any appreciation on the home.
How Much Do I Need For A Downpayment?
Lenders require homeowners to either make a downpayment of 20% of the purchase price or get Private Mortgage Insurance (PMI).
PMI is required by the lender to protect them against the potential foreclosure. It adds an additional expense to your mortgage, which makes paying the mortgage and interest takes longer than it would without PMI. However, without PMI you would not be able to get the mortgage you are trying to get. So it might make sense depending on your situation. Once you have 20% equity in your home, you can request to remove the PMI.
If you are considering purchasing a home with PMI, I highly recommend speaking with a Financial Advisor, and checking with multiple mortgage brokers. There are 4 different types of PMI with slightly different features and benefits. There are also a number of alternative loans or government-sponsored down payment assistance programs. A trusted professional can help you make sense of which option is best for your unique situation.
Are You Financially Prepared?
When evaluating your finances for home purchase there are a few numbers you should focus on. The upfront costs: the downpayment (3%-20% of the purchase price) and closing costs (2%-3% of the purchase price). Do not forget moving is an expensive process, furnishing a new home is not cheap and you may have some potential home improvements you want to tackle right away. Lastly, you are now a homeowner you should keep some savings ready for unexpected repairs, especially in that first year. Those guides can give you a sense of the total cash you want available for the purchase and move.
Evaluating the longer-term cash flow. Earlier in this blog, I talked about the cost of home ownership. It is important to understand how home ownership will change your monthly cash flow. Mortgage, taxes, and insurance should not exceed 25% of your pre-tax income. All other debts should not exceed 35% of your pre-tax income. Ideally, you are able to get those numbers even lower by clearing other debt before taking on a mortgage. However, at those ratios, the average US household is able to manage and save which is paramount now that you own a home.
If you can handle those debt ratios and have the appropriate amount of cash, you are financially ready to buy. If the cash flow is fine but the upfront costs are the challenge, you can look into downpayment assistance programs, take on PMI or perhaps a family member can help you out.
Are Homes An Investment?
Like many other types of investments, real estate fluctuates in price often for unexpected reasons out of your control. For example, prior to 2007, people assumed you buy a house and the price goes up. Unfortunately, we found out that is not true. From 2007 – 2009 the median home price in the US dropped 13%! and in some overheated markets like Miami, prices dropped as much as 62% from peak to valley. Currently high tax states such as CA, CT, NY, NJ, and others that have lost the ability to write off mortgage interest on their taxes. In prior years people were able to write off larger amounts of mortgage interest which made ownership of higher priced homes more attractive. Those homeowners are now forced to pay far more in taxes than planned when they purchased the house. Many are trying to sell, however, the new tax status has impacted the cost of ownership and therefore the homes impacted by this change have all been harder to sell as the asking price does not match the potential buyer’s willingness to pay.
If you are purchasing a home for an extended period of time and your financial situation can handle the cost of ownership along with the debt, shorter-term price fluctuations should not deter you from purchasing a home that you like.
However, it is important to consider how much of your savings you want to put into a single asset like a home. If you buy a house that stretches your budget and makes it hard to save. Yes, you are building equity, however, if you have an emergency and are forced to use that equity to cover costs (medical, education, retirement) because you have been unable to save. And because of the high costs of ownership, you have problems managing the new debt, now the house itself is in jeopardy.
Yes, real estate is an investment but is an illiquid investment. If the sole reason you are purchasing a home is for an investment you want to make sure you have the appropriate cash flow to support the downtimes and prepare for potentially slow appreciation to protect yourself.
Should You Buy or Keep Renting?
Hopefully, the information above was helpful. There are many great benefits of ownership like having a home, building equity and potential for appreciation. However, there are many benefits of renting, flexibility to move, not dealing with maintenance, taxes or the costs of ownership. Figuring out which is right for you is a personal decision.
Here are some great calculators to look at the financial side of things:
Rent vs Buy Calculators:
Often it is a wise move to talk over big purchases with someone you can trust to provide an honest unbiased opinion. As a fiduciary for my clients, I fill this role regularly. I understand both the complexities of real estate purchases as well as the emotional side of deciding where to buy and what that might mean off the books. If you have questions or would like to discuss any of these items specific to your situation, do not hesitate to reach out.