Top 10 Issues to consider before buying a new home in this hot housing market… Part 1
1. Payment: Do not base most of your decision on what you can afford to pay. Why? How does payment relate to housing? First, let me say that I feel 30 year mortgages should not exist. It’s a ploy to keep people paying more interest for most of their lives; they are rare in other countries. Even without changing the down payment requirements, which are usually around 5% these days for an owner occupied median home, we could have a very healthy, and perhaps healthier housing market. I hear a lot of buyers these days talking only about what their payment will be, particularly the already disadvantaged millennial generation. When you hear this, they rarely discuss the purchase price relative to their net worth. It’s also common in autos where someone will buy a 30 thousand dollar car because they can easily swing the $500 a month payment. More often than not, that car will be nearly worthless in 5 years and you’ve blown away 30 thousand dollars of your total net worth, which is very often already negative. Housing offers the potential for appreciation, however, and it’s for that reason so many overlook the issues at hand. I think in light of 2008, we can all agree there is a reasonable chance 10 years down the road it’s possible your home would not have appreciated. It’s always good to be conservative when analyzing an investment this large. Well consider a 315 thousand dollar home with 5%(15K) down. With a 30 year loan at 4% interest (higher at the moment) you would still owe 236 thousand dollars after 10 years. You would have approximately $79 thousand in so called equity. That sounds like a decent return on what was probably about 20 thousand down including closing costs. Let’s consider this however- Payments depend on location but with taxes, insurance, and principle (not including potential HOA dues) your payment on a 300 thousand dollar loan is typically around $1800 a month. In 10 years, you will have sent your lender $204 thousand dollars. You would have to pay at least a small amount of yearly maintenance, and possibly HOA dues. Say an average of $2000 a year which is a very conservative number. Here is the math:
- Downpayment – $20,000
- Monthly payments- $204,000
- Maintenance- $20,000
- Total: $248,000 in reductions to your net worth over 10 years.
In this event, you would have $79 thousand in equity. Assuming the home doesn’t sit vacant for some reason, have a major issue of any kind, or depreciate of course. Also, don’t forget it’ll cost you 15 thousand plus to sell the home if you go through a Realtor.
I know what you’re thinking- “I’d be paying the $204,000 in rent anyways.” Fair enough. In the majority of cases you are right, this 30 year mortgage is much smarter than renting for 10 years. Also, don’t forget the average tax benefit. Remember though, there is much more at play here. First, there is risk associated with ownership; in this case a fair amount. A small 10% market drop just wiped out a huge portion of your equity. A 2008 style drop, and you will still be underwater by at least $16 thousand not including your lost down payment, and seller closing costs of 15 thousand plus. You also may find that you have to sell after 5 years and then the math is much nastier for the seller assuming even average market performance, you’d still owe $271 thousand for a net loss of about $1000 after all expenses and downpayment are figured in. That’s assuming you are lucky enough not to have a true maintenance issue, or have the home sit vacant for any period of time.
To really put it in perspective, listen to this! If you had invested your $20 thousand, as well as added $167 monthly which would have otherwise gone to homeowner maintenance (conservative), in a 3% riskless CD (they’re out there for smaller amounts you just have to look) for the same 10 years compounded monthly, you would have $50,382.23 !! Rates are currently near 3% but the assumption would be rolling over the CD at a higher rate in the future, meaning you would most likely have the same net worth, with all of the freedom, and risk free living that comes with renting a beautiful home. The same investment over 5 years and rather than losing $1000, you’d have netted $34 thousand!
So we’ve determined that renting in the above situation in light of conservative analysis, would for the most part be more intelligent. You’re probably thinking I’m the type that thinks everyone should rent but you’d be very wrong. I’m a huge believer in smart home ownership. In fact, I think everyone should be out buying a home right now, investment or owner occupied, assuming they conservatively have the funds to ride out rough weather. Later we’ll discuss how you decide whether an investment may be better than buying your own home.
Let’s do the math on the same situation using a 15 year loan at 3.25%. Usually, you could expect to pay nearly 1% less these days.
- Downpayment $20,000
- Monthly Payments $288,000 ($2400 month)
- Maintenance $20,000
- Total: $328,000 in reductions to your net worth over 10 years.
Here is where it gets interesting though. Your loan amount now is only $115 thousand. This means you have $200 thousand in equity! All for an extra $700 a month. To really compare apples to apples, we should reduce the equity by the added $700 a month investment leaving you a total of $116 thousand in real equity! This compares directly with a 30 year loan which would leave you with $79 thousand in equity for a difference of $37 thousand dollars. That may not sound huge, but you would most likely enjoy much larger tax deductions with the 15 year loan. For most, 20 thousand or more over 10 years. Also, by contributing an extra $700 a month toward this wonderful asset you were forced to save more rather than blowing it on that $30 thousand car. Finally, this method is truly most valuable during unforeseen problems. If you were forced to sell after 5 years, you would only owe $214 thousand, allowing you plenty of room to pay expenses and still add nearly $13 thousand to your net worth.
If all buyers practiced this method, then the housing crisis of 2008 by nature would have been a fraction of the problem it ended up being for the country; not to mention saved millions of families from losing their homes. Of course having a 30 year loan but making larger payments would have a similar affect but it’s rare for Americans to budget with that kind of chosen discipline and you also won’t have the benefit of a lower interest rate.
In the next part, we’ll discuss the benefits of investment property versus owner occupied homes. Hint, your primary residence is not an investment.