The following is a guest post…
Are you ready to buy a home? Or should you continue to rent? There is no one-size-fits-all solution. Buying a home can be of fantastic long-term benefit to a family. And by some metrics, there’s never been a better time to buy. For example, mortgage interest rates, as of this writing, are not far off of their all-time lows. Early indications are that they may be headed back up (though no one knows for sure). But as we know from the recent housing recession, there are risks to homeownership, too. Every family is different, but here is a breakdown of the key considerations.
Are You Able to Save Money?
Generally, to qualify for a conventional mortgage, a lender will expect you to come up with a 10 percent down payment. In recent years, a somewhat larger down payment than that has become the norm for conventional mortgages. It is true that you can get an FHA mortgage for as low as 3.5 percent down and VA mortgages for zero down. There are other programs available, too, for special situations. But if you just don’t have 10 percent to put down, and you are nowhere near it, think carefully before committing to a mortgage. Is there a reason you haven’t amassed the savings? Is that reason in the past? Or does it still exist? Zero down is great if you can invest that cash productively elsewhere – or just keep it in reserve for a rainy day. But if you haven’t been able to put together the cash and are relying on such a program to buy a home, think about whether that’s telling you something. You may need to make some lifestyle adjustments before you are ready to own a home.
What are the Transaction Costs?
Buying and selling a home requires a lot of paperwork – and all the paper pushers need to be paid. The real estate agent gets paid a commission – generally 6 percent, though in recent years that figure has started to crumble. True, the seller traditionally pays the real estate commission. But it’s still worked into the purchase price one way or another – which means you pay it, indirectly. For a $200,000 home, that’s $12,000 right there.
You can also expect to pay another percent or two of your mortgage in “origination fees.” (You can sometimes add these costs to the balance of the loan, but you will pay them sooner or later.)
You can also expect to pay a few hundred dollars for a title search, title insurance premiums (you don’t want to be left hanging in the event someone else has a valid claim to the property while you still have a mortgage!), and perhaps $500 or so in appraisal fees. Throw in attorneys’ fees, escrow fees, survey fees and transfer taxes within your jurisdiction. Add another $30 or so for a credit report fee. All told, it is not unusual for transaction fees alone, over and above real estate commissions, to add up to 3 to 5 percent of a property’s value. This equates to $6,000 to $10,000 on a $200,000 home.
Now, if you stay in the home for a long time, that’s no big deal. But if you buy and sell every few years, incurring transaction costs each time, they sting a lot more. Again, every situation is different, but the consensus among real estate professionals and financial planners is that buying tends to make sense if you are going to stay in a home for about five years or longer. For shorter holding periods, the transaction costs and real estate commissions tend to eat up any gains in price appreciation. Furthermore, in the short run, house prices don’t always appreciate.
Ongoing Costs of Ownership
In addition to the immediate transactional costs of purchasing a home, you should also consider the ongoing costs of homeownership, over and above your mortgage payment. These additional costs will almost always include the following:
- Property taxes.
- Insurance premiums.
- Homeowners insurance.
- Flood insurance. Homeowners insurance does not cover floods.
- Fire insurance. Most standalone homeowners policies don’t cover things like wildfires.
- Private mortgage insurance (if your loan-to-value ratio is 80 percent or higher, or you don’t have a VA loan). This can amount to 1 percent of your loan amount per year.
Additionally, you have to consider homeowners association or condo association fees, if applicable in your community. (In some circumstances, a homeowners association can foreclose on your home if you don’t pay!) You may also have to pay a “subscription” to fire services in some rural areas. If you don’t pay the fee, the fire department may not extinguish the flames if your home catches fire.
Repairs and Renovations – You’re the Landlord!
In addition to closing costs, taxes and insurance, you should also anticipate the occasional repair and renovation. Eventually, you’re going to need a new roof, for example – an investment that can run tens of thousands of dollars when the time comes. Water heaters and dishwashers break down – and there’s no landlord to call. You’re the landlord! Don’t stop saving just because you already own a home. The need for personal savings and a healthy emergency fund becomes even more acute when you own a home. On average, expect to pay between 1 and 4 percent of your home’s value on repairs each year. Older homes will be closer to the higher end of that range.
The High Cost of Renting
In the short run, owning is expensive. But renting may well be even more expensive. This is because mortgage payments eventually stop, when you pay off the loan. Renting goes on forever!
Furthermore, if you have a fixed-rate mortgage, your payment remains level and predictable. It will not increase for the life of the loan. On the other hand, renters have to be prepared for a rental increase every year. Yes, as a homeowner you may experience a property tax increase. But property taxes affect renters, too. They just don’t see the bill directly. All renters see is higher rents at their next renewal notice.
Renters also give up a tremendous opportunity cost: the potential for property price appreciation. While real estate is a frequently volatile asset, in the long run, property values tend to go up more often than down. Any increase in value accrues to the owner, not the renter. All the renter will see is higher rents.
Rent on your personal residence is not normally deductible, though you can sometimes take a deduction for the business use of your home. If you buy your home, however, you can deduct any mortgage interest you pay. You can also deduct most taxes against your income when you file your federal income tax return. As a result, Uncle Sam is therefore subsidizing a portion of the costs of homeownership. (You also don’t lose the right to take a deduction for the business use of your home if you have a home office.)
Moreover, homeowners also get a break on capital gains tax on the sale of their primary residence: If you have lived in the home, and owned the home for at least three of the previous five years - called the “ownership and use test” – you can exempt the first $250,000 in gains from capital gains tax. For married couples, the exemption is double that, or $500,000.
Long-Term Planning Considerations
Homeownership can be a viable long-term retirement strategy. This is because it is possible, through taking a reverse mortgage, to convert your home into a stream of income for retirement, while still living in your home. This may seem like a long way off, but it’s worth considering. The potential for your home to act as a store of wealth – given a time horizon several decades long – is too powerful to ignore.
Jason van Steenwyk is a staff writer for Market Leader. He has written professionally about personal finance and investments since 1999. Jason’s writing career began when he got a job as a staff reporter with Mutual Funds Magazine and managing editor of Investors’ Digest.