Despite the recent problems in the real estate market, homeownership remains a big part of the American dream. It’s importance is all but woven into the fabric of the American experience: Consider how many of our ancestors came to America fleeing neofeudalism and tenant farming systems, under which they were always at the mercy of oppressive landlords, to pursue the dream of economic as well as political and religious freedom.
But that doesn’t mean homeownership is right for everyone. Indeed, as we have discovered over the past five years or so, homeownership isn’t right for everyone.
Are you ready? Let’s look at the numbers:
First of all, let’s take a look at the costs of acquiring a home – and subsequently selling it if you change your mind.
Assuming you finance the house, you can expect to pay a loan origination fee of as much as $2,000 to $3,000, or even more, just to put the financing together. You can pay this all up front, or you can have it “hidden” within the loan itself, by rolling the origination fee into the loan balance, or paying “points” on the loan.
However, whether you pay it in a lump sum up front, or roll it into the loan balance, the mortgage brokers, bankers, and other people involved with the transaction don’t work for free. You will incur these charges one way or another.
On top of the transaction costs to originate the loan, you will also have to account for any agents’ commissions as part of the transaction. Traditionally, real estate agents receive about 6 percent of the purchase price of a house, between the buyer and seller’s agents and their parent agencies. That will add $12,000 to the price of a $200,000 house.
Yes, normally the seller pays the commissions, not the buyer, directly. But ultimately, all costs are passed on to the buyer, one way or the other.
So with a price tag of $12,000 to $15,000 on a modest-priced $200,000 home, it doesn’t make much sense to move into a home you’re only going to occupy for a year or two. That doesn’t give price appreciation much time to help you overcome the break-even point!
Most advisors recommend buying only when you plan on remaining in the home for three years or more. In fact, you must live in your home longer than three years out of the five years prior to selling in order to qualify for the $250,000 capital gains exemption on personal residences. For married couples, the exemption is up to $500,000. Special rules apply for those in the military.
Am I ready to buy?
Again, this is an individual question. Most planners recommend that you have some savings in the bank, first, before attempting to purchase a home.
How much savings? Financial planner Thomas Jensen, of Vaerdi Financial, a fee-only advisor in Portland Oregon, suggests maintaining an emergency fund of about six months’ worth of expenses – even after the down payment.
If your income is reasonably secure, you may be able to get away with a bit less. If your job is at risk of elimination, though, or in a very cyclical industry, you may want to have even more cash in the bank or other reasonably easily-accessed account.
Many people make the mistake of thinking they can substitute a credit card or home equity loan to get them through a tough spot, rather than having a robust emergency fund serving that purpose. This is a mistake: Unless you have been in the home a long time, and/or have built up significant liquidity in the home, the lender will be looking to your income to secure any borrowing you do. If you lose your job, you will likely simultaneously lose your ability to borrow your way through the crisis. It’s vital to have enough in hand to see you through an unemployment period of up to six months – a real possibility in today’s economy!
How much to put down?
There are two schools of thought on this: One school of thought recommends making as big a down payment as you can – thus lessening your risk and building equity in the home as fast as possible. If you decide to rent the property, this also makes the property in question go “cash flow positive” that much sooner. Which means you can keep the property indefinitely.
The other school of thought says don’t commit anything more to your down payment than necessary. Why? You may need the cash for something else. Meanwhile, you are taking a tax deduction on the debt. With many home mortgages at less than 5 percent today, for those with good credit, the after-tax equivalent mortgage rate is closer to 3 percent – your “hurdle rate.”
This would be the rate you would have to earn on your money in order for it to make sense not to pay down your mortgage or put extra down on a house. Most skilled investors can make this hurdle. But not everyone can. The right decision is going to be a very individual decision.
Tip: Some states provide substantial creditor protection to home equity. If you are at risk of a lawsuit, this could be an important factor in the decision.
No down payment deals
These are few and far between, these days, unless you qualify for a Veterans Administration loan. For FHA mortgages, you will typically need to come up with something – perhaps 3 to 5 percent, depending on what programs you qualify for. For conventional mortgages, you will typically need to show a down payment or other reliable security of at least 10 percent for owner-occupied mortgages – and 2 to 3 times that figure for investment properties.
One advantage to paying down at least part of your mortgage, though, is that if you have at least 20 percent equity in your house, you don’t have to pay primary mortgage insurance, or PMI. This can save you a couple of hundred per month in premiums – that protect the bank, not you. It’s wasted money, from your perspective. (Note: VA borrowers shouldn’t have to pay PMI. The U.S. government guarantees their loans).
Whatever down payment arrangement you opt for, however, you should still have a substantial emergency fund to see you through those repair and maintenance emergencies and shocks to your income.
If you haven’t been able to come up with a three-to-six month emergency fund, though, or a 10 percent down payment (even if you elect a lower down payment option), that is a very good sign that you are not yet in a financial position to buy a home.
What can I qualify for?
Bankers look at your credit rating: The best loan terms go to those who maintain a credit score of 760 or so or better.
They also look at two key cash flow metrics: Your “front-end” ratio and your “back end” ratio.
Your front-end ratio is all your housing expenses (think “PITI”, or payment, interest, taxes and insurance), divided by your gross income. According to the Federal Housing Authority, you want to be able to show a front-end ratio of 29 percent or less. This means that you shouldn’t be paying more than 29 percent of your total income for housing.
This is the ratio of your total housing expenses plus all your debt payments to your total income. Federal Housing Authority standards require lenders to insist on a maximum back-end ratio of 41 percent. Guidelines for VA loans are similar.
Tying it together
Homeownership isn’t for everyone. And there are no guarantees, obviously, that your home will go up in value over any given time period. But renting is an expense, too. If you are relatively stable in your location, you have at least three to six months’ worth of expenses set aside in cash or something else reasonably liquid, you fall well under the front-end and back-end guidelines for favorable financing, and you want to own a home, it is certainly still an option worth pursuing. A home can be a valuable store of wealth and retirement security. More on that in a future article!