Buying a house

For many of us, buying a home will be one of the biggest financial deals we are ever involved with. As with any major financial decision there are costs and benefits. Any important choice deserves a good benefit/cost analysis:

Should you buy?

Ask a renter why they don't buy a home and they may say:

• They don't have enough for the down payment,

• They may need to move too soon because their job requires it,

• They are unsure of where they want to live,

• They believe they can make more money in investments,

• They don't want to be tied down,

• They think they can't afford it,

• They don't think the benefits outweigh the costs.

Ask homebuyers why they bought and they might tell you:

• It's the fulfillment of a dream,

• They want to settle down,

• They see it as enforced savings,

• They are tired of paying rent,

• They don't want to deal with landlords,

• They want a place they can call their own.

Costs

Buying a home is a lot more than making a mortgage payment. It also means paying taxes, maintenance costs, and insurance premiums. If you are buying a condo or townhouse, it will also mean paying home owner dues or common charges. If you own a home you have a leak, you fix it or pay someone to fix it. There is no landlord to call.

You also pay real estate taxes. You help support your local school system, fire and police departments and your city government. You are buying into your local community.

A home is not a liquid investment. Selling a home may be easy or difficult. You might get multiple offers or it might sit on the market for a long time. You may not be able to get what you want for your home on your timeline.

Additionally, home owners who want to take some of their principal out of their home must go through a mortgage lending process to take out a second mortgage or home equity line. Although this process is available, it sometimes entails too much time and or money in the form of loan fees to go through this process.

Even if you choose to move out and rent your home, you are subject to the rental market and you need to become a landlord.

If you live in a place where the real estate market takes a dive, personal circumstances may force you to sell and lose money.

Benefits

The benefits of home ownership may compensate for the hardships. First of all, you have your own place. Within the law, you have total control of your living space.

The government gives you tax breaks because you can deduct the interest you pay on your mortgage and your real estate taxes.

You can also roll over capital gains to your next home if you sell your current home and move to a more expensive one.

Usually home prices at least keep up with inflation, so home ownership usually is a good financial investment.

If you buy wisely and have the good fortune of living in a desirable place, owning your home can be the best investment you could make.

Pre-home-purchase planning

Assuming you are going to pursue purchasing a home, you want to take stock of what you have in terms of assets and the qualities you want in a home. Consider the following questions:

How long do you plan on living in this home?

First of all, think about your employment. If you purchase a home and get transferred, lose your job, or decide to leave after only a short time, you may end up losing money.

You want to feel like you will live there long enough to have the appreciation on the home cover the costs of buying and selling your home. If you pay a 6% real-estate commission to sell your home and roughly 2% to buy your home in closing and loan costs, you can check out community appreciation with your realtor to see how long it has taken homes to appreciate 8%. This is a rough guide to your "break-even" point in owning a home. (Assuming you have made no improvements and have no major maintenance costs.)

How long will the home meet your needs?

What features do you require in a home to meet your needs now? Five years from now? For example, if you are planning on having children, is this a place to raise them, or conversely, if your children are going to college in three years, will your home seem huge without children? Could the basement be turned into a den? Could the attic be a master suite? Could you turn part of the house into a rental unit? Is it zoned for rentals? Could you find a place in the home for your mother-in-law?

How much home can you afford if you buy now?

Is now the right time for you to buy a home? Are you in good financial shape? Do you feel good about your employment future? Is your credit good? (See the cash flow chapter for some good tips on getting and keeping a good credit score.) You can almost always find a lender to lend you money, but can you get a good interest rate?

How much home can you afford? If you buy a home you can easily afford today, that leaves more money for other things. If you have uncertainty about your financial future, or know you are going to go through a period where one of you isn't working (such as having children), buying within your means allows you to have more freedom and financial flexibility.

Another way to look at how much to pay for a home is to stretch yourself to buy the home now that you will enjoy living in for a long time, because as your resources grow, any fixed rate mortgage stays the same. As time goes on you will have relatively lower costs in the future for owning your home as you get pay raises or have a higher earning potential. Another factor in this decision is that the cost of selling one home and buying another is substantial. If you feel you will be in one town for a long time, you may well come out ahead buying the home you will be happy in without the need to move to a larger home later. Make sure, whatever you do, that both of you are in your financial and home quality comfort-zone.

Depending on where you plan to buy your home, the investment potential of owning a bigger home may be a compelling factor. Every time you buy a home with a mortgage you are purchasing a leveraged investment. For example, if you put $20,000 down on a $100,000 home, you have put down 20% on something that will appreciate (or depreciate) on 100% of its value. If your house appreciates at 3% per year, after the first year you will earn $3,000 on your $20,000 investment or 15% on your down-payment! Conversely, if home prices fall three percent, you will lose 15%. This leveraging effect can be substantial in some areas of the country where home appreciation is consistently good or where there is a likelihood of economic downturn.

This phenomenon does not take into consideration the size of your mortgage payment, tax savings, mortgage loan costs and real estate taxes. If these costs and benefits end up being less or about the same as what you would have paid in rent, you still probably grow your net-worth because of this leveraging effect.

To determine how much home you can afford, talk to a lender and ask them to give you an idea of how large a mortgage you can qualify for. Add that to your down-payment and you have an idea of your price range. Traditionally, lenders like to see a "28/36" ratio. This means that your monthly house payment is about 28% of your monthly income and your total debt payment is no more than 36% of your monthly income. Depending on credit history, job potential and other factors, lenders can push these ratios up to 40% - 60% or higher. Although it's important to know your options, be careful. It's not fun to be house poor!

Where will the money for the down-payment and closing costs come from?

Typically, you will need some money to put down. If you can put down 20% of the home cost, you will avoid having to pay for mortgage insurance. However, with today's broad range of loans available, you can sometimes get away with paying less down if you have a good credit rating.

Look at your current sources for a down-payment. Ideally you will have money you can lock away in your down-payment and still have cash for closing costs, moving and your cash reserve.

You may need to sell your current home. If so you will have some transition and timing concerns about coordinating escrow times.

If you don't have a 20% down-payment from these sources, look at other sources. Other sources always have a cost associated with them. Taking a larger mortgage means a higher payment, borrowing from your 401k means you feel you will be in that job for long enough to pay it back, (if you leave for employer, you need to pay back the loan from your 401k within a year.) Taking a second or borrowing from friends means a higher monthly payment to live in your house.

Can you afford the ongoing costs of home ownership?

Because you own your home, you will incur ongoing maintenance costs. In addition to taxes and insurance and homeowners dues if you own a condo, things will break and repairs will have to be made. You will also want to make improvements as time goes on. All of these costs are part of the deal. Make sure you look beyond the loan payment when you are looking at what you can afford.

Do you have reasonable expectations?

When you own a home, you have a lot of money at stake. No house is perfect. As you go through inspections during closing, find out what you are getting into. Get a good reputable home and pest inspector. Have them thoroughly examine the home. Some inspectors over-play the implications of what they find. (They are marketing their services in some cases.) But inspectors can also find things that will save you thousands down the road.

After you have gathered all the information you can, sit back and analyze what the house is worth to you today and what you think you can reasonably sell it for later. Is it worth the time and money you will spend on it? Given everything, is the price fair?

Emotions for both the buyer and seller may be high. Understand the seller's motivations and your own expectations. Try not to make this transaction personal.

There is a lot of money involved for you, the seller and the realtor. Everyone has a motivation to come out on top. Remember, the accurate price is the price you and the seller can agree to. If you are not in agreement, or your partner isn't, step out of your emotional attachment to living in the home and look to see if you are making the right move at the right time.

Buying a home is an emotional, stressful, exhilarating and consuming process. As you and your partner take this on, listen carefully of each other to make sure you are both on the same page about this big purchase. Remember, you are literally buying the environment for your life and partnership. Making good choices really pays off in your happiness.

Home purchase to do list

1.     Check your credit. (See the cash flow chapter.)

2.     Get mortgage approval before you buy.

3.     Find a great buyer's agent.

Work with someone you like because you will be spending time with them. They know the neighborhood you are moving to, relative home values and real estate law. Use their expertise.

Remember though, they get paid when you do the deal. They will tend to want you to act. In the end, what you pay for a home doesn't have that much effect on the amount of commission they receive. They are in sales. If you pay $10,000 more or less, that translates to their portion of $600 in a 6% commission structure. They are financially motivated to get the deal done at any price. You need to be the primary person looking out for your interests.

4.     Learn about the neighborhood

Do your research to find out what properties sold last year. How does your home rank? If it's in the top range, it might be hard to resell. Homes can be changed. Land remains the same. If you are on the average or low end, you have better potential to do well when you are selling.

      Check out the schools. A good district means that your neighborhood will be desirable.

      Contact the police station to obtain crime statistics. Are they acceptable to you?

      Talk to neighbors. See if they like living there and if you like them.

      Check out the locations of shopping, schools, police and fire stations, freeways and air traffic overhead. These things can affect property value and your quality of life.

5.     Be your own advocate.

Ask your realtor for a copy of documents you will be asked to sign if you buy a house. Read them. Know what you are getting into.

Getting the right kind of mortgage for your needs

Hopefully, you have been pre-approved; because everything happens very fast once you tender an offer. One of the most important decisions you will make is to choose who much to put down and what kind of mortgage (if any) is best for you. Look at the following factors:

• Interest rate

• Monthly payment

• Term of loan

The key questions to ask are:

How long to you think you might live in this home?

Generally, the longer you feel you might live there, the more advantageous a fixed-term mortgage is for you. If you can lock in a good rate for the long-term there are two major benefits: first, as your income and resources grow your payment becomes less burdensomeâ?? it will never change as inflation increases the cost of everything else. Second, you may be paying relatively less for your home if interest rates go up. Adjustable mortgages will become more expensive, your fixed rate mortgage will stay the same.

Think about how the banks see it. They are on the hook for fixed rate mortgages, (so the initial rate is higher so they can hedge their bet). They take a lot less interest rate risk with adjustable mortgages so they tease the initial payment to an artificially low rate and in the same initial interest rate environment. (If a fixed rate is at 6%, an adjustable may be 5.37 %.)

Now, you can also opt for hybrid mortgages with a fixed rate for a period of time, (three, five, seven or nine years) and an adjustable thereafter. This monthly payment amount will fall somewhere between the adjustable and the fixed, but may be a great choice if you know you will be moving within the fixed-rate period. Other permutations include the interest only, and a negative amortization loan.

Gauging your period of home ownership informs your mortgage choice, however other factors are important too.

What monthly mortgage payment fits your overall cash flow picture?

Using the 28% of income rule, what mortgage payment amount fits which type of mortgage?

If you can afford the 30 year fixed-rate mortgage, do you think you will live there seven years or longer? (This is a generalized break-even point of fixed vs. adjustable rate mortgages.) If not, you may be paying too much for a 30 year fixed mortgage. Consider the interest rate environment and choose the mortgage option which provides your best guess at the lowest interest rate cost. Remember interest rate equals loan cost. If you get a fixed rate and don't need it you will be paying extra money for your home because the fixed-rate loan interest rate is higher.

If you have bought at the top of your price range, you may want to go for a mortgage with a lower payment. If you feel you really can't afford a fixed-rate mortgage, be careful about taking it. Your mortgage payment comes due every month and you also need to eat, heat your home and live the rest of your life.

Loans are available with lower payments: the interest only loan will have a lower payment for a period of time, (three, five or seven years). After that, the loan will go to a much higher payment than any 30 year fixed or adjustable loan because you only have the remaining term of your 30 years to pay off the house. If you have 25 years to pay off the interest and principal on your home, you will pay more than if you have 30 years.

Also, you may be offered a loan where you can have negative amortization. (Amortization means the reduction of a debt by making payments in installments to pay down a loan to zero within a given period.) If you have a negative amortization loan, your loan balance will rise, not fall. This means that eventually you will have an even bigger payment than the interest only loan to pay off the bigger balance within 30 years.

Be careful about choosing either an interest only or negative amortization loan. These loans are worth considering if cash-flow is a concern and the following exist:

• you feel you won't live in your home a long time;

• you live in a place where homes consistently appreciate;

• you are OK with refinancing when the initial period expires; and/or;

• You know you will have more income in the future.

What is the interest rate environment?

Finally, this mortgage choice analysis must consider the interest rate environment. If you are in a high interest rate environment, adjustable interest rate loans become more attractive than fixed rate loans because their interest rates can fall. If you are locked into a fixed-rate loan and interest rates are near the high end of the usual range, chances are you will lose the 30 year bet on interest rates going still higher.

Are interest rates stable or volatile? If you are in a volatile period, you may need to worry about the day you lock the loan. This nerve- racking event means that you can pay a lot more for a fixed-rate loan if you lock your rate on the higher day.

Getting the right mortgage is complicated. At Wealth by Design,LLC we can help you sort through your options before you are in escrow. Because you must get into action on your loan right away after you have an accepted offer.

Loan costs are substantial, so it pays to do your homework and make a good choice. Refinancing is an option, but is also an extra expense.

Homeowner tax tips

Deducting mortgage interest

Mortgage interest on a primary residence is usually fully tax deductible, unless your mortgage exceeds $1 million or you took out a mortgage for reasons other than buying, building or improving a home. You claim this deduction on Schedule A of your Federal taxes. Your lender will send you a form giving you the amount of interest you paid for the year.

Late payment charges may also be deducted as well as pre-payment penalties.

Deducting real estate taxes

Real estate taxes are also deductible.

Deducting loan points paid on a purchase.

The points you pay on a purchase mortgage are deductible the year you made the purchase. In order to deduct points the loan must be secured by your primary residence and the loan was used to buy, improve or build the home. You also must put cash into the home at least equal to the points you were charged.

Deducting points on a refinance

If you refinanced last year you may be able to deduct points proportionately over the life of the new loan. If you took a thirty year loan, you can deduct 1/30^th each year. If you refinance multiple times, you can write off the rest of the points on the first refinance the year you take the second refinance. (This is often overlooked, so make sure you get what's due you.)

Deducting interest on a home equity loan

The interest on a home equity loan is deductible up to $100,000. There may be deductibility limits if your home value is less than your combined first mortgage and home equity balance amounts.

As always, check with your tax advisor to determine which deductions apply to you.

Barbara Bachelder, CFP® for Wealth by Design, LLC