Personal Finance (Sec. 2.1)

FUNDAMENTALS OF FINANCE

A Guide for Helping Professionals

Adam J. McKee


SECTION 2.1:  Houses


This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.

Open Education Resource--Quality Master Source License


You have to live somewhere.  If you are young, you probably live in an apartment if you do not live at home with your parents or with relatives.  Houses are hugely expensive; they are the biggest investment that most people will ever make.  (I want you to be different; I want your retirement account to be your biggest investment when you reach retirement age).  There are a couple of different ways to get this wrong.  The first is to decide that houses are too expensive and you can never own one.  Those are for rich people and old people and you, after all, are neither.

Renting is throwing your money away, and unless you are renting from your sweet aunt Matilda for a little of nothing, it is a very sizable chunk of money.  The only reason to ever rent is that you have nowhere else to live and you can’t get financing to own, or you know that you will live in a particular locality for a very short period of time.  The biggest reasons that people can’t get financing is because they do not have a job or they have bad credit.  As a college student, you probably can’t work a professional job and do well in classes.  The solution: Pick the cheapest alternative.  Do the math, and if living on campus is a good value, then do that.  And you have to consider the bottom line of the unthinkable option:  If living with mom and dad is the most cost-effective approach, then that is what you should do.

Another option is to work with an older, more established relative that has a good job and good credit to buy an investment property.  Finance a modest home, and the rent you would be paying someone else goes to pay the mortgage on the investment property.  After you graduate, you can refinance the property and pay your partner back, or you can keep it, rent it out, and split the profits after expenses are taken care of.  After the four or five years of college is over, you’ll have some equity built up on the investment property so refinancing will be easier despite your short work history.  The bank will lend to nearly anybody with decent credit and 20% equity.

When you rent, you are paying for a service.  Once the service is rendered, your money is gone, just as if you’d flushed it down the toilet.  Buying a house, on the other hand, is a form of investing.  When you rent, you are paying for the landlord’s investment.  You are in essence paying the mortgage for the property, but it belongs to the landlord when you are done.  That is a terrible financial mistake to make if you can possibly avoid it.  Sometimes you can’t help but rent.  If that is the case, spend as little as possible!  But keep in mind that overall expenses matter.  Consider the cost of commuting; a rental way out doesn’t save you any money if you burn up the savings in gas.

Depending on where you live, you may consider a mobile home as an option.  This is usually a terrible idea.  Mobile homes are like cars; they start depreciation the moment you pull them off the lot.  You will lose equity at a very rapid pace.  Mobile homes only make sense if you buy one that has already depreciated most of its value and you are paying cash and getting it for next to nothing.  If there is land in the deal, then you will almost always be okay since the value of the land will appreciate as your aging mobile home continues to depreciate.  As I’ll keep reminding you, buying a new car is pretty stupid from a purely financial perspective.  Buying a new mobile home is really, really stupid.

There are other factors to complicate the decision.  Mortgage payments are often more than rent payments, but not by much in my personal experience.  If you live in a college town, mortgages are often much cheaper than renting the same square footage!  If you own, you take on the responsibility of repairing things that aren’t covered by your insurance; they don’t cover your new HVAC system.  When you rent, part of your money is going into the insurance that the landlord ultimately pays.  You are also responsible for property taxes.

Become an Expert

To get a good deal on a home is one of the best deals you’ll ever get because of the amount of money involved.  Even if you absolutely hate to “haggle”, you simply have to negotiate when buying a home.  Real estate brokers always pad asking prices expecting you to make a counteroffer.  If you don’t you are throwing away huge sums of money.  To really understand whether or not you are getting a good deal, you need to become somewhat of a real estate expert.

A major element of home prices is the comparable properties that have sold recently in a particular neighborhood.  Months prior to purchasing, you will want to keep an eye on the homes that are selling that match the major characteristics of the type of home you are looking for.

How Much Can You Afford?

Going to a loan officer at the bank and asking how much you can get is a notoriously bad idea.  They’ll help you out, and that is a bad thing.  Very often, loan officers will give you an amount that will saddle you with a debt burden that you’ll find difficult to pay for thirty years.   Just because you can get half a million dollars doesn’t mean that you should!  An old rule of thumb is to never spend more than three times your annual salary on a home.  So if you are making $50,000 per year, then you should not buy a home for more than $150,000.  This has been made easier and more scientific by lending institutions on the internet.

Prequalification

Before you start looking for a home, you will need to know how much you can actually spend.  First, base this on a realistic budget.   You will also want to know if your lender will agree with your decision as to how much house you can afford.  One way to do this is to get prequalified for a mortgage. To get prequalified, you just need to provide some financial information to your mortgage banker, such as your income and the amount of savings and investments you have. Your lender will review this information and tell you how much they can lend you. This will tell you the price range of the homes you should be looking at. Later, you can get pre-approved for credit, which involves providing your financial documents (W-2 statements, paycheck stubs, bank account statements, etc.) so your lender can verify your financial status and credit.

Real Estate Agents

Real estate agents can be important partners when you’re buying or selling a home, and you may want to seriously consider using one.  This is especially true if you are a real estate novice.  (Although bank loan officers will do a lot of the stuff a real estate agent does in better banks). Their knowledge of the home buying process, negotiating skills, and familiarity with the area you want to live in can be extremely valuable. Usually, it doesn’t cost you anything to use an agent– they’re compensated from the commission paid by the seller of the house.  Remember that agents are not qualified to give you an official appraisal or do a home inspection.  Those are separate professionals.

Selecting a Home

Back in the day, you had to visit a lot of homes to find the right one.  Today, apps and websites can help you eliminate a ton of wrong houses.  While I encourage you to consider your home an investment, its usefulness to you and your family are the foremost consideration.  A home needs to have a location you’re happy with, a size that works for your family, a layout you like and of course, a price that fits your budget.  Given those important things, there are some important things you will want to consider so that your investment appreciates in value.

Remember the Realtor’s Motto: “location, location, location.”  A home’s location will always have a huge impact on its ability to appreciate (and depreciate) over time.  This is true because unless your property is a mobile home (then it will only depreciate), the location of the property is never going to change. You can gut the inside and do a complete renovation that would make the HGTV folks proud, but you’ll never be able to take a good house out of a bad neighborhood. Important aspects of location include school district rankings, access to parks, stores and restaurants and crime rates.  The average price of other homes in the area places a limit on what your home is worth.  No matter how much money you put into a house, the neighborhood it is in caps the ultimate value.  Be careful of overpaying for houses in “posh” neighborhoods; as the neighborhood ages and becomes less posh, property values may actually decline.

It is smart to buy a home that has some cosmetic problems because a lack of “curb appeal” can save you about 10% on the home.  If you can save 10% on a $100,000 home (That’s $10,000!), then it’s worth some sweaty weekends painting and landscaping!  Just don’t neglect the curb appeal elements yourself.  Nice looking homes keep the neighborhood property values higher, and your individual home’s value higher.  Peeling paint can also cause moisture damage, and can be very expensive to fix down the road.

Home Inspections

Typically, purchase offers are contingent on a home inspection of the property to check for signs of structural damage or things that may need fixing. Lenders usually insist on this; they don’t want to be left holding a mortgage with a money pit for collateral.  Your real estate agent (or lender) usually will help you arrange to have this inspection conducted within a few days of your offer being accepted by the seller. This contingency protects you by giving you a chance to renegotiate your offer or withdraw it without penalty if the inspection reveals significant material damage.

Both you and the seller will receive a report on the home inspector’s findings. You can then decide if you want to ask the seller to fix anything on the property before closing the sale. Before the sale closes, you will have a walk-through of the house, which gives you the chance to confirm that any agreed-upon repairs have been made.

Home Appraisal

Real estate agents are usually pretty good at determining the fair market value of a home.  The bank is betting on the home being worth a particular amount before they issue a mortgage, so they will insist on a professional home appraisal that they pay for so that they can be sure of the results.  The appraiser is a third party company and is not directly associated with the lender. The appraisal will let all the parties involved know that you are paying a fair price for the home.

Mortgages

One of the big takeaways from this little book is that debt is evil, and you should avoid it without fail.  I do understand that some people are not willing to save for 15 years to buy a house, and you will buy a house with borrowed money.  When you take on debt to buy a home, the debt is called a mortgage.  Some people call mortgage debt “good debt.”  That is a load of manure.  No debt is good debt, and if you take on a mortgage you should make it a priority to pay as little as you can to the bank.  There are all sorts of reasons that people will tell you that a large mortgage over half a lifetime are perfectly fine; those people are either bankers, or have been duped by bankers.  The first argument is that you are making an investment.  Most real estate in most markets most of the time does a good job of hedging inflation, and that’s about it.  Homes do not really generate new value like companies do.

Unless you are very lucky and buy a home in a market just prior to a speculative bubble getting started, you can expect it to appreciate at about the same rate as inflation.  That means that once inflation is taken into account, you are hedging your mortgage interest not at all.  The bottom line is that the family home is a lifestyle choice, and not an investment in the sense that you plan to make money with it over time.  Even if it does appreciate, you’ll have to sell it to realize the profit, and many people will not sell a family home for emotional reasons.  If you spend lavishly on a home, you are doing it because you want to live in a lavish home, not because it is an investment.  If you are paying interest for 30 years so you can have a lavish home far above your means, then get ready to die poor.

Every home buyer has their own priorities when choosing a mortgage. Some are interested in keeping their monthly payments as low as possible. Others are interested in making sure that their monthly payments never increase. And still, others pick a loan based on the knowledge they will be moving again in just a few years.  My advice is to never choose a mortgage based on the monthly payment alone.  Always keep in mind that loans cost you a ton of money in interest.  You want to get a good rate, so shop around before you choose a lender!  Also remember that the amount of interest charged is based on an APR or annual percentage rate.  The whole “annual” part means that every year you drag out the loan, the more interest you are paying.  When you choose a thirty-year mortgage, you are paying more in interest to your lender than you are for the house.

Some mortgages are known as a variable rate.  Avoid these like the plague.  If interest rates go up substantially, so do your monthly payments.  What you want is a fixed rate mortgage.  Fixed-rate mortgages allow buyers to spread out the costs of purchasing a home over time while making predictable payments each month. There are some crazy loan products out there these days, but 15-year and 30-year fixed-rate mortgages are the most common. You can normally make extra payments in order to shorten the loan term without incurring any prepayment penalties.

Consider the interest rate and time frame when you are deciding how much house you can afford.  Since houses are so costly, most people cannot pay them off in less than ten years.  My suggestion is to look at the 15-year mortgage market.  Let’s consider an example:  Say you want to buy a $100,000 home at 5% interest.  If you got a 30-year mortgage, your monthly payment would be about 537.00 per month and you will pay the bank $193,256 over the life of the loan.  If you borrowed the same amount at the same interest rate for 15 years, your payment jumps to $791 per month, but you only pay the bank $142,343 over the life of the loan.  This means you get the house paid off faster and save a little over $50,000!  If you have to stretch it out to 30 years just to make the monthly payment, you are looking at too much house for your budget.  You can always get more house by saving up a substantial down payment.

Become a DIYer

Depending on where you live, some home repair projects have to be done by professionals because of housing codes.  Sometimes it’s just smart to hire a professional because they are licensed and bonded and if they drop a tree through your living room, they have to pay for it.  These days, skilled tradespersons charge a premium once reserved for physicians.  Learn all you can about basic painting, landscaping, carpentry, plumbing, and electrical work.  These skills can save you thousands of dollars, especially if your home is starting to have a little age on it and the “honey do” list seems to have something on it every weekend.  There are tons of great DIY books out there, and YouTube has a video on how to make just about any home improvement.  The DIY channel and HGTV both have loads of shows that show you how to do some pretty amazing things.  Don’t forget This Old House on PBS!  Just make sure you understand the safety issues around whatever projects you undertake.  The savings from your DIY skills will keep saving you money for as long as you own your home.

References and Further Reading

Discover financial services has an Affordability Calculator that is pretty conservative.  https://www.discover.com/home-loans/affordability-calculator/

Want a quick estimate of your payment?  Google “Mortgage Calculator”


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