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Personal Finance FAQ

Making Your House Your Home and Not a Money Pit

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

One of the biggest financial decisions any family has to make is how to pay for a roof over their heads. There’s the question of buying versus renting, and how much to spend on housing. We’ll examine all of these issues in this article.

If you listen to all of the clichés, than home ownership is supposed to be the American Dream. It’s an economic investment where you’re able to turn your living space into a house, a castle, a refuge from the rest of the world. The U.S. government gets in on the act, giving you tax breaks for mortgage interest, allowing you to sell your house, assuming you lived in it for two out of the past five years, at a profit without needing to pay capital gains taxes. It created two semi-private organizations, Fannie Mae and Freddie Mac, whose primary purpose is to provide a secondary market for mortgage notes, which allows banks to lend homebuyers money at much lower rates than they otherwise would.

It seems like all of the factors favor owning a home, don’t they?

Once you get the keys to your brand new house, reality might start to set in. You’ll be responsible for all of the maintenance, the insurance, the property taxes, the homeowners’ association fees, and any upgrades that you want to do to the property. If you rent, you might not get to customize it the way that you want, but aside from basic maintenance, you probably won’t be responsible for any of the other costs, and renter’s insurance is much cheaper than homeowner’s insurance.

On the other hand, when you move, you won’t have any equity built up in the house (assuming it’s appreciated and you’ve lived there long enough to make a significant dent in your mortgage), so, aside from actually having had a roof over your head for the time you rented, you won’t have any financial progress to show for all of that rent that you paid.

Which one is better, then, rent or buy a house?

There are a few big considerations to keep in mind when trying to answer this question.

  1. How long will you live in the place? The less time you’re going to live somewhere, the less time you have to spread out the costs of getting a home loan (if you get a mortgage) and the costs to sell the home, not to mention to get value and use out of any major home improvements that you’ve made to your residence.
  2. What is the price/rent ratio where you’re looking? This is a calculation of a purchase price of a home divided by the annual rent you’d pay. You need to take two similar properties and find out how much one would cost to buy and the other would cost to rent. If a house would cost $100,000 to buy and $800/month to rent, then the price/rent ratio is 10.4: $100,000 / $9,600 ($800 X 12). Price to rent ratios under 14 favor buying and ratios over 16 favor renting.
  3. How disciplined are you at saving? If you’re going to take the financially beneficial route, are you disciplined enough to save the difference? One of the arguments in favor of buying a house is that it is a forced savings program, albeit an expensive one, since you have to pay a ton of mortgage interest over the life of the loan. If you’re disciplined already, then you don’t necessarily need another forced savings program, since you’re already saving and investing.
  4. How much house maintenance are you willing to take on? If you’re like me, the idea of anything more mechanically complicated than nailing a nail into a wall is a terrifying concept. If I were to try to take on a project like remodeling a kitchen, I’d leave a trail of destruction in my wake and significantly reduce the value of the property. If, on the other hand, you’re very handy and you enjoy those types of home renovation projects, then you can probably add value to your property over the course of time.

It’s not as cut and dried of a decision as the clichés would have you to believe. In the good old days, when people worked for the same employer for 40 years, retired, received a gold watch and a pension, and then promptly kicked the bucket, it made sense to live in the same place your entire life. You raised your kids, you were part of the community, part of the neighborhood, and had no need to be mobile.

Nowadays, job changing is much more common. In 2008, the average tenure at an employer was 4.1 years.[1] This doesn’t necessarily mean that every 4.1 years, you can expect to up sticks and move somewhere else for an employer, but there is a real possibility, particularly dependent on your avocation, that you could move cities to change jobs or to move up the corporate ladder. Being stuck in a house and either unable to move or forced to become an unintentional absentee landlord is not a position you want to be in unless that was something which you intentionally planned all along.

The tradeoffs between renting and buying come down to three main categories:

  • Cost of renting versus cost of buying: if there is a significant cost advantage to one versus the other, then this should be an important determinant in deciding which way you want to go. The New York Times has an excellent buy versus rent calculator that will tell you, given the circumstances in your particular location, how long it will take for home ownership to be a better deal than renting (if ever).[2]
  • Flexibility versus stability: how important is it for you to be able to pick up and move when you want? If you own a home, then you’ll have to put it up for sale or rent it out. If you rent, then you can move at the end of your lease, or if you really want to move, you can pay your lease break fee and move out when you want. Neighborhoods with home ownership are more stable, so there isn’t as much transience among the people with whom you live. We lived in a condominium complex which had a significant number of renters, and that was a major issue for us. It seemed like as soon as we met our neighbors and found people we liked, they moved. It’s hard to put a dollar value on not having to see new friends move away every six months if that’s something which is important to you.
  • Functionality versus customization: if you rent a property, then you’re not going to be able to customize it to suit your specific tastes. Sure, if you want to upgrade the kitchen (and have the demonstrable ability to do so), your landlord won’t complain if you want to leave an upgraded kitchen behind, but don’t expect to get the market value out of that upgrade. Want black walls? Don’t count on it if you’re renting. If you’re more minimalist, though, and don’t care as much about paint on walls or custom cabinetry and just want a functional place to live, then renting will be a more appealing option. Landlords are going to provide habitable, suitable places to live, usually without the frills associated with a custom or upgraded home.

Alas, in most instances, there is no clear-cut right answer. The purpose of the section above wasn’t to give you a clear-cut answer, either. The purpose was, instead, to open your eyes up and get you to consider that, in many cases, renting may be a better option than buying a house. It’s very feasible that you could never own a home in your life and be perfectly fine. Don’t accept that buying a house is simply the default answer.

Let’s look at what happens in each situation that you decide. First, we’ll examine what you need to know about renting a place to live in.

What to Know About Renting

Naturally, you’re going to want to find a place that fits within your budget and has size enough to accommodate your living needs and doesn’t look like it doubles as a crack distribution center. Beyond that, though, there are some questions that you’ll need to ask your potential landlord before ever committing to a lease.

  • What do you need to know about me before moving in? Most landlords will require a credit check and a background check. Many will also require proof of income or verification of employment. You will probably also have to pay a security deposit.
  • What is required to get my security deposit back? Do you just need to leave the place tidied up, or do you need to steam clean carpets and spackle and repaint holes where you hung your pictures?
  • Can I bring my pet(s)? Some landlords do not allow pets, and some will require you to either pay an extra fee or to pay an additional security deposit. Many landlords limit the type, size, and number of pets allowed.
  • Who pays utilities? Sometimes some or all utilities are included in the rent, and sometimes the utilities are the tenant’s responsibility.
  • What repairs am I required to cover? The landlord is not going to change a lightbulb for you, but if the dishwasher springs a major leak, you shouldn’t be expected to fix that.
  • How much parking do I get? If you have two children of driving age and a car each for you and your spouse, you may need to negotiate for additional spots, unless it’s a first-come, first-served situation or you’re renting a single family home.
  • Who shovels snow? If you’re in south Florida, this isn’t an issue, but in many places, liability accrues if snow remains on walkways and driveways. Find out who gets to do the back exercises in moving the fluffy stuff.
  • What are the penalties for breaking the lease? If you get the dream job on the other end of the planet and you’re only six months into the lease, what happens? How much do you have to pay for moving out?
  • Why did the previous tenant leave? This, hopefully, will be an innocuous answer, but if you get any sort of discomfort from the landlord in answering that question, then it should be a warning sign.
  • What is the month-to-month agreement after the lease expires? In many states, once the lease is up, you move into a month-to-month agreement, but the rules vary from state to state. In some states, the landlord can give you notice and then kick you out. In other states, you have the right to stay as long as you keep paying rent.
  • What’s been the history of rent increases here? You want to know how much rent has historically risen so you have a good idea of how much it might rise if you want to renew your lease.
  • Do I get a discount for paying the entire lease up front? If you have a 12 month lease for $800 a month, can you pay $9,000 up front and be paid up? Sometimes you can get the cost knocked down if you’re willing to pay a full year up front.
  • Do I get a discount for leasing for more than 12 months? The standard lease is 12 months. Landlords don’t like vacancies and having to find other tenants, so if you’re a good tenant and are willing to stay for longer, sometimes they’ll cut you a deal.

Before you sign a lease, it’s important to know the tenant-landlord rules in your state. These will be your guide for the rules governing what your landlord is legally responsible for and what you’re legally responsible for.

Additionally, you’ll want to do a walkthrough of the property before you sign the lease and take the keys. Here is an excellent checklist of items to verify before you sign.[3]

If you decide to buy instead of renting, there are other areas to focus on as well.

What to Know About Buying a House

The maxim in real estate is “location, location, location.” That works, but only if you have “money, money, money.” There are two ways to buy a house:

  1. Pay cash. That’s the preferred method to me. I’d rather see you rent for a few years at a lower price and really save up the money so that you can pay cash than to get into a 100% mortgage. Once you have a paid off house, the only expenses you’ll have related to the house will be property taxes, insurance, and upkeep.
  2. Get a mortgage. While I don’t think that there’s any such debt as “good debt,” most people are going to go this route. I can’t be all sanctimonious and say don’t get a mortgage because we had two of them in our time. However, we paid off the mortgage on our second house as fast as humanly possible, killing it in just under five years. I can certainly tell you that the grass is greener, the air is sweeter, and your house is homelier when you don’t have a mortgage.

Therefore, I’m going to assume that most of you, if you’re going to buy a house, will wind up getting a mortgage. If you haven’t figured it out already, I’m not a big one for rules of thumb. Instead, I’d rather you go through the exercise of prioritization to see where housing falls on the list of priorities in your life to determine how much you should be spending on it. So, my rules will be few and narrow when it comes to getting a mortgage.

  • Put as much down on the house as you can. The rates for a 20% down loan will be lower than for a 0% down. That’s almost tautological. Don’t be fooled by the siren song of believing that mortgage interest deductions will make financing more of your house worthwhile. The mortgage interest deduction only kicks in above what your standard deduction is. If you’re filing single, your deduction in 2020, is $12,400. If you’re filing married, it’s $24,800 for 2020. That means you have to have enough in itemized deductions to exceed that threshold for the mortgage interest deduction to kick in, and then, it’s only going to be the amount above the deduction which counts. Furthermore, you’re making financial decisions because of tax implications, not based on whether or not the decision is a smart move in the first place.
  • Get the lowest length for your mortgage that you can. The payments will only go up by a small percentage, but you can probably get a noticeably lower interest rate, and you’ve already cut the term of the mortgage by at least half compared to a normal, 30 year mortgage. If you can get a shorter term than 15 years, do it.
  • Get a fixed rate loan. Interest rates have hung around at record lows for quite a while now, and while they could potentially go lower, common sense says that they’re only going to go one way – up. When they’ll go up is a big mystery, but eventually, they will. You don’t want to be left holding the bag on an adjustable rate mortgage when the interest rates do go up, because, almost assuredly, they will.
  • Don’t trade points for interest. This is a common ploy that banks use – they tack on more into your mortgage and give you a higher interest rate to reduce the amount of money that you have to pay up front. Don’t fall for it. You’re trading a little less pain now for increased pain for the next 10, 15, or 30 years. If you can, buy down the interest rate by putting more money down.
  • Get preapproved before you put in your offer. This will get you more negotiating leverage when you put in your offer. Many offers are contingent on the buyer getting financing, so coming in with a preapproved mortgage means that you have the ability to deliver on your offer. You might be able to make a lower offer and get it accepted if the sellers know that you can come through rather that needing to wait up to 90 days for a flakier offer to come through.
  • Don’t forget about maintenance expenses when determining your budget. It’s easy to forget that roofs need replacing and brick needs tuck pointing until you have to pay for it. Annual home maintenance usually costs about 2% of the overall cost of the house.

Going through this exercise will let you know how much you can afford per month in mortgage payments or how much cash you’re willing to shell out to buy a house. If you’re going the mortgage route, once you’re approved at a given rate, you can take the payments per month that you’re prepared to make and figure out how much house you can afford. Don’t forget to add in closing costs to the amount you’ll have to pay up front; that’s usually about 3% of the purchase price, so you’ll need to account for that money before you start making offers.

Once you know how much you’re willing to spend on a house, you can start to go house shopping. I personally like to scour foreclosures first. I’m willing to take on a little work, or, in my case, hire someone to do a little work, in exchange for getting a better deal. Here are two resources you can use for looking for foreclosures:

I also use Zillow to look at foreclosures, although their data isn’t always updated in a timely manner. I’ve found that many of the homes which Zillow lists as foreclosed aren’t on the market. You can usually confirm these listings by searching for the same address on http://www.realtor.com.

Once you have a few houses that you want to look at, then you can take that list to a Realtor. If you’re willing to do a lot of the leg work doing the research, you can try to negotiate the Realtor down a percentage point in commission. The buyer’s agent doesn’t have nearly as much work to do as the seller’s agent, so you may as well ask. If you’re prepared and have done your research thoroughly, the buyer’s agent shouldn’t have that much work to do anyway.

A note about Zillow, Trulia, Redfin, and their ilk. I like to use those websites to get a general idea about how much a property is worth (you can see how we use Zillow to manage our real estate estimates). They’re good for ballpark estimates, and their accuracy varies depending on where you live. The closer to a large metropolitan area, the more likely the estimates are to be reasonably accurate. You can always compare the Zestimates with recent sales or with current homes for sale to see what the difference is.

Before you start looking at houses, though, you need to get in a proper frame of mind. Realtors will tell you that your house is an investment. It’s not. You want to buy your house on sale and not for an outrageous price, but it’s not an investment. Stocks, bonds, small businesses, commodities, and investment real estate are investments, but your house is not an investment. It’s a place where you live. If you start to think of any house that you look at as your home before you even put in an offer, you’re going to fall for something called the endowment effect, which is one of the Monkey Brain biases. If you get an emotional attachment to something, whether or not it’s conscious, you’re going to put a higher value on it. This is going to decimate your willpower and your negotiating strength when it comes to putting in an offer on a house.

The way to avoid this effect when you’re looking at houses is to bring a few dollar bills with you. Each time you pull up to a place and before you actually go into it, pull out the dollar bills and count them. Say the numbers out loud. Yes, your Realtor is going to look at you like you’ve grown a third eye, but doing this exercise will get you to focus on the financial aspects of the transaction and reduce the emotional attachment that you might feel about a property. If you, at any point, feel the urge to utter “I love this house,” pull out the dollar bills and start counting. You can get emotional about a house once you live in it, but not before then.

If you find a house that you like and can reasonably afford, there are a few more tests you need to put it through before making an offer. You will want to drive in the area near rush hour so that you can see what a potential commute is going to be like. You will want to drive around the neighborhood to get a sense of who your neighbors are. Do they like to walk their dogs and do the kids converge in the playground, or are there cars on blocks everywhere? Also, you will want to check zoning and planning to make sure that there will not be an enormous strip mall plopped down right next to your house in a few years.

Finally, if you’re ready to put in an offer, you will want to make the offer contingent on getting an inspection. Unless you’re a homebuilder or work in repairing homes, you’re not going to know what could be hiding underneath the foundation or behind the walls. Get an inspection and make sure that the house is either in sound condition or that all of the items noted in the inspection will be repaired before you close.

Once you’ve gone through all of those steps and you close, congratulations! There’s one final gotcha, and we fell for it hook, line, and sinker. Don’t feel compelled to fill every room in your house with furniture. We got a great deal; it was a builder who was on the verge of bankruptcy, so he was firesaling the homes in inventory to try to avoid bankruptcy. We got a huge house. It was 5 bedrooms, 2 ½ bathrooms for me and my wife. No dog, no kid(s). Just us. We filled every room in the house with furniture. When we decided to move a few years later, we downsized to a 2 bedroom, 2 bathroom condo. We had to sell most of the furniture we’d bought, and probably got about 30 cents for every dollar that we spent. Don’t make the same mistake! Remember your priorities. If nice furniture isn’t high on your priority list, then don’t go crazy buying a bunch of nice stuff shipped directly from North Carolina. Shop estate sales. Use Craigslist. Use Freecycle. Be reasonable in what you purchase!

Now that we’ve covered getting a roof over your head, we’re going to move next to getting your affairs in order and look at all of the documents you need to protect yourself and your family in times of catastrophe.

 

Related articles:

What Should You Think About If You’re Planning on Buying a House Next Year?

The Value of Mortgage Shopping

Six Things You Won’t Learn About Real Estate From HGTV

Why You Should Buy LESS House Than You Can Afford

The Endowment Effect: Why You Should Buy a Foreclosure and Never Sell to an Investor
 

[1] http://online.wsj.com/article/SB10001424052748704206804575468162805877990.html

[2] http://www.nytimes.com/interactive/business/buy-rent-calculator.html

[3] https://web.archive.org/web/20131101122959/http://housing.asuw.org:80/resources/pdf/inventorychecklist.pdf

The next article in this series is Papers, Please! The Important Documents in Your Life.

By

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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