Chapter 1. The Benefits and Drawbacks of Home Ownership
When you buy a home, you open a new chapter in your life. It’s a time of both excitement and trepidation. You tour potential houses and picture yourself in a new environment. But you also worry about how you’ll pay for everything. It’s easy to feel overwhelmed by the home-buying process.
This chapter gives you a bird’s-eye view of the benefits and challenges of buying a home so you know what to expect. In subsequent chapters, you’ll work through these challenges in a logical, step-by-step fashion until you get the keys—literally—to your future.
The Pluses of Owning a Home
For many people, home ownership is the ultimate dream. It means you’ve got a permanent place in the world—somewhere you can raise kids, gather family and friends, and unwind from a hectic day. Whether you’re in a one-bedroom condo or a turreted mansion, owning your own home means comfort, safety, and pleasure.
Owning your own home comes with practical benefits, too. You can borrow against the value of your house, take impressive tax breaks, and treat your house as a long-term investment.
A Place of Your Own
People buy homes for a number of reasons, but “I want a place of my own” tops the list. When you own your own home, you don’t have to ask a landlord if you can wallpaper the dining room, install a luxurious tub in the master bath, or paint clouds on the ceiling of your daughter’s bedroom. You can create an environment that reflects your taste, lifestyle, and personality.
On the other hand, you may buy a home because you need more space—an extra bedroom, an office or family room, perhaps a yard with room for kids and pets to run around. Or maybe you’re tired of hearing your neighbors through the wall.
Buying a home also lets you put down long-term roots. You can become a permanent part of your neighborhood instead of someone just passing through. Settling in may inspire you to become more active in your community—join the PTA, start a gardening club, or even run for local office. A sense of belonging can be one of the most satisfying aspects of home ownership.
Almost everyone takes out a loan to buy a house. As you pay that loan back, you build equity in your property. Equity is the difference between the market value of your home—what someone would pay for it if you sold it today—and what you still owe the lender on the loan. If your home has a market value of $275,000 and you currently owe the lender $200,000, you have $75,000 worth of equity. Congratulations!
You’ll see the term “lender” used throughout this book (instead of the more commonplace “bank”) to refer to a mortgage issuer. That’s because many institutions besides banks make mortgage loans, including credit unions, mortgage companies, and savings and loans institutions.
By paying back your loan. Every month, when you pay back part of your home loan, you reduce a portion of your principal, the amount of cash you borrowed from the lender. (The rest of the monthly payment goes to paying interest, what the lender charges you for loaning you its money in the first place.) For the first few years, most of each payment goes toward interest. Over time, however, you pay back more of the principal than the interest. And the more you reduce the principal, the more equity you have in your house.
Some loans let you make extra payments toward your principal each month. That reduces the term of your loan (the number of years you have to make mortgage payments) and builds your equity faster. See Reducing Your Loan’s Term for the details.
By increasing the value of your home. If your home is worth more now than it was when you bought it, your home gains in equity. The value of your house increases under two circumstances: when housing prices go up as a result of market conditions and when you make improvements to your house (because improvements may put your house in a higher price bracket).
These two factors usually work in tandem. Consider this example: Say you find a house you want to buy for $180,000. You pay 10 percent of the purchase price ($18,000) in cash as a down payment and borrow the rest, $162,000, from a lender in the form of a mortgage. A mortgage is the loan you get to buy a house, and it’s defined as the home’s purchase price minus your down payment.
A few years down the road, as you pay off your mortgage month by month, you’ve reduced the loan’s principal by $4,500, to $157,500. At the same time, home values in your neighborhood have gone up, and your home is now worth $187,500. When you factor in your loan’s reduced principal and the home’s increased value, you have $30,000 worth of equity.
Housing prices can also decrease—as they did in many areas of the U.S. when the housing bubble burst in the late 2000s. So while homes historically increase in value over time, it’s possible that your home could lose equity.
When you sell your home, you can profit from the equity it’s gained over the years. If you sold the home in the example for its new market price of $187,500 and paid off the $157,500 remaining on your mortgage and the costs associated with sale, the rest would go straight into your pocket—or perhaps into the down payment on a new home.
Normally, when you profit by selling an investment, you have to pay a capital gains tax on that profit. But when you sell your home, Uncle Sam gives you a break. Currently, the IRS exempts home-sale profits of up to $250,000 for a single homeowner or $500,000 for a married couple who owns a home jointly. That means that when you sell your home, you only have to pay capital gains tax on any profit over those amounts.
The beauty of equity is that you don’t have to wait to sell your house to benefit from it. You can put it to use right away by borrowing against it through either a home equity loan or a home equity line of credit (HELOC).
Keep in mind that borrowing against equity means that you’re using your home as collateral for the loan, so make sure you don’t borrow more than you can afford to pay back. It also means that you now have two loan payments to make each month.
Home equity loans
With a home equity loan, you borrow a fixed amount of money, usually at a fixed interest rate. You repay the loan over a set period of time, just as you do a mortgage. (In fact, this kind of loan is sometimes called a second mortgage.) Homeowners often use home equity loans to pay for a single large expense, like adding a room or remodeling a kitchen.
Home equity line of credit (HELOC)
For this type of loan, lenders extend you a line of credit based on your equity rather than giving you a lump-sum payment. Taking into account the amount of equity you have in your home, the lender establishes a maximum line of credit and gives you a book of checks or a special credit card that lets you draw on that credit. You can spend any amount at any time for any purpose, until you’ve borrowed the maximum. So if your HELOC gives you a line of credit of $50,000, you can draw $5,000 one month, $20,000 the next, and so on until you reach the $50,000 maximum.
Most HELOCs have a term of 20 years. Lenders call the first 10 years the draw period. That’s because you can tap your line of credit any time during that first 10 years. You can pay back some or all of what you borrow during the draw period, or you can make interest-only minimum payments. After the draw period, your borrowing privileges end. And if you have an outstanding balance, your lender amortizes your payments, which means she figures out how much you need to pay each month to pay back the HELOC’s principal plus interest over the remaining term of the HELOC (the remaining 10 years in this example).
HELOCs usually have an adjustable interest rate. That means that the interest you pay goes up and down in conjunction with an established financial index, such as the prime rate (the interest rate lenders charge their best customers for loans). Some HELOCs have an initial fixed-rate period, during which the interest rate stays stable. When that period expires, however, your interest rate can change quickly. Your payments also fluctuate depending on how much money you borrow. If you draw $5,000 one month and then $15,000 the next, for example, your minimum payment increases after the second month.
Some or all of the interest paid on home equity loans and HELOCs is tax deductible. The total amount of your home equity debt can’t exceed $100,000 ($50,000 if you’re married but file income taxes separately), and all mortgages on the home can’t add up to more than 100 percent of the home’s fair market value. Check with your accountant or tax adviser to find out how much home equity loan interest you can deduct.
Certain costs related to buying the home, such as points you paid (see Points)
Some or all of your mortgage interest
Local property taxes
In some cases, private mortgage insurance (see Your Home’s Loan-to-Value Ratio)
Other home-related costs, such as a home office or improvements you make to boost your home’s energy efficiency
Of course, tax laws change frequently, and not everyone qualifies for each deduction. Check with your accountant or tax preparer to find out how homeowner tax breaks can best benefit you.
Short-term home ownership—say of three years or less—doesn’t always make a good investment. Over the short term, the real estate market can fluctuate significantly. Home prices can leap up one year, drop sharply the next, change a little, or stay flat. In fact, the real estate market can be so volatile that if you plan to stay in your house for just a couple of years, renting may be a better option. Also, the up-front costs of buying a home are high, and you’ve got to live in the home for several years before you break even on those initial expenses. Aside from the down payment on the house (Chapter 6), you have to pay a long list of other charges and fees to get financing and to transfer legal ownership of the house to you (Chapter 9 outlines these for you). The longer you live in the home, the more those initial costs are spread out over time, reducing their impact. For example, if you pay $6,000 in purchase fees and live in your house for only two years, the fees cost you $3,000 a year and, in all likelihood, your home hasn’t increased in value in that short a time to make the investment worthwhile. If you stay in the home for 12 years, however, that initial $6,000 cost you only $500 a year (and all the while, presumably, your house has increased in value, making the investment a good one).
Finally, lenders calculate your repayment schedule so that, for the first few years you pay back the loan, a much bigger chunk of each monthly payment goes toward interest rather than principal. Unless you take out a shorter-term mortgage (Shorter Term or Longer Term?) or make extra payments toward the principal (Reducing Your Loan’s Term), you won’t build much equity in those first few years. To see an example of how much of each monthly payment goes toward interest and how much goes toward principal in the first year of a loan, check out the amortization table on Amortization.
To get a sense of how long you have to live in the home before owning becomes cheaper than renting, try the “Is It Better to Buy or Rent?” calculator on the New York Times website at http://tinyurl.com/2sdtvd. Give the calculator information about how much you currently pay for rent, the home’s purchase price, the size of your down payment, the interest rate of your loan, and the cost of property taxes. Click Calculate to get an estimate of the tipping point when buying becomes the better deal.
If you plan to live in your new home for a while—say, more than six or seven years—home ownership is almost always better than renting. According to the U.S. Census Bureau, the average price of a home has risen steadily over the past 40 years, as the following table shows.
Average home price (adjusted for inflation to current dollar values)
The Census Bureau surveys home prices every 10 years, and the data isn’t yet in for 2010. But in August 2009, the National Association of Realtors reported that the average sale price for an existing home was $177,700. So even though prices may slide in the short term, if you’re in it for the long haul, your home remains a good investment.
As you shop for a home, you’ll probably encounter the phrase "starter home.” Real estate agents use that term to describe property that may be of interest to first-time homebuyers. The home may be priced lower than others on the market, making it easier for buyers to come up with a down payment, or perhaps it’s smaller, so it appeals to single professionals or couples without children.
"Starter home” also implies that second-time homebuyers move up to larger or pricier homes, using the profit from the starter home to beef up the down payment on their next home. It’s a sensible strategy; thanks to the equity you build up over time, you can usually move up to a home you couldn’t afford the first time you went house-hunting.
The Minuses of Owning a Home
When you figure out how much your new home will cost, purchase price is only part of the story—it’s the biggest part, to be sure, but you need to expect other costs, too, both one-time and recurring.
The down payment. This is money you pay up front toward the purchase of a home. Mortgage lenders see the down payment as a sign of your intent to buy the house and your ability to repay your loan. These days, lenders prefer a down payment of at least 20 percent. You may be able to qualify for a lower down payment (FHA-insured loans, Government Financing Programs, are the best place to start looking).
If your down payment is less than 20 percent, you’ll probably have to buy private mortgage insurance (Coming Up with a Down Payment), paying monthly premiums until you accrue at least 20 percent equity in your home.
Mortgage-related fees. There are all kinds of costs associated with getting a mortgage, such as the application fee, the home-appraisal fee, and an origination or processing fee (what the lender charges for the administrative tasks involved in processing your application)—and that’s just for starters, as you’ll see in Chapter 9.
Other closing costs. Mortgage-related fees are only part of the story. To legally transfer ownership of a house (what industry types call closing on a house), you’ll also pay transfer taxes and recording fees, a title search and title insurance fee, settlement fees, and more. To prepare for the closing, you’ll pay for a home inspection and buy hazard insurance as well.
Chapter 9 gives you the details on closing costs, but in general, expect to spend 3 to 6 percent of your new home’s purchase price on fees and other charges.
Of course, after you borrow money to buy your home, you have to pay the lender back. You do this by making a payment to the lender each month. Part of each payment goes toward paying back the money you borrowed (the principal), and part of it goes toward paying interest on the principal. But principal and interest aren’t the only recurring payments you have to make; you also have to pay taxes and insurance. Some homeowners pay these once a year, directly to their tax collector or insurance agent. In other cases, the lender itself breaks the annual cost into 12 installments and adds them to your principal and interest payments. The lender holds the tax and insurance payments in an escrow account (basically, a special-purpose holding account), and then uses that money to pay your tax and insurance bills when they come due.
You may hear real estate professionals talk about PITI (pronounced pity, as in “It’s a pity you have to pay it”). That acronym refers to the four components that may make up monthly payments to lenders:
Principal. This is the amount of cash you borrowed from a lender to buy your house. You pay it back over the term (the total length) of your loan. Each month, part of your payment goes toward paying back the principal.
Interest. Interest is the money you pay your lender for using their money to buy your house (“renting” their money is probably more accurate). For the first few years of your mortgage, most of your monthly payment goes toward paying interest.
Taxes. This refers to your local property taxes, which support municipal services like sewage, trash pick-up, playgrounds, and the like.
Insurance. This includes homeowner’s insurance and possibly one or more of the following: private mortgage insurance (PMI), which lenders require when your down payment is less than 20 percent of the home’s purchase price; flood insurance; and homeowners’ association fees. Homeowner’s insurance protects your home and its contents in case of fire, theft, vandalism, wind damage, and other disasters. It also covers you if someone is injured on your property. Living trust has tips to help you choose a policy. And if you live in areas that have a high risk of flooding, your lender will require you to buy flood insurance in addition to your homeowner’s policy. FEMA, the Federal Emergency Management Agency, administers the National Flood Insurance Program; you can get info about flood insurance at www.fema.gov.
You can find links to all the websites mentioned in this book on the book’s Missing CD page. To get there, go to the Missing Manuals home page (www.missingmanuals.com), click the Missing CD link, scroll down to Buying a Home: The Missing Manual, and then click the link labeled “Missing CD”.
Say you borrow $200,000 at an interest rate of 6 percent for a term of 30 years. Property taxes are $2,000 a year, your homeowner’s insurance policy costs $750 a year, and you don’t have to pay PMI. Based on those numbers, your monthly payment breaks down like this:
Principal and interest
Total monthly payment
Use the mortgage calculator at www.realestateabc.com/calculators/PITI.htm to plug in your own numbers and estimate PITI for the home you’re considering.
That’s what you’ll pay the first year. But keep in mind that the amount of your monthly payment can change from one year to the next, depending on several factors:
The type of mortgage loan. If you opt for an adjustable rate mortgage (ARM; see Adjustable Rate Mortgage), your interest rate can change from year to year. When the interest rate goes up, so does the interest portion or your mortgage. Likewise, if the interest rate goes down, so does your interest payment.
Tax increases. When your city, town, county, or school district hikes taxes, your monthly PITI payment reflects that. You have to pay more each month to make sure there’s enough in escrow to pay next year’s taxes. Your lender calculates the tax portion of your PITI once a year.
Increased equity. If you put down less than 20 percent to buy your house, you can request cancellation of PMI after you build 20 percent equity in the home—whether the equity bump came from rising home values, payments toward the principal, or both. Getting rid of PMI lowers your monthly payment and can save you hundreds or even thousands of dollars. By federal law, your lender must cancel PMI when your equity in the home reaches 22 percent.
When you figure out whether you can afford a home, don’t forget to take utilities into account. Ask the seller about monthly costs for electricity, heating fuel, cable, Internet access, water, trash removal, and so on. Make sure that you can afford these charges along with the PITI.
Depending on the terms of your loan, your monthly payment may comprise PITI (principal, interest, taxes, and insurance) or just principal and interest. If you pay PITI each month, the lender holds the money for taxes and insurance in a special account and pays these costs on your behalf when they come due. If you pay just principal and interest, staying current with tax and insurance payments is your responsibility.
Whether you buy a brand-new home or an old fixer-upper, sooner or later you’ll have to pay maintenance costs. With all the rewards of home ownership comes responsibility—and that means you’re the one who pays the bills when the lawn needs mowing, the shutters need painting, or there’s a foot of snow in the driveway. You’ll invest your time or your money—and probably both—in routine upkeep.
Aside from routine and seasonal maintenance, be prepared for other expenses. You may have to replace the water heater, buy a new dishwasher, fix a leaky roof, or replace rotting trim. When an appliance dies without warning or other issues crop up unexpectedly, you need to find the money to fix the problem. Once you have sufficient equity in your house, you may decide to borrow against that equity. But it’s a good idea to have an emergency fund that you can tap when things go wrong.
You may decide to remodel. Whether you replace carpets, redesign the kitchen, build an addition, or wallpaper a room, this can be a significant expense. On the plus side, remodeling can increase the value of your home and build equity faster, so it not only adds to the enjoyment of your home, it’s a good investment.
Condominiums. As Condominium explains, a condominium is a housing arrangement where specific parts of a piece of real estate are owned individually (such as apartment-style units in a building or complex of buildings) and shared areas and facilities are owned in common and controlled by a board that represents all the individual owners. These shared areas and facilities include walkways, hallways, elevators, staircases, building exteriors, heating and cooling systems, and perhaps a pool and parking lot. Monthly condo fees (sometimes called common charges) pay for all this—maintenance to the grounds, exteriors, and common areas; lighting in entries, hallways, and the parking lot; insurance; and sometimes a long-term fund for emergencies.
Co-ops. Short for housing cooperative, in a co-op, residents own shares in a corporation—and the corporation itself owns the real estate. (See Townhouse for more on the legal ins and outs of co-ops.) If you buying a co-op—or, more accurately, shares in a co-op—you pay a monthly fee for maintenance and other building-related expenses, just as condo owners do.
If you buy a condominium or co-op, your monthly fees will minimize out-of-pocket costs for routine maintenance. But these kinds of housing also may require unanticipated repairs, such as fixing a crack in the community pool, resurfacing the parking lot, or scrubbing away graffiti. Or a storm may damage the building or complex, and even though insurance will cover most of the damage, the deductible has to be paid. In such cases, a special assessment, charged to each unit, pays the tab—which means you’ll have to chip in.
Homeowners’ associations. Some developments of traditional single-family homes include lots of attractive amenities, such as a community pool, tennis courts, a clubhouse, and so on. In such communities, a homeowners’ association (HOA) collects monthly or annual dues to pay for these amenities. Some HOAs charge the same dues for each home in the development, others base fees on each home’s square footage or purchase price, with the owners of bigger and more expensive homes paying more.
Potential for Lost Value
As any investor or Lotto player knows, there’s no such thing as a sure thing. When you invest your money, you take a risk, and that’s true when you buy a home. Even though houses tend to gain value over time, sometimes (especially in the short term) they can lose value. A recent example is the U.S. housing bubble that peaked in 2005, popped in 2006, and continues to deflate in some parts of the country now. Some people who bought at the height of the bubble now find themselves with negative equity—they owe the lender more money than their home is worth.
Fluctuating markets represent one way a house can lose value, but other factors can have the same effect. For example, crime rates could increase in your neighborhood, or the city could build a sewage-treatment plant a block away. Developers could saturate the market with new housing developments, or a major employer could lay off employees or go out of business. You could lose your job and be unable to afford to keep the house in good repair.
When you’re a homeowner, you can’t just pack up and move when wanderlust strikes or your company transfers you to a different city. You have to continue to pay the mortgage or pay off your home altogether. That means you either open your wallet far enough to keep paying the mortgage after you move, find a tenant to pay you rent so you can pay the mortgage, or sell the house.
So now, with eyes wide open, it’s time to find your new home.