Sat, May 03, 2008
Sub-prime on Steroids: Not Everyone Is Ready to Be a Homeowner
The Wall Street Journal recently reported that former pro baseball player José Canseco has decided to let his Encino, California mansion, originally purchased for $2.8 million, slip from his grasp and into foreclosure. Canseco, who apparently lost $1 million of his equity due to a decline in property values, has expressed his sympathy for homeowners who are facing foreclosure due to their inability to pay off sub-prime mortgages.
You don't have to experience a foreclosure to regret buying a house. I've met people who weren't at the brink of foreclosure who nonetheless realized too late that they had purchased houses before they were ready to be homeowners. I'm not going to speculate here about whether the housing market has finally bottomed. But I'd like to offer five questions that anyone thinking about a home purchase should seriously consider.
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How long do you expect to live in the house after you buy it?
Why is this so important? It's simple: houses don’t always go up in value in the short-term and sometimes not in the mid-term. If you have to sell your house after prices have been flat or after a price decline, you’re forced to lose money; in the worst case, you may have to pay money out-of-pocket (or go into foreclosure) because you owe more than your house is worth. Here in Boston during the mid-1980s and again in the last decade, it wasn’t hard to find people who bought a house (or condo) with the expectation that they'd live in it for a couple of years and then sell it. It worked then, but most people who bought a house two years ago with that strategy in mind now find themselves disappointed. If you’re going to buy a house, you need to have a reasonable level of certainty that you'll live in it for at least five years. Don't assume, by the way, that you can rent the house out if you have to move. If the rental market weakens, you could have a hard time renting your property for an amount that covers your costs - so you'd actually be paying money to own a house that you don't even live in. You should also do some research and be sure you understand what’s involved in being a landlord in your state if you think that could happen.
If you have a job that is uncertain, either because your employment isn't stable or because there's some probability that you'll be transferred to another geographical area, that should be factored into your analysis.
Another reason that the duration of your stay in a home is important is that there are usually significant costs associated with buying or selling a house; these start around 3% and may be as high as 10%. With such high transaction costs, you’re guaranteed to lose money unless your home's value increases meaningfully during the time that you own it. This is more likely over a longer period of time than over a few years. For example, the average person who bought a house near the end of the Boston housing boom in the late 1980's would have been unable to break even on the sale of his home after expenses unless the property was held for 8-9 years.
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How much have you saved for a down payment?
At the height of the housing bubble, some people bought homes with essentially 0% equity. Suddenly, with the drying up of the mortgage markets, lenders are no longer willing to offer those deals. Although you might be able to get a mortgage with a down payment of only 5%, you should probably think in terms of least 10%. If you haven’t saved that much, you should wait a while before buying.
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How much can you afford to spend on a house?
There are a number of online tools to help you analyze how much of a house you can afford, including this one at the Kiplingers Magazine website. If there’s a big disconnect between what you can afford and the cost of the kind of house that you want to buy, you need to ask some hard questions about whether your expectations are realistic. Maybe you should keep renting, or perhaps you should reevaluate your housing needs and see if a smaller house or condominium would meet your needs for the foreseeable future. -
How much are you spending now?
No, you don’t need to have a detailed budget or know how much you spend down to the penny. But you do need to have a fairly good idea of what you’re spending money on now while you’re still a renter. You'll need that information to be able to figure out whether you can handle the cost of being a homeowner. Speaking of which....
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How much it will cost to own a house like the one you want to buy?
When I first bought my home, I dutifully kept track of all of my house-related costs. After about three years I stopped looking at that data, although I still kept good budget records. Why did I stop looking at the data? Well, it was too depressing to actually total up what I had spent. If you’ve never owned a house, you don’t realize all the things that homeowners spend money on. If fact, I'm convinced that even most homeowners don't have an accurate idea of how much they spend on ownership and maintainance. Most people’s brains just don’t want to process that kind of information, so it gets ignored.
When you apply for a mortgage, you'll have to provide the bank or mortgage broker with reasonable estimates of the expected homeowners insurance and property tax costs for the home you want to buy. These costs are typically added to your current debt payments and the projected cost of repaying the mortgage and the estimated closing costs (plus the cost of private mortgage insurance, if you’re making less than a 20% down payment) in order to determine how much you can afford to borrow. But these costs are only the beginning of the new expenses you’ll incur as a homeowner. Once you own a home, you'll be responsible for all the costs of maintenance and repair. Most people don’t believe me when I tell them that I use a figure of 1% of a house's value when I estimate these costs, but it’s a reasonable number to use unless the house is absolutely brand-new and comes with a home warranty. If you’re considering buying a condo, factor in condo association fees, and be sure you understand the condition of the building's exterior so you can estimate how soon there might be extraordinary assessments in the future (to replace the roof or repair common areas, for example).
Most people find that their spending for utilities goes up when they move into their first home. Unless you have a really good reason to expect your utility costs to go down, plan to spend more for heat, electricity and hot water in your new home. In calculating the cost of buying your first house, expect some additional spending to replace some of the furniture that you own now. This sounds strange, but many families find that they buy or replace furniture within a couple of years of buying their first home. Unless you're moving into a home that's smaller than the place you're renting now, expect to spend at least a couple of thousand dollars in the first few years even though you have no intention now of doing so.
As a subtraction from your costs, calculate the amount of interest that you will be able to deduct and using your marginal tax rate calculate (1) whether you’ll be able to take itemized deductions as a result of buying a house and (2) if you can itemize, calculate the expected savings in your tax bill as a result of buying.
Now total all these things up, and determine whether you have the capacity, either through surplus savings or unused cash flow, to cover the cost of being a homeowner. If not, then hold tight until you've built more capacity to meet these expenses.
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How's your credit rating?
Six months to a year before you intend to buy a house, review your credit reports and address any errors or negative elements of the reports. Buy your credit scores at http://MyFico.com. If you don’t have a history of paying your bills on time and maintaining credit card balances that are well below your credit limits, you’re not ready to be a homeowner; the mortgages for which you qualify will be at unfavorable rates. Work on getting your balances down and your credit ratings up before seriously thinking about buying a house.
Most of us aren’t in danger of owing a bank $2.5 million, as Mr. Canseco did, and that’s a good thing. But his situation illustrates something: making lots of money does not guarantee financial security. No matter how much you make, you need to be sure that your spending rate won't put you at risk of a financial meltdown if your personal circumstances change unexpectedly or the housing market takes a tumble.
The question of whether owning is really better than renting is receiving fresh attention these days as many housing markets around the U.S. are cratering. I haven't really addressed that question here, but I hope to in a future series of posts. Stay tuned.