5 things to consider before buying a house

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New to the Rockville, MD area, we found a groomer to get our dog Rudy (Shih Tzu) cut. We like to get him cut as short as possible or “rat” style, for what he resembles once he is done. After an excellent cut, the owner/groomer and I had an interesting discussion about her townhouse. She bought it 15 years ago for about $250,000. It is now worth $750,000. Wow! That’s terrific.

Hanging By A Thread

My groomer also talked about her neighbor (let’s call him Bob) who recently bought a similar townhome next to her for $750,000. Bob was telling her the he was getting killed with his payments. No wonder! Assuming a 6% fixed rate, he would have to pay $4500 a month (At 6%, you are paying approx. $600 per $100,000; at 7%, you are paying approx. $700 per $100,000, etc.).

To shell out $4500 a month at a 30% tax rate, you need to make $77,000 to afford those payments. Don’t forget to add in $500 month in property taxes, at which point he will need $5000 a month or $85,714 to cover the payments. Now if you want to eat or afford a car to get to work, you will need to make a lot more.

I am pretty confident that at the time Bob was not really considering other expenses or the risk of losing his job, or worse, being married to the job because he can’t afford to leave. Bob was probably thinking he would have a nice retirement built into his house, and he would eventually get enough raises or get a better job to make up for any shortfall.

Some people buy a house just out of their price range, hoping to survive until they can afford it or until the real estate market turns around.

We are all programmed with the same assumptions:

A house is a great investment because it forces you to save (this one is true!)
A house is the best place to put my money (o boy are you in for a surprise)
I can always do better than renting (not always – depends on the area)
My house will be worth more tomorrow (I hope so!)

A different way of looking at it

Consideration #1: Overextending vs. Renting: Let’s start by talking about Bob, who is now trapped with house payments he can barely afford. Let’s compare his purchase to a great town home rental in my area, which is 5 miles down the road in an equivalent community. Renting a comparable corporate 3 bedroom town home will run $1800 – no taxes, no Home Owner Association (HOA) fee, no insurance.

My rented town home $1800

Bob’s house $5000 (mortgage, taxes, ins. and HOA)

Difference $3200 a month

Let’s say I am willing to give up the benefits of owning my own house and invest that difference every month earning 6% annually (over time), which is the average appreciation of real estate in the last century. (The stock market in contrast is about 8%).

Using my savings calculator at 6%, I will have accumulated $918,118 in 15 years. My groomer only realized $500,000 in appreciation in 15 years of owning her own town home*, but she did manage to pay off her mortgage early – giving her $750,000 total. Keep in mind that even though she may live rent free after that, she still has $500 in monthly real estate taxes, $100/month in insurance, and ongoing maintenance/repair.

As you can see, buying a home will not necessarily yield a better investment. Plus, she also has an asset that may take time to sell at a price she may not get.

*Taxes will affect the outcome but not enough, besides the last 15 years of appreciation has been the greatest percentage rise in the history of modern real estate.

Consideration #2: Future Growth: In this example, I was talking about a pretty affluent area with a good rise in appreciation in the last 15 years. But if we take a look at Altoona, PA where my wife is from, there is no industry to bring growth to the area, so home prices have not escalated in 30 years. In contrast, my brother, who lives in the SF area, will certainly see price escalation every single year. The future growth of the area has a great deal to do with the success of picking your next home.

Consideration #3: What prices are really based on – Family Income:: What most people don’t realize is that housing bubble didn’t just burst from over speculation, exotic mortgages, easy lending practices and excess inventory. When you get down to it, homebuilders have a tough time charging more than what a family can afford. So if most people’s average income has not being escalating along with home prices, what do you think will happen to home prices in the long run (especially with higher food and fuel costs)?

If you buy a home for $750,000 (or insert your own figure) like Bob in hopes that the home will double, there has to be enough people in the future who will make enough money to afford double or triple that cost. In contrast, the average American family income has not doubled or tripled in the last 20 years, why should home prices continue to double in the next 20?

Consideration #4: Environmental Factors: I grew up in Florida, which a great place except for the occasional hurricane. Unfortunately, these hurricanes have really increased insurance rates so much that many consider leaving. Imagine paying $150/month in premiums one year and $600/month the next. It has happened to many friends I know. With earthquakes, forest fires, hurricanes, or floods, know the potential dangers of the area you are moving to first before making the move.

Consideration #5: Insurance, Taxes, HOA fees: As you can see, increasing insurance premiums can become an extra financial burden in certain areas of the country. Or, taxes or HOA can also become that burden, as with my groomer. Think of it as her paying for the massive appreciation through higher real estate taxes. There is always a price. These other escalating costs over time can make a house difficult to afford, which is another reason if you purchase to purchase within your price range.

Choose the right house for you, and then make it a home

Be realistic about your expectations by purchasing a house you can comfortably afford. Besides, your home shouldn’t be your only investment. By overextending yourself financially, you not only squeeze yourself today but also take a risk that your home (your only investment) may not appreciate to a value that you can afford to retire on.

Pay only what you can comfortably afford in today’s dollars with your current income. A general rule of thumb is to pay no more than 1/3 of your monthly income toward your mortgage. You should also look at homes less than 3 times your annual income, unless you have saved a substantial down payment to cover any difference. Finally, choose the right house for you, and then make it a home. Fall in love with your house only after it makes financial sense.

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