Evaluating Homeownership
The last year has been a whirlwind for Craig and Marcy. The couple both graduated from college and married a short time later. Marcy landed a job with a regional accounting firm and Craig was working for a large insurance underwriter.
Craig was doing pretty well as a husband in training and, despite the pandemic, they were doing well financially. They called looking for advice on buying their first home.
Marcy said, “We’ve looked at some condos around the area we want to live and found a few we are interested in.” She added there had been some vandalism in their current neighborhood.
Craig ask, “What are your thoughts?”
Regarding the condo question, or any other question, almost anything is possible. However, it is a matter of what you are willing to give up. Life is a series of compromises.
There are certainly pros and cons to homeownership.
The pros of homeownership are control and associated peace of mind. This is not just a building, but your home. You may derive some appreciation and there is no ornery landlord to deal with.
The cons of homeownership start with buying your slice of heaven. Budget approximately 1% of the fair market value for closing costs, survey expenses and title insurance.
After you have made your claim upon the American dream, you are now responsible for the maintenance. Much of this will depend on the age, improvements and how much sweat equity you are willing to put in. However, a decent rule of thumb is to budget 1% of the homes value for annual maintenance.
I asked my friend, John, who is a professional real estate investor about this. He quickly opined that if you own your home, there is no landlord to come over and fix the toilet or broken HVAC system.
He added, “Owning property is not just about money, it is about time. Whether you fix it yourself or pay someone to do it, you still have to manage the property.”
John said, “I remember the joys of having a free Sunday and thinking, hmm, what should I do today?” John said he never answered, “Gee I really wish I had some leaves to rake or grass to mow! Or a broken washing machine to fix. Or a leaky galvanized pipe to replace.”
He added that homeowners should develop a capital replacements budget. This budget should prepare you to deal with a roof, air conditioner, water heater or appliances every five years.
With interest rates as low as they are, it is tempting to see homeownership through rose-colored glasses. Despite this, don’t be surprised that your payments don’t increase your equity much until you have been making payments at least five years.
In addition to mortgage and interest payments, you need to factor in insurance. We typically budget about 1% to 2% of the fair market value of the property.
If you have very little in the way of a down payment (less than 20%), then you also incur private mortgage insurance. This will typically cost about .5% to 1% of the loan value on an annual basis.
Your new friends at the county appraisal district will be very interested in your new acquisition. Depending upon how they value your castle, they will assess property tax somewhere between 2% to 3% of fair market value on an annual basis.
There is also the issue of illiquidity. If circumstances change selling a house takes time, money and effort. If you aren’t going to be in a property for at least seven years, you should seriously consider renting.
There is also opportunity cost. This is one of my favorite economic and investment concepts. If you put money into an asset you are affirmatively stating this is the single best place to allocate money.
If you take this position, you are saying that money in a house should not go to a 401k with a match, or to pay down credit cards or to any other investment opportunities.
The circumstances might change if you are in a really hot area with lots of growth and constant demand. However, if you’re in a regular neighborhood, the price appreciation is not the same. Neighborhoods also change over time. Sometimes they turn better and sometimes worse.
As a general rule, average real estate increases by about 3% per year. This is offset by the annual holding costs of property tax, maintenance and insurance.
Homes do go up in value, but it is not a good investment. Net of holding costs, it is a breakeven proposition.
Even if it is a break-even proposition, a large illiquid asset doesn’t make sense from an investment perspective. This is especially true if you are a young couple and money is tight.
With a large illiquid asset you have less flexibility if something goes wrong. What could go wrong? Oil could drop from $65 to $25 and the energy market could seize up. There could be a worldwide pandemic in which virtually all retail jobs evaporate.
My advice to Marcy and Craig was to prioritize their goals. First, pay down any credit card debt. Secondly, accumulate six to twelve months of emergency cash. Third, maximize any savings vehicle, like a 401k that offers a free match.
Until the basics are covered, renting is not a bad option.
Dave Sather is a Certified Financial Planner™ and owner of Sather Financial Group. His column, Money Matters, publishes every other week.