Evaluating Homeownership
In the last year Dylan and Marie both graduated from college and got married. Marie landed an accounting job and Dylan was working for an insurance company.
Dylan was doing fairly well as a husband in training and, despite the challenges of life, they were doing well financially. They called looking for advice on buying their first home.
Marie said, “We’ve looked at condos around the area we want to live and are interested in a few.”
Dylan asked, “What are your thoughts?”
Regarding any question, almost anything is possible. However, it’s a matter of what you are willing to give up as life is a series of compromises.
There are certainly trade-offs to homeownership.
Homeownership offers control and associated peace of mind. This is not just a building, but your home. You may derive some appreciation and there is no cranky landlord to deal with.
The cons of homeownership start with buying your slice of heaven. Budget approximately 1% of the value for closing costs, survey expenses and title insurance.
After you make your claim on the American dream, you are now responsible for maintenance. Much depends on the age, improvements and how much sweat equity you are willing to exert. A decent rule of thumb is budgeting 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 a gutter to clean! Or a broken washing machine to fix. Or a leaky pipe to replace.”
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.
Be pragmatic about the interest costs. Don’t be surprised if you don’t increase your equity much until you’ve been making payments at least five years.
In addition to mortgage and interest payments, you must factor in insurance. We typically budget 1% to 2% of the fair market value of the property. This has become more difficult as more insurance carriers are either rating property coverage higher or denying coverage to states altogether.
If you have little in the way of a down payment (under 20%), you also incur private mortgage insurance. This typically costs about .5% to 1% of the loan value annually.
Your new friends at the appraisal district will be very interested in your new acquisition. Depending upon how they value your castle, they will assess property taxes somewhere between 2% to 3% of fair market value each year.
Your kingdom is also illiquid. If circumstances change, selling a house takes time, money and effort. If you aren’t going to own a property for at least seven years, seriously consider renting.
There is also opportunity cost. This is an important economic and investment concept. If you put money into any asset, you are affirmatively stating this is the single best place to put money.
If you take this position, you are saying money in a house should not go to a 401k with a match, or to pay credit cards or to any other investment opportunity.
Circumstances might change if you’re in a 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.
Generally, 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 at best 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’re a young couple and money is tight.
With a large illiquid asset, you have less flexibility if something goes wrong. What could go wrong? The tech sector in Austin could slow. Oil could drop and the energy market could seize up. There could be a worldwide pandemic in which virtually all retail jobs evaporate.
My advice to Dylan and Marie 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 CEO of Sather Financial Group, a fee-only strategic planning and investment firm.
