Part of the proverbial “American Dream” is to own your own home.
We daydream about it, we plan for it, couples discuss it endlessly—the house becomes an extension of us, of our families. We develop the idea of our dream home.
Honestly, it’s probably not possible to overestimate the significance of home ownership.
Of course, once the dream exists, then come the numbers: the cold water of reality that slaps us into shocked awareness of what achieving home ownership costs—and entails.
Key word: ownership.
One of the most frequent questions we hear all the time: “Is it better to rent or to buy?”
Well, if the question truly is, “Is it going to benefit me more financially to rent my home or to own my home?”, then:
There is definitely a mathematical answer to that question.
We are happy to help clients crunch those numbers.
For most people (let’s just say for pretty much everyone), the decision to buy a home is not based on the results of a mathematical equation. It’s just not.
People buy homes for many different reasons, some not based in financial logic:
- because the desire seems built into our DNA
- to bring stability to their lives
- to be a part of a neighborhood
- to be in a certain school district
- to express themselves
- to have a place we can call our own
- to “build equity”
None of these motivations (including building equity) are the answer arrived at via a mathematical equation. They are driven by the heart, by emotions.
This article, therefore, is not addressing the rent-vs-buy question. Instead, this article is assuming you’re gonna buy a house!
That being said, here are some important factors to keep in mind.
It Takes A Team
Purchasing a home may be the largest purchase you make in life. That’s not to say you’ll only purchase one home in life—but, for most families, a home will be their largest purchase.
You want a lot of good advice when you approach homebuying. Generally speaking, the type of advice you need is not found in just one person. It could happen, but it’s unlikely as the disciplines involved in the homebuying process are diverse.
You may not have a financial planner; if so, you may wish to recruit one. Or you may be your own financial planner.
Regardless, there’s one question you must have the answer to when you start considering a home purchase: “How much can I afford?”
There is an age-old rule of thumb that your house payment should not be more than 28% of your income. Google it, you’ll see: it’s widespread. I have not researched where the 28% comes from originally, but it seems that lenders use it as a starting point when deciding whether to loan money to an applicant (like you) for a house.
However, that only helps you to part of the answer. It’s really just a standardized metric that lenders use as part of the determination of how much they’ll lend to you.
What you can afford and how much you want to spend is a two-part, far more complex question with many variables, all of which fall into the realm of financial planning.
At the outset, we determined this article is assuming that you’ve already made the decision to buy a house, so understanding how this fits into your financial plan for life is just more information and not the deciding factor.
You’ll want to consider questions like:
- How will this affect the accomplishment of my other goals, both short and long-term?
- How will this affect my lifestyle? (e.g., Will I be able to travel as much? Will I be able to eat out as much? In other words, you have to look at your spending plan.)
- How will this fit into my career trajectory? Is there a promotion on the horizon that could result in a relocation?
- Is the house the right size for growth (i.e., children or aging parents)?
- How does the location affect work/life balance? What’s it going to do to my commute?
- What’s the real cost to me, taking income tax impact into account?
- Besides the mortgage and escrow payment, exactly how much will it cost me to own this house?
Some of those bullet points are not purely number issues, but still part of a well-developed, integrated financial plan.
You want to understand how the purchase of the home impacts your holistic financial plan.
So, you’ve made the decision to buy a house. What next?
Find a mortgage professional that you can work with—this person will be key in the successful purchase of your home.
Be sure to ask around for references: ask your family, ask your friends, and even ask your co-workers for recommendations. Ask your financial planner!
Adding a mortgage professional early in the process is desirable, and I recommend you find one even before you’ve located the house you want to make an offer on.
There is a great deal of upfront work that the mortgage professional will do on your behalf in order to pre-qualify you for a mortgage.
Pre-qualification can make your life so much easier and make the process go much more smoothly. It gives you the ability and confidence to make an offer on a home knowing that you can follow through. It will give your real estate agent confidence. And it will give a potential seller reason to rank your offer— among the many they might be entertaining—at the top of their list.
The information that the mortgage professional will require from you is extensive. This isn’t one of the most fun parts of the whole process, but (unless you’re paying cash) there’s no way around it. They are going to really get up in your business. So just embrace it and get through it efficiently!
Just as a heads up, here are some of the types of information and documents the mortgage company will require:
- Past three years tax returns.
- Copies of most recent Form W-2
- If you own your own business, past three years tax returns for the business
- Again, for a business owner, current year financial statements for your business.
- For individuals, a net worth statement (they will provide the form to fill out)
- Most recent statements from retirement accounts.
- Most recent statements from brokerage accounts.
- Past three months bank statements.
- And, whatever else a creative underwriter can think of!
Are you self-employed or own your own company? As indicated above, the information required by the mortgage professional is going to be even more extensive. If you are one of the lucky entrepreneurs that owns your own business, make sure you seek out a mortgage professional who is adept at working with that segment of the population.
Real Estate Professional
This person is critical: they will be your best friend throughout this process.
Seek out a real estate professional as soon as you start considering homes and build a relationship with them. The more that person knows about you, your family, your dreams, your ”perfect” house, and what you’re pre-qualified for, the better they can help you.
Without that information, you can waste a lot of time looking at a lot of wrong houses.
As with the mortgage professional, ask around, ask for references, and find a real estate professional that you can work with as a partner in this process. They’ll be instrumental in coordinating all the moving parts of this journey—basically the coach of your homebuying team.
As soon as you have both the mortgage professional and the real estate professional in place, introduce them! They’ll work together for you.
OK, your team is in place and you’re on the search for your dream home. That leads us to…
How much this is will depend on a few factors, including:
- the type of loan
- your creditworthiness
Where does this money come from?
If you’re working with a financial planner or you’ve developed your own plan, you should have previously established a savings goal to accumulate your down payment. This is usually a significant hurdle for most people in purchasing their first home—successful accumulation of your down payment should give you a huge sense of accomplishment.
It’s also common for parents to help their adult children with this first home down payment. If a parent (or anyone else) helps you with this as a gift, then they will be required to affirm to the mortgage professional that it is, in fact, a gift and does not need to be paid back.
Alternatively, you may withdraw up to $10,000 from your retirement account for a first-time home purchase down payment. You will be taxed on the $10,000, but there will be no early withdrawal penalty. However, if you take the distribution from a Roth IRA, you would ONLY be taxed on any earnings of the IRA that were included in the IRA.
You may also borrow money from your 401K (not from an IRA however). You will have to pay the money back to the 401K at some fairly nominal interest rate; however, you are essentially paying the interest to yourself. You would be required to disclose to the mortgage company that you have borrowed the funds from your 401k and that would enter into your debt to income ratio (mentioned below).
As I said above, the mortgage professional is going to get into your business.
They will also look at certain ratios, namely your debt-to-income ratio, in determining how much you can borrow, what the down payment must be, and the interest rate they will offer on your home loan. If a friend or family member loans you money for a down payment, then this can skew the ratio and have a negative impact on the ultimate outcome of the mortgage.
Generally, your monthly house payment will include four, maybe five things:
- principle payment (this is the part of the payment that actually reduces what you owe overall on the house)
- interest payment
- property taxes
- homeowners insurance
- PMI (Private Mortgage Insurance, generally required if your down payment is less than 20%)
This payment can fluctuate from year to year because the property taxes and homeowners insurance rates can fluctuate from one year to the next. Once a year, your mortgage company will do an analysis and let you know what the mortgage payment will be for the upcoming year.
This assumes a fixed interest rate. If your mortgage has a variable interest rate, then that could also cause the payment to increase.
The fact that this monthly payment has the potential to increase year over year is something that should factor into your planning. If your spending plan is already stressed with what the initial mortgage payment is going to be, then there must be a plan for addressing future increases in the payment.
Of the five components of the mortgage payment, three of them are tax-deductible:
- Interest expense: Mortgage interest is deductible on the first $750,000 of mortgage debt. If your mortgage exceeds, $750K, then the interest on the excess is simply not deductible.
- Property taxes: Under current law, up to $10,000 of combined State and Local Taxes are deductible.
- PMI is deductible; however, the deduction phases out as your income increases.
Talk with your tax advisor to project how the purchase of a home is going to impact your taxes. Very likely, it will result in a decrease in your overall taxes, which helps to mitigate the cost of home ownership.
When you purchase your home, you will likely make a visit to a Title Company where you will sign many documents.
You should read all of them, of course. (But I know people: you likely won’t!)
Keep all of those documents in a safe and secure place for as long as you own the house. In fact, you should provide copies of those docs to your CPA or financial planner because when you eventually sell the house, information included in those docs will be needed in preparing your tax return in the year of sale.
During the time you live in the house, you want to keep detailed records of any improvements, upgrades or major remodels that you do. When you sell the house, it will be important to know:
- how much you paid for the house, which will be in the documents you sign at the title company; and
- the cost of any remodels and improvements that you do over the years (you’ll need documentation for this).
These are critical pieces of information in determining the gain or loss on the house when you ultimately sell it.
Other Costs of Home Ownership
Much is written about calculating the maximum amount of house you can afford and how much the monthly payment is going to be—but that’s just the beginning of home ownership.
It is absolutely critical to factor into your spending plan all the other costs.
Furnishings and Appliances
If you completely deplete your resources coming up with the down payment, then how will you furnish the house?
I’ve literally seen clients over the years with a huge house but empty rooms! Those rooms stayed empty for years, too.
As you’re planning your dream home and you’re consulting with your team, keep in mind that you need to be able to furnish the house. And do it intelligently: often, if the cash is depleted in purchasing the house, the furniture gets put on a credit card or some other kind of high interest purchase plan, which is a really bad idea in terms of final cost.
Swimming Pool Costs and Maintenance
The arrival of COVID-19 into our lives has caused the phrase “new normal” to take an entirely new and robust meaning. We’re staying home more. And, people are considering their homes to be their oasis.
We’ve seen many of our clients who didn’t already have pools to take the plunge!
Whether you’re buying a home with an existing pool or adding one to your first purchase, you’re going to have significant costs associated with owning a pool.
These days pools are becoming part of an overall outdoor living area with relaxation, cooking and swimming areas all combine into an area that makes us happy to stay home!
Think through the costs and incorporate them into your spending plan. Theoretically, money we might otherwise have allocated to travel, we’re now going to allocate to our own home-based resort.
If you have A/C in your home (and in Texas you do!), you have to take care of it.
Filters must be changed regularly and you must have the A/C serviced regularly (about twice a year in summer and winter) by a professional.
Ask for references, do your due diligence, and find a good heating and cooling company that you can work with for years to come. They will get to know your A/C system and make sure the proper maintenance is done. They’ll also help you establish a regular schedule of maintenance with them.
Quarterly pest control inside and outside your home is essential to keep bugs and critters at bay, especially if you have many trees around your home.
You will either do this yourself or you’ll hire it out: one way or the other, it must be done. Some homeowners associations will even have certain expectations in this regard.
If you hire it out, then you come to an agreement with your yard crew what needs doing (cutting grass, edging the lawn, cleaning gutters, bagging leaves, etc.) and how often. With larger and/or more complicated landscaping, this can become pricey.
If you are going to do it yourself, then you’ll need the equipment to do the job. For instance:
- lawn mower
- leaf blower
Factor in the cost of maintaining your equipment as well. The lawn mower’s blade will need to be sharpened periodically.
If you live in a neighborhood with big, established trees, you’ll also need to have the trees pruned periodically. How often? Discuss it with a professional who understands the types of trees you have; they’ll help you determine a schedule. And, a heads up: this is not cheap.
Not maintaining trees on your property can result in limbs falling, trees becoming diseased, and perhaps the (very expensive) removal of a tree entirely.
Unless you have astroturf, you’ll also need to water your yard. This can be surprisingly expensive.
If you live in a neighborhood that has a homeowners association (an HOA), you will need to factor that cost in to your spending plan.
HOAs—well, people either love them or hate them. But if there’s one in the neighborhood you’ve chosen to live in, then you just need to accept that you’re a part of one. Participate. Let your voice be heard. And follow their guidelines.
A home is your largest purchase and it contains your most precious assets: you and your family. An alarm system should be considered and factored into your monthly spending plan.
“Unexpected” repairs is kind of a misnomer. These things happen and honestly should be expected: you just don’t know when they are going to happen.
- You will have plumbing issues.
- A cabinet door will come loose.
- A light switch will stop working.
The list could go on for pages…
Some of these things—maybe most of them—can be repaired on a do-it-yourself basis by watching a YouTube video and making a trip to The Home Depot.
If you choose the DIY route, that’s great, but there will still be certain costs associated with it. You’ll be doing the labor, but you still have to pay for parts.
How do you plan financially for these “unscheduled” repairs?
Your emergency fund!
Part of any well-rounded financial plan includes an emergency fund of about six months of living expenses. This can be your source for these repairs that you will encounter.
Now, none of this information is meant to discourage home ownership—we only wish to encourage planning thoroughly. Take the whole picture into account, and try not to be blindsided as you embark on this journey of home ownership.
Sure there are costs, but
The Rewards are great!
See the full article here: https://drive.google.com/file/d/1HoFcp03DRqTWa6HcgpFr_vN4k_JrB1nh/view?usp=sharing
As always, if we can be of any help, give us a call at (214) 763-5167
From the desk of David Freeze, CPA/PFS.