How Much House?

by Rob Reed, CFP®, Ph.D

www.ReedPlanning.com

A home is the single biggest investment most Americans ever make. While there are good emotional reasons for owning your own home (it is the only investment you can truly use and enjoy), there are also strong financial reasons to buy a house.

First, a house is your best protection against inflation. Inflation raises the value of your home, but with a fixed-rate mortgage your payments remain the same. Second, a home offers significant tax advantages because you deduct property taxes and mortgage interest from your taxable income. Finally, when a couple sells their home the first $500,000 of profit (the selling price of your home minus what you originally paid) is tax-free ($250,000 for single tax payers).

To take full advantage of home ownership, it is critical that you buy the right size house. Buy too much house and the mortgage payments will crush you. Buy too little and you neglect a valuable investment opportunity. But how much is enough? How much is too much?

HOW MUCH HOME SHOULD YOU BUY?

Buy a home that costs 2 – 2½ times your annual income. If you make $40,000 a year, you should be looking at houses between $80,000 and $100,000. Visit more expensive homes to discover features you would like, but buy a home you can afford. Don’t let realtors or mortgage brokers talk you into buying too much house. These salespeople won’t be around two years later when you can’t make your mortgage payments. When you buy a house, they collect their sales commissions and leave. Dismiss their sweet talk about “special arrangements” and “finding a way to make this deal work for you.” Stick to your price range.

Here are some general points about buying and improving a house. First, don’t buy the best house on the block; buy a modest house and improve it to neighborhood standards.  Second, watch your cash flow after you buy.

According to Harvard’s Joint Center for Housing Studies, the average home buyer spends $9,000 in the first year for furnishings and home improvements (and it is easy to go over that). Also don’t forget increased maintanence costs. Even if your mortgage payment is comparable to the rent you paid, you will annually spend an additional 1½  – 2% of your home’s value annually on maintenance you did not pay when renting. So, if you buy an $80,000 home, you will spend $1,200 - $1,600 a year on ordinary home maintanence.

Finally, be careful about renovations. While improving a modest home to the neighborhood standard is a good investment, you will never recover the cost of putting an high-tech kitchen into a modest home. Recognize that most renovations increase a home’s value only for a few years. The $10,000 bathroom restyling you did ten years ago does not increase your home’s value today. 

HOW MUCH SHOULD YOU PUT DOWN?

Your down payment should be twenty percent of the purchase price. If you buy an $80,000 home, you should put $16,000 down (giving you $16,000 equity [ownership] and a $64,000 mortgage). If you put down any less, the bank will require that you buy private mortgage insurance. This insurance, usually between $600 and $1000 a year (more for premium homes), protects the bank in case you default on the loan. In other words, you buy insurance to protect the bank. Once you have 21% equity in your house, you can cancel the insurance—but don’t expect the bank to tell you that.

If 20% down is beyond your means, find the money somewhere else. You might borrow from your parents or enter into a share-equity agreement with them. FHA and VA loans are available with little down payment. Religious groups and state organizations often have special programs to help (especially first-time) home buyers. Finally, you can often withdraw or borrow money from retirement savings with no penalty if you use it to buy a home.

WHEN SHOULD YOU REMORTGAGE?

There are two times to think about refinancing. First, when interest rates fall and you can refinance at a lower rate with lower payments. There are refinance calculators on the internet (try Bankrate.com or Quicken.com) to help you decide if it makes sense given your current mortgage rate and the rates being offered now.

The second time you should look to refinance is when you have too much equity (ownership) in your home. To give you adequate inflation protection your mortgage should be 50% – 80% of your home’s value. If the mortgage on your $80,000 home is now $40,000, you should start looking to refinance at $64,000 again. (Remember you want to keep 20% equity.) This refinance will allow you to pull $24,000 of equity out of your home and use it for long-term investing (not for a vacation!). Pulling equity out of your house (and investing it elsewhere) also increases your positive leverage. Positive leverage is when you borrow money to buy something that gains value over time. Say your $80,000 home appreciates at 4% annually (the historical average). That means its value rises $3,200 a year. If you have $40,000 equity in your home (and a $40,000 mortgage), then your investment return is 8% (3,200 divided by 40,000). If you have only $16,000 in equity (a $64,000 mortgage), your return is 20%, almost three times more.

WHEN SHOULD YOU BUY A BETTER HOME?

You originally bought a home that was 2 to 2½ times your annual income. When your income rises to where your home is worth 1 to 1¼ times your annual income, you should get a better home. In our example you earned $40,000 and bought a home for $80,000. If in ten years your home is worth $90,000 but your income has jumped to $75,000, you should look for a new house costing between $150,000 and $187,500. It doesn’t have to be a bigger house; it can be the same size but better built in a better neighborhood with better schools.

Another time you should consider selling is when your probable profit (what you will get for your home minus what you paid) begins to exceed the tax credit allowed ($500,000 for couples and $250,000 for singles). Beyond this point profit on the sale of a residence becomes taxable. 

Remember this is a general overview. For more information, contact Rob Reed at 614-263-3900 or Rob@Reedplanning.com.