CHAPTER
16

Investing for a New Home

In This Chapter

• How much money do you need for a down payment?
• How much should you borrow?
• What loan options are available?
• Ways to increase the value of your investment
• Knowing when to sell
• Working with a real estate agent to sell your home

The holy trinity of personal goals is usually buy a home, send the kids to college, and have enough for a decent retirement. In this chapter we’ll discuss building investments for a home purchase, ways to accomplish it, and what costs you should anticipate.

How Much Money Will You Need?

There are two main challenges in purchasing a home: having an income that will qualify you for the mortgage necessary to purchase your desired home, and saving enough down payment as required by your mortgage.

My advice is you need to decide how much of your income and funds you’re willing and able to invest in a home, and not necessarily let the mortgage lender decide. Sometimes lenders are willing to loan you more than you can comfortably pay. They judge you on (total) debt to income, often allowing up to 45 percent of your income to service total debt (auto loan, education, credit cards, and mortgage). In my opinion this is way too high if you’re going to do anything else with your life but make payments.

One of the biggest ways to enhance wealth building is to keep your housing costs low. Your fixed costs drive your budget, and the lower they are, the more discretionary money you will have to invest (and spend). Housing costs are the biggest part of fixed costs for most people. You don’t have to buy the biggest house you can possibly afford.

Your monthly cost includes not only your mortgage payment, but also property taxes and the homeowner’s insurance your mortgage company will surely require. Depending on the type of property, you also may need to pay condominium or homeowner’s association fees.

Deciding How Much to Invest

In the old days (the late 80s and early 90s when I sold real estate) it was easy to figure out what someone could buy. You simply multiplied their income by 2.5, added on their down payment, and voilà! As long as interest rates stayed low—lucky you! Now, it’s still based on a percentage of your gross income. Right now, you can probably get a mortgage based on a payment of 28 percent of your income (and that’s a doable payment for most people). The lower the interest rate you can secure, the higher your purchase price can be.

Let’s look at how this might work. Let’s say your income is $76,000 per year. Find a mortgage with interest of 4.5 percent and you can buy a house with a purchase price of $350,000 (with a monthly payment for principal and interest of $1,773.40).

But let’s say you can find a loan of 3.75 percent. Now you can buy something around $380,000, with a monthly payment of $1,759.84—more for less. Now you know what all the shouting is about concerning mortgage interest rates. By the way, that’s 5 times your income—more than twice the house price you could have purchased 20 or 25 years ago. Low interest rates make houses more affordable.

But let’s look at the flip side—interest rates go up to 5 percent. Now the house you can buy is down to $330,000, and generally that’s a different kind of house than you can buy for $380,000. Obviously, if at all possible, you want to buy when interest rates are at their lowest.

Try not to exceed the 28 percent of gross standard for your monthly payment, even if the lender will make a larger loan. I’ll relent a little if you have no other debt, and have a generous emergency fund. Because you probably already have tapped the maximum loan possible on the property, you’re not going to be able to get a home equity line of credit (HELOC) to fix anything that goes wrong.

You don’t want to invest your entire net worth in the home. It doesn’t generate income, and even if the value improves significantly, you have to sell it to realize the gain, and that may not be easy depending on the market. When you sell, you will still need to live somewhere, and in real estate all boats tend to rise on the same tide. Anything else you can buy will also have risen.

If you’re under 40, real estate is probably going to be your major investment, although I hope you’ve been consistently contributing to your workplace retirement account (and if you haven’t, you probably shouldn’t be buying a house yet). As long as you stick to the 28 percent guideline, you should be able to start saving for other goals as soon as you recover from the closing.

However, once you’re halfway to retirement age, real estate should become less and less a percentage of your portfolio. Ideally, I like to see your residential real estate investments (including, perhaps, a vacation home by then) constitute no more than a third of your total net worth. Whether you count what you paid for the property, or use a figure for what it’s worth now, the rest of your investments will be the only ones that can generate income for you in retirement. Unless you plan to sell your home at some point in the future, it’s not going to help you pay for things, although, especially if the mortgage is eventually paid off, you may not find another place to live that is as low-cost as your home. (More on deciding when and if you should sell later in this chapter.)

Unless you have an inheritance or some other source of a large amount of cash, you’re probably going to be financing the balance of your purchase. There are several common types of financing. In general, the less down payment you make, the higher your monthly cost will be, not only because of the amount financed, but because low down-payment loans will generally require you to have some type of mortgage insurance. After all, the less equity you have in the property, the easier it is to walk away from it.

VA loans can be a terrific deal if you’re a member of the U.S. armed services, a qualified veteran, or the surviving spouse of a veteran. VA loans permit a no-money-down purchase, although you’ll be charged a funding fee of 1.25 percent to 3.3 percent, which can be rolled into the loan. The VA doesn’t make the loans; it simply guarantees them, so you’ll have to find a lender that works with the VA. There are limits on the purchase price by area in which you live, but these loans can be a great way to purchase and still have money left for renovations or other investments. And if rates go down after you purchase, they provide a streamlined process to refinance into lower rates.

FHA loans require a minimum down payment of 3.5 percent and may allow you to have a total debt load of as much as 56 percent of your income. (Although I’m not advocating you borrow that much!) You must have a decent credit rating. You also must pay a premium (about 1.5 percent) at closing for insuring the loan, and a yearly premium as long as you hold the mortgage. The amount of an FHA loan is limited depending on where you live and will generally be in an amount equivalent to a moderately priced home in the area. The FHA appraiser who will evaluate your potential purchase may be a little tougher on the condition, and it can be harder to get the loan if you’re buying a wreck to renovate. It never hurts to try if you’re in the right purchase-price marketplace.

If your down payment is less than 20 percent of the purchase price, you will probably be required to pay private mortgage insurance (PMI) as part of your monthly payment, to insure the lender’s ability to collect if you default. Once your equity (or the property’s value) rises to 20 percent, you might be able to get this removed, but they may force you to refinance.

The Bank of Mom and Dad

Sometimes parents think of lending their children money to buy a house (or the kids come up with the idea). This works, but it’s fraught with problems for both sides.

Parents lending cash should be certain they can afford to lose it entirely. Your child may have every intention of paying you back, but can become ill or unemployed and unable to pay. If you need the money for retirement, you can’t really afford to lend it. If you do decide to go ahead, be certain that you both agree in writing as to what the transaction actually is. In the event that the child goes through a divorce, or one spouse gets sued for any reason, this money can be considered joint assets and divided accordingly. Even if it’s a gift, get the agreement specified in writing. Spend a little money on an attorney to make sure you have an agreement.

Adult children who are borrowing should at least pay an interest rate above what the parents could get in a conservative investment. There may be tax consequences to both parties if this isn’t done and the IRS catches up with you. Please check with a CPA, attorney, or other knowledgeable party before you do this. If it’s a gift above $14,000, a gift tax return may need to be filed.

Oh, and did I say get it in writing?

What Investments Should You Make to Build Funds?

You’re probably hoping that buying a home is a fairly near-term goal, as in 2 to 5 years. If so, you probably need to build your down payment in a steady, stable investment, such as a savings or money market account. Sure, some of us would be willing to take a chance that a good investment in a more risky investment will generate a higher down payment. But in general, savings is what will build your down payment, with a little boot from investment returns.

If your time horizon is 2 years out, your investment should be in something that won’t lose your principal, like a savings account or money market fund (see Chapter 7 on where to stash your cash short term). If you’re a relatively calm investor, and have a time horizon of 5 years or more, you may want to consider a balanced fund, equity income fund, or life strategy fund for the possible extra return you could achieve.

Protecting Your Investment

I’ve emphasized the need for an emergency fund over and above the amount you’ve saved for a down payment. Your mortgage company will undoubtedly require homeowner’s insurance not to protect you, but to protect their interest in your property if, say, the place burns down or you destroy the kitchen frying donuts. Even if you’ve gotten the loan from the Bank of Mom and Dad, or paid cash, do not own a home without homeowner’s insurance!

The Importance of Regular Maintenance

Now that you’ve unpacked the boxes, start thinking about planning for the cost of regular maintenance, or your investment will quickly deteriorate. As a rule of thumb, plan on spending at least 1 percent of your home’s market value in repairs and maintenance per year.

I’m not talking about the kid who mows the lawn; I’m talking about treating your trees for ash borer, replacing a rusted gutter, fixing a shorted-out electrical outlet, repainting, replacing the water heater (mine is 20 years old and I’m praying). If you’ve invested in an old home, 1 percent might even be low.

You won’t necessarily spend this much every year, but then you’ll get on a roll and everything will come down on you at once. If you’re not paying out every month on some repair, squirrel a little away in a segregated checking account as part of your monthly expenses—when your dryer lets out a puff of smoke and dies, you’ll be glad it’s there. Well begun is half done.

Making Improvements That Increase Value

Clean and neat probably beats everything else. Buyers always tell their real estate agent that they can “look beyond” the piled-up magazines, the icky towels, and the stinky cat pan, but in the 7 years I sold real estate I never met one who could. Nor can the other real estate agents—the first thing they ask the listing agent is whether it “shows nice.”

It’s your place and if you plan to live there a while, go crazy. If you’ve always wanted a purple dining room, go ahead, but know that when you sell you’re going to have to repaint it. Buyers (and agents) like a home that’s up to date but doesn’t have so much personal stamp on it that they can’t picture themselves and their stuff in it.

There are trends that seem to take over the housing market. They become essential for that era, but scream outdated 10 years later. For example, in the 1980s you could hardly sell a condo or midpriced home unless the kitchen cabinets were white laminate with oak edging. Still like that look? Jacuzzi tubs were a hit until people got wise to how often they saw their friendly plumber. If you upgrade to the trend of the moment, and sell 10 years later, just be aware that you’ll probably have to change it out to something then on-trend.

If you plan to live in your house forever, but can imagine a time when you might need serious medical care, keep up with maintenance. As we become older, we might not see the need for freshening paint, or fixing the slight leak in the closet, or repairing the fence that’s falling down (that would be my place), or updating the electrical system that’s no longer up to code. Remember that your home is a significant investment asset, but it must be maintained to retain its full value. If you have to sell to afford nursing care, that sale can be delayed a long time while your spouse or your kids chase down contractors, come up with the money, and get it done.

The kitchens, the baths, and the way your place looks from the street are the three main places to improve value visually. Don’t improve it more than the neighborhood, but make it look a little better than it does now. You don’t have to have a professional landscape designer if every other house just has foundation plantings of evergreens. Ask every Realtor you interview for suggestions, and consider hiring someone to stage the place for sale.

If you’ve considered leaving the place empty before you sell, try to have at least a little furniture so buyers can get an idea of the real size of the rooms. Empty rooms look smaller because the eye has nothing to provide scale. If, on the other hand, your place is full to the brim, try to remove some pieces and all clutter to make it seem more roomy.

If it’s a cookie-cutter kind of property, try to give it something distinctive. Give the buyer something that will make it feel as if this home is better than the rest. At least one sale has been made in this world because someone loved the red front door or the swing beneath the tree (even if it’s stuff you’re ultimately going to take with you).

On Your Own

If you have a property where the sign can be seen from the street (and that’s permitted in your area), it’s a lot easier to sell than if you’re trying to sell a condo or a house in a restricted-access community. If that’s the case, then you have to place an ad, list it on a website, and sit back to screen all the lookie-loos who call or show up. A real estate agent can do a much better job of screening prospects, pitching the property to other agents, and convincing their clients to go look.

Two things people believe are important to selling their home that actually aren’t:

Putting ads in publications The people who call are almost never right for that property, and the company advertises mostly as teasers to get those calls and convert the prospect into whatever else is in the listing inventory.

Holding open houses Once in a while is fine, but mostly you will get all the nosey neighbors. This, however, will make your agent quite happy because your neighbors might want to list their home with her, too.

I might consider going solo without an agent if I were the buyer, although you’ll miss being connected with a lot of properties that you might have overlooked and you won’t get help with mortgage brokers, lawyers, and the title company. I would always use an agent if I were the seller.

Using an Agent

Your listing agent is legally required to represent your best interests, unless she is also working with the buyer, with whom she also has a duty. If you’re working with an agent, you should be absolutely certain you know who she is legally representing. If she has the listing, she is representing the seller.

The only reason not to use an agent when selling your home is that you will have to pay the commission. Selling as a FSBO might tempt you because you think you’ll save the commission. Except that’s exactly what every buyer is also thinking—I can get this for less because there’s no commission being paid. I’m not sure if anyone actually saves the money, especially if the agent is a smart negotiator for you and does everything to facilitate the sale.

How much is that commission going to be? It varies by area, but it’s often 5 or 6 percent of sale price. You can probably beat your agent up by negotiating a lower-than-normal commission, but in my view you’re shooting yourself in the foot—not only is she going to be angry and cut back on her efforts, but every other agent in town is going to put your house at the bottom of their show list.

You may think you’re paying $30,000 in commissions, but it’s unlikely that your agent is getting paid that. First of all, she has to split it with her broker. It’s also likely that she will not be the one to bring in the buyer. So she’s going to split that commission with the selling (buyer’s) agent (who also splits it with her broker). So maybe she’s made $7,500 from that $30,000.

Deciding When and If to Sell

When should you sell? It’s a difficult answer with any investment, and your home is an investment at some point.

Sell if you can afford to upgrade. Most people’s first home is not their dream home. If your first property has appreciated enough that you can walk away with more cash on sale than you started with, and you’ve managed to save and invest in such a way that you have a goal fund account to apply to a new home, it’s time to start looking.

Sell if you truly need more space. I’ve felt that way nearly every day, but the truth is, I would have plenty of space if I’d gotten rid of more junk. Consider investing in assistance from a professional organizer; it’ll be cheaper than moving.

Many people feel they need more space once they have a couple of teenagers draped seemingly everywhere, with the clothing, sports equipment, and general junk that seem to follow them. However, buying a much larger house (or building a huge addition) may be one of the worst timing mistakes you can make. The kiddies will go off to college or a trip around the world in a few years and you’ll be stuck with huge heating and air conditioning bills, perhaps a property tax reassessment, and a lot of empty rooms they’ll use as a giant storage locker. Unless they plan to return home after college (which you may or may not want to encourage!), don’t spend a lot of money for space you’ll only use for 3 or 4 years.

Sell if you could live with less space or would like to move to a cheaper property or location, realizing the gain in your investment. I love this reason because your purchase has truly resulted in investment gain. Aside from the obvious reason that it will prevent your jobless relatives from parking in your extra bedroom, many people find they don’t need all the space, or the maintenance or utility bills that go with it, once the kids are grown.

Maybe you’d like to move to someplace warmer, or nearer to grandchildren or your own aging parents who live, hopefully, someplace cheaper than Manhattan or where you live now. You can get a lot better property outside the center of major cities.

On the other hand, moving from the big suburban home to a condo downtown may cut living costs in other ways—you won’t need the car or a lawn or snow-removal service, and the building may have amenities like a pool or health club that you’re paying for now.

A smaller home also may be more accessible as you age. The biggest difficulty that drives people out of their homes against their will is mobility and maintenance issues—they can’t handle stairs, gardening and snow removal has become an overwhelming physical effort, or they need assistive devices that won’t fit in the space available. If you’re moving in your retirement years, be certain that you could negotiate the space if you were less healthy than you are now.

Should You Pay Off Your Home?

This is perhaps the number-one question I’m asked in financial planning. The answer is not clear-cut.

The financial answer, in a low-rate environment, is no. If you have a low-rate mortgage (say, under 5 percent), you would probably be better off over the long term by investing that money instead. If rates were closer to 5 or 6 percent, it’s a bit of a toss-up—you could compare it to the rate on bonds, since paying it off is virtually a sure thing. Still, over the course of a few decades, you would probably do better in a diversified portfolio of investments, and you still get the tax deduction of the mortgage interest.

Then, there’s the behavioral answer. Most people, particularly those who are near or in retirement, feel much more secure with a paid-off house. It reduces the largest component of your fixed costs (although you will still have repairs, maintenance, and property taxes).

As long as it doesn’t deprive you of income-generating investments that you need for retirement, I can support paying off your mortgage—maybe not when you’re younger and could grow your money better in other investments, but certainly at retirement.

The Least You Need to Know

• Invest your down payment goal money based on how long it will be before you want to purchase.
• Don’t necessarily borrow the most money a lender will lend you, because they may allow you to borrow more than you can afford, given your lifestyle.
• Maintain and update your home in order to maintain the value of your asset.
• Good reasons to sell your home include wanting to use built-up equity for another investment, wanting a different-size or more-accessible space, or wanting to relocate to a different environment or to be nearer family.
• Paying off your mortgage is as much an emotional decision as it is a financial one.
• Working with a real estate agent enables you to sell your home much more easily.