12
Buffett's Views on Cars and Homes

“All things considered, the third best investment I ever made was the purchase of my home.”

—Warren Buffett, 2011 Letter to Berkshire Hathaway Shareholders

Introduction

It's considered part of the American Dream to own your own home. You know, the proverbial house with the white picket fence. Although Buffett is a huge fan of stocks, he considers his home in Omaha to be the third-best investment of his life. In case you're wondering what the two best investments Buffett thinks he made, they are marrying his two wives, Susie and, after her death, Astrid.

Despite being a billionaire many times over, Buffett has lived in the same house since 1958, which he bought for $31,500. It's a nice home, but it's not a mansion. Odds are some of the nicer homes in your neighborhood are probably more luxurious than Buffett's home. Nonetheless, he said in one interview, “For me, that's the happiest house in the world. And it's because it's got memories, and people come back, and all that sort of thing.” He also said, “All things considered, the third-best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks.” Despite Buffett's preference for stocks, let's turn his views on owning your own home into a Tip.

You want to be smart about all of your purchases, but especially related to the big-ticket items, such as cars and homes. These aren't only purchases but may also be considered investments in many respects. Let's tackle these big-ticket items in the order that you'll likely encounter them. First, owning your own car and then owning your own home. As usual, Buffett has had a lot to say on these topics, so we'll weave his comments in when appropriate. We'll discuss one more big-ticket item—paying for college—in Chapter 14.

Do You Need a Car?

Although the driverless car is on its way, it's not yet here in full force. Some people live their entire lives without owning a car, especially those living in large cities with well-developed mass transit systems. Others choose to use Uber or Lyft to get around, the equivalent of taxis run by regular people. In Denmark, 9 out of 10 people own a bicycle and many people ride it to work, even in the winter! It saves money, and the exercise keeps the Danish fitter than people from most other countries. However, most young people in America today still want a car since it often provides them with extra freedom. Freedom to get to school, work, shopping, and social activities. Of course, having a car also results in extra expenses—the cost of the car, repairs, insurance, and gasoline. It's a rite of passage into adulthood for many teens.

Buffett was, and is, a fan of cars. He once said, “When I was 16, I had just two things on my mind—girls and cars. I wasn't very good with girls. So I thought about cars.” In contrast to his frugal behavior today, Buffett and a friend each owned half of an old Rolls Royce when he was in high school. They bought it to impress girls and tried to rent it out to earn extra money. They paid $350 for the car and rented it out for $35 a day. He also co-owned another car when he was in high school, a hearse, which is the car used to carry a coffin in funeral processions. Buffett once picked up a date in a hearse. As you might guess, the date didn't go too well, and he later said his approach “wasn't the smoothest thing.” Today, he drives a Cadillac XTS, a nice car, but nothing too extravagant. He puts about 3,500 miles a year on the car, mostly driving from his home to the office and McDonald's with it.

In the next few sections, we'll address the main issues related to car ownership, such as new versus used, buy versus lease, and the best time to buy a car. Of course, the answer is “It depends,” but we'll provide you with a general framework for thinking about these issues and give you some rules of thumb. So let's roll.

New Cars vs. Used Cars

No doubt, from a financial standpoint, a used car is a lot cheaper, at least with the sticker price. You've probably heard the expression that as soon as you drive a new car off the dealer lot, it falls 20% in value. We encountered the term “depreciation” in our accounting chapter. It refers to the drop in the value of an asset, such as a building, car, or machine, due to its age and wear and tear. Depreciation differs dramatically by car make and model, but it often tends to be the least for Toyotas, Hondas, Nissans, and Jeeps. These cars tend to be reliable and aren't too expensive to fix when things go wrong. Expensive cars, such as Mercedes, BMWs, Cadillacs, and Lincolns, tend to depreciate the most, since they often cost a huge chunk of change to repair. Someone buying a used car tends to be cost conscious, so hefty repair bills aren't a good fit for these folks.

Older cars tend to break down more than newer cars. Their warranties, which fix problems at no or low cost, also expire over time. Certified pre-owned (CPO) cars are newer used cars that are in good condition with relatively low mileage, and they often come with extended manufacturer warranties. They tend to be less than five years old and have fewer than 50,000 miles, but CPO requirements vary by make and model. CPO cars typically cost about 20% more than a similar used car without the warranty and stamp of approval, since it reduces the risk that you've bought a “lemon,” or a car with a bunch of problems.

Newer cars also usually look nicer and have fancier features, making them desirable for a lot of consumers. For example, many new cars have Wi-Fi and perfectly synch with your smartphone. Even high-end cars from a decade ago, costing $100,000 or more when new, wouldn't have these features since they didn't exist. New things will surely be invented in the future that we'll want to have in our cars, say, artificial intelligence software that effectively eliminates the urge to read and respond to texts or emails while driving. Think about a Siri or Alexa app that can perfectly read and respond to texts or an app that can effortlessly find you a parking spot during at a busy location. We know some cars aim to offer these feature3, but they aren't ready for prime time. And, as we said at the chapter opening, the widespread arrival of driverless cars is just a matter of time.

New cars also usually have better fuel efficiency and faster 0-to-60 times, a great combination for most drivers. Today, you can find new cars that go from 0 to 60 in in less than 5 seconds and also get 30+ miles per gallon. That was virtually impossible a decade or two ago. And electric cars, such as Tesla's Model 3, are changing the automotive landscape requiring no gas and fewer items to repair and often have tremendous acceleration to boot. When you flip on a modern light switch, the light appears instantly. Similarly, electric cars have full power, or torque, as soon as they are turned on, providing neck-snapping acceleration in some cases. For more on that topic, do a search on Tesla's Model S in Ludicrous Mode, hitting 0 to 60 in less than 2.3 seconds! To top that, they have a reboot of their Tesla Roadster car in 2020 with a 0-to-60 time of 1.9 seconds!

So what's better to buy, a new or used car? Financially it's usually more beneficial to buy a used car, but it really depends on what role a car plays in your life. If you want something to get from point A to point B, a used car is undoubtedly cheaper. If you view a car as an important extension of your personal brand (i.e., the coolness factor) and really hate having to wait around while your car is in the repair shop, then a new car may be best for you. Plus, some people hate the idea of buying something that is used, which by definition means you got someone's leftovers. A recent study aimed to determine what type of used car may be optimal for most people. Picture a U-shaped curve where the cost depreciates each year, but it is offset by higher repair costs over time.

A detailed analysis posted anonymously on Reddit, a social media and bulletin board website, estimated the cheapest strategy for buying a car over the long term taking into account things such as the cost of the car, depreciation, repairs, insurance, and the cost of gasoline. The result? Buy a 10-year-old car, hold it for 5 years, sell it, and then repeat the process. The most expensive approach was to buy a new car every 5 years, selling it at the end of each 5-year period. With this latter method you are absorbing the biggest depreciation years of the car, essentially locking into a loss of 50% or more each time you buy a car, as well as paying more expensive insurance.

Buying vs. Leasing a Car

Let's say you've made a decision to get a new car, even though used cars tend to be a better way of saving money. Obviously, the cost of the car can vary greatly. You can buy a brand-new Nissan Versa or Chevy Spark for $13,000 or less. If you're the next Justin Bieber, Miley Cryus, or Kylie Jenner, you could afford a multimillion-dollar Bugatti or Koenigsegg. You still have to go through a buy-or-lease decision regardless of the price of your car, if you care about money. A lease is the rental of a new car, usually for a period ranging anywhere from one year to four years. A two- to three-year lease is most common for cars. With a lease you don't own the car but have the right to use it for a fixed period of time, so the monthly payment is cheaper. With most leases, you have the option to purchase the car after the lease term ends, but it usually is more cost effective to buy the car from day one if that is your plan.

There are several buy-vs.-lease calculators on the web, such as those at Cars.com, Lease.Guide.com, or BankRate.com. We'll give you the intuition of what's going on with them, while not getting bogged down too much in the details. The best-selling vehicle in America is usually not a car but rather a truck. Specifically, the Ford F-150, which is typically purchased more than 900,000 times a year. Trucks are widely used in business, such as in the construction industry, but many people simply like driving trucks. The Ford F-150 is usually followed in the rankings by two other trucks, the Chevy Silverado and RAM trucks. RAM was formerly a model under the Dodge brand but now has evolved into its own separate brand. The Toyota Rav4 is typically the best-selling non-truck in America, with about 400,000 purchases a year. It's a sport utility vehicle (SUV) and in recent years has outsold its sister car, the Toyota Camry.

A new Toyota Rav4 or Camry starts at about $25,000. It can cost $10,000 more than this with a high-end option package. Let's use the base model as the basis for our buy-vs.-lease calculation. Further, let's assume you have put no down payment, known as a capitalized cost reduction in the auto world, to reduce the purchase price and that you don't have an older car or truck to trade in to reduce the price of the new one. Most states charge a sales tax on car or truck purchases, which is exactly what it sounds like: a tax that goes to the state government for sales of goods or services. Sales tax on cars varies widely by state, ranging from 0% to more than 11%, so let's assume 5% is the sales tax rate.

We've talked a lot about interest rates and the time value of money in this book, so you probably have the intuition that the level of interest rates also affects the price of a car. The lower the interest rate, the cheaper your car payment. Sometimes lease calculators use a variation on interest rates called the money factor, which can be estimated by taking the interest rate and dividing it by 2400. Let's also assume a 5% interest rate, even though interest rates are currently abnormally low, and that the car depreciates 40% over a three-year period.

Buying the Rav4 or Camry with a three-year loan results in a payment of $786 per month. Leasing the same car over a three-year period, the most common lease period, results in a monthly payment of $379 per month. Obviously, the purchase payment is a lot higher than the lease payment, but you actually own the car after three years. Many car loans are over a five-year period since paying the $786 a month in our example is a pretty steep number for most people. Using the same numbers, it would result in a monthly payment of $495 a month over five years. Still significantly more than the lease payment. Plus, the bumper-to-bumper warranty for a Toyota, and most other cars, expires after three years, so you would be on the hook for most repairs after the three-year period since the bulk of the warranty expires. Toyota does provide a powertrain warranty, which covers the engine, transmission, and a few other items, for five years or 60,000 miles.

If the buy-vs.-lease calculation seems a bit confusing to you, don't worry, we'll give you a simple rule of thumb in a minute. But first, a couple of more details on leasing. When you lease a car or truck, you can only use it for a certain number of miles, or else you have to pay a penalty for any miles over that amount. The typical penalty is an extra 15 to 25 cents per mile for anything over the limit. Car leases generally permit you to average 7,500 to 15,000 miles per year over the lease term. The most common mileage limits are 10,000 or 12,000 miles per year. Also, if you trash the car and don't have the repairs covered by insurance, then you have to pay extra fees to repair the damage.

So here's the bottom line. Under most scenarios, if you don't drive a lot of miles (i.e., 12,000 per year or less) and you want a new car every few years or less, it's generally more efficient to lease the car. Plus, if you have a business, there are some advantages to leasing that may reduce your tax bill. This rule of thumb brings to mind an expression credited to the late oil tycoon J. Paul Getty, once the richest person in the world and the founder of Getty Oil: “If It appreciates, buy it. If it depreciates, lease it.” Even though Buffett didn't give that quote, it merits a tip that Buffett would likely approve of, since we mentioned his views that reinvesting the money he allocated toward his home would have earned much higher returns if he put it in stocks.

Stocks, bonds, and homes usually appreciate. Cars and most other things that you buy depreciate. One last point before moving on to the next section. Classic cars often increase in value. Classic cars are generally at least 25 years old and are also in demand by collectors. Thus, an older Ferrari or Corvette may be considered a classic, but a 25-year-old Camry probably wouldn't be. Classic cars could be a hobby or an investment but are usually not the primary means of transportation for someone. Therefore, we'll stick to Getty's rule of thumb. Buy what appreciates and lease or sell what depreciates, unless you drive a lot of miles, or would like to own the car for many years. That latter point is what Buffett has followed in recent times, typically owning his car for at least eight years and not being concerned about looking cool or having the latest high-tech feature3.

The Best Time to Buy or Lease a Car

Like with many items, you can get a good deal if you buy at certain times. For example, if you buy holiday items such as a Christmas tree after January 1, you can probably get it for 50% or more off. If you buy a bathing suit or shorts in the fall, you can probably get a good deal too. If you rent a car on a weekend, it's usually cheaper than a weekday since fewer businesspeople use cars on weekends. If you buy a plane ticket about two months before your flight, it's usually cheaper than buying it way in advance or at the last minute. There is also some advice you can use to get a better deal on buying or leasing a car.

Buying or leasing a new car during the last few months of the year (October–December) often provides you with an opportunity to get a good deal since dealers want to make room for the new model/year cars that are coming on the lot. Many car salespeople have minimum sales hurdles, known as quotas, to meet, so you can often get a good deal at the end of the month since their quotas are usually based on the number of vehicles they sell each month. Using simple supply-and-demand analysis, if fewer prospective customers are in the dealership, you can probably get a better deal. Most people shop for cars after work hours, on weekends, or on holidays. So going to a car dealership during a weekday in the morning or afternoon might be a good time to snag a great deal.

If you hate haggling with car dealers over prices, you can try using Costco's car buying service or websites such as TrueCar.com to put you in a better buying position. You can also get a good deal on a car if it will no longer be made or if the model is undergoing a significant style change. For example, you probably see a bunch of cars on the road that are no longer made, such as those made by Pontiac, Saturn, Oldsmobile, Plymouth, or Mercury. If you bought one of these cars during the last year that they were produced, you probably could have negotiated a very good deal. The manufacturer will still honor the warranty over the full period or else they would have had extreme difficulty selling the car. The 2019 Toyota Rav4 was a significant revamp from the 2018 model, so dealers were probably extra motivated to get rid of the 2018 models since they look out of date compared to the new model.

One last word on cars before we move onto the next section, homes. You might think, “Why don't I rent a car when I need it, rather than paying the full cost of buying or leasing a car?” This statement might be especially true for someone who doesn't need a car to get to work or school. It might make sense if you are 25 years of age or older. In one of the last few areas of legal discrimination, most car rental companies won't rent a car to someone under the age of 21. The same goes for being an Uber or Lyft driver to earn some extra cash with the help of your car. Firms think young people, without a lot of driving experience, are more likely to be unsafe drivers. Even if you are 21, you will probably have to pay an extra underage driving fee until you reach the age of 25 to rent a car. If you are able to rent a car, you can use car rental search engines, such as Kayak or Travelocity, to find a good deal. Costco and AAA also can help you score some good deals. Some companies, such as Zipcar, also let you rent a car for a portion of a day. Instead of going through a rental car company, such as Avis, Hertz, Budget, or Thrifty, an additional option is to rent an individual's car through websites such as Turo. It's the car rental version of Airbnb, a firm that allows you to stay in someone's home for a fee, instead of a hotel.

Home Basics

It's been said that buying a home (e.g., apartment, condominium, townhouse, or house) is the most important purchase of your life. It's probably true since it will be one of your largest purchases, and it also has a big effect on your credit rating. It will most likely be the biggest expense that you have that will be tracked by credit agencies, and therefore it will be an important part of your credit score. The main reason is that unless you're rich and can afford to pay for the home entirely in cash, you'll probably have to borrow money to help buy your home. We mentioned earlier in this book that money borrowed to help pay for the purchase of a home is called a mortgage. Most mortgages last between 15 and 30 years, so a mortgage might weigh as an anchor on your credit report, since it will be there for a really long time. But paying your mortgage every month on time also gives you a chance to demonstrate the responsible use of credit and may ultimately increase your credit score. Let's start with a discussion of the basics.

The first thing you should consider is if you plan on staying for at least a few years in the area where you want to buy a home. If that's the case, then buying a home usually makes financial sense instead of renting. If you are renting a home, you're basically throwing money away, helping the landlord, or homeowner, build wealth at your expense. A landlord is someone who purchases a home with the purpose of renting it out to someone. In many cases they own multiple homes. A slumlord is a landlord who spends little money on maintenance and repairs of a rental home and often rents it to low-income people. Most homes also go up in value over time, building wealth for the homeowner. Plus, there are some great tax benefits to owning a home that we'll get into, not to mention the great memories that Buffett alluded to in our opening section.

So why then would someone rent a home? Well, owning a home is a big financial commitment. First you need to come up with a down payment on the house, which you can view as a deposit to protect the bank or other lender that provides you with a mortgage. It's typically a serious chunk of change in the tens of thousands of dollars or more. Many people can't get over that hurdle. Plus, if you don't pay your mortgage consistently, you might wind up bankrupt, which would result in a terrible hit to your credit rating, as well as the eventual loss of your home. In addition, when you sell a home you typically have to pay a real estate agent a commission, which is the sales fee they (and their agency) get from selling the home. Commissions vary, but 5% or 6% is typical. So, a 5% commission on a house sold for $200,000 would result in a $10,000 sales fee to the real estate agent, sometimes known as a real estate broker, and their firm. That might be enough to wipe out the financial benefit from owning a home. Some online real estate firms, such as Zillow and Redfin, charge lower commission rates, but it's still a sizeable amount.

In order to move on to the next section, home ownership, let's summarize the boxes you need to check off for it to be worthwhile. First, you need enough money for the down payment. Second, you should plan to stay in the area at least a few years. Third, you should have a steady income. The last point is important because it will be hard to get a mortgage from a lender without one, unless you have someone, such as a parent, co-sign the mortgage loan for you. If someone co-signs a loan, they agree to pay the mortgage if the original borrower (i.e., you) does not. Being a co-signer is a legal obligation, which affects their credit rating. So think carefully about co-signing for another person, or, if someone is co-signing for you, thank them for their generosity.

Finding A Home

You should know the general area where you want to live. It's likely near your job, family, or a place that makes you happy. Some people, such as writers, the self-employed, and those able to work remotely, can live almost anywhere. They might choose to live near the beach, a mountain, a park, or any other place that speaks to them. You can drive around the area and look at homes with “For Sale” signs, but a more efficient way to find a home is through the use of a search engine or a real estate agent. A real estate agent probably knows the neighborhood well and can do a search that is custom-tailored to your needs (e.g., 2+ bedrooms, 2+ bathrooms, or property size). The most common database real estate agents and buyers search is called the Multiple Listing Service (MLS).

You can also do your own search for real estate and then take that “short list” of homes to the real estate agent for a more efficient buying process. Most of the homes on MLS can be found on Realtor.com, Zillow.com, or Redfin.com. Craigslist often lists homes For Sale by Owner (FSBO). Someone with a FSBO listing is trying to sell their home but wants to avoid the commission paid to the real estate agent. Both the buyer and seller usually each use the services of a real estate attorney to make sure everything is legit. The real estate attorney fees vary, but they usually range from a few hundred to a few thousand dollars, often with higher fees for more complex cases and sometimes for more expensive homes.

Bidding for a Home

Okay, let's say you found your dream home—or at least a home that you think you'll be happy with. The next step is making an offer. Unless you are making an offer for an FSBO property, the offer is usually made through the real estate agent. Both the buyer and seller typically have their own agent, who communicate with their respective clients. In most cases the seller is the only one who pays a commission, and it's split in some manner between the buyer's and seller's agents and their respective firms. A fairly common split is 50/50. However, in some markets both the buyer and seller may pay commissions.

Although you know the list price of a home when you see it, the actual sale price is subject to negotiation. Home prices, like most things, are subject to supply and demand. The price at which the seller is willing to finally sell the home is subject to a bunch of factors. Some of these factors include how motivated the seller is (i.e., Do they need the money? Are they relocating to a new job?), how long the home has been on the market, the condition of the home, the price the seller paid for the home, the number of offers (if any) the seller has, the number of similar homes for sale in the same market, and so forth. In general, most sellers are willing to lower the price anywhere from 1% to 5%, with a 1% or 2% discount from the list price being the most common. On the other hand, during “hot” markets, you might have to pay more than the list price if the property has multiple buy offers.

If you're looking for a deep discount (i.e., 25–50%) on the price of the home relative to its market value, you might want to look into buying a foreclosed home or a home through a short sale, which we'll define in a minute. A foreclosed home is one that is taken back by the lender after the homeowner stops paying the mortgage, in part or full. A mortgage is a legal contract and obligation to pay. If you don't pay, the bank or other lender will take the house back from you. A well-known legal expression is “The wheels of justice grind slowly but surely.” In other words, think carefully about missing any mortgage payments because there will be consequences. The foreclosure process must go through the legal system and takes a while to occur, usually about 1 to 2 years after the person began missing payments. Properties foreclosed by banks are often called bank real estate owned (REO).

A home that is in pre-foreclosure means the current owner has missed payments and that the lender is in the process of taking the home back or negotiating new payment terms with the owner. A foreclosure sounds like a great deal for the new buyer, and it can be sometimes. But there are some things you should keep in mind. First, a lot of homes sold after foreclosure require a full cash payment, with no mortgage. Foreclosure homes are also usually sold “as is,” and you often can't inspect the inside of the house before you buy it. So if the prior tenant trashed the place, the new owner would be responsible for the repairs. In some cases, the former owner remains in the home, and the new buyer has to evict them. Not fun!

We used the term “short sale” in one of our stock market chapters, Chapter 5. A short sale when talking about stocks is a bet that the stock is going to drop in price. Short sale investors benefit from drops in a stock price. A short sale in the context of a real estate transaction is when the owner sells the home at a price less than the current mortgage value. Why would the owner do that? At least two reasons. First, maybe the owner overpaid for the house when they first bought it. Let's say they paid $250,000 for a house and, due to a recession or some other reason, similar houses in the neighborhood are now selling for less than $200,000. A second reason is similar to the case of a foreclosure. Perhaps the current owner can't afford the home anymore, or is in a rush to sell, and wants to get out of the mortgage contract before they spiral into bankruptcy and trash their credit rating. The mortgage company usually has to approve a short sale but often prefers it to the long, drawn out foreclosure process.

Paying for a Home: The Down Payment

Earlier in the chapter, we said you need to come up with a down payment. How much? It varies. Before the Great Recession of 2007–2009 it was possible, under certain circumstances, to purchase a house with virtually no down payment. The financial press referred to these loans as “liar loans” or “NINJA” loans. Liar means that that the applicants lied on the mortgage application about their ability to pay, fabricating their income and/or assets. NINJA is short for “No Income, No Job, No Assets.” Why would lenders approve these people for mortgages? Well, home prices usually rise in price. So if the buyer stopped paying at some point, the lender could simply take the home back and try to resell it at the higher price. Also, some lenders sell the mortgage to other lenders, essentially “passing the buck.” They'd then view it as someone else's problem. A lot of new financial laws were passed after the Great Recession, such as the Dodd-Frank Act, that now require banks have rigorous paperwork and that purchasers must make a down payment. There is one valid exception. If you're a member of the US Military, you can often qualify for a US Department of Veterans Affairs (VA) Loan, which may be obtained with as little as nothing down.

Okay, getting back to the down payment, the typical down payment is 10–20% of the purchase price of the home, but in some circumstances you only have to put down 3.5%. We'll explain all of these numbers in a minute. If you're lucky, your parents or grandparents might help with the down payment of your home, but we'll assume for most people that isn't the case. Buffett didn't do it for his kids, preferring they develop a strong work ethic before providing them with any meaningful amount of money. Bank lenders also consider the loan-to-value ratio (LTV) of an investment. For instance, a $200,000 mortgage loan on a $250,000 home has an LTV ratio of ($200,000/$250,000 =) 80%.

Buffett suggests putting at least 10% down. In his 2008 shareholder letter, which he wrote in the midst of a housing crisis during the Great Recession, he said:

Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser. The present housing debacle should teach home buyers, lenders, brokers, and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower's income. That income should be carefully verified.

Let's summarize that sage advice with a Tip.

The government knows the down payment is a major obstacle to home ownership for many people, so they offer some special programs, especially for those in the low- to middle-income range, in order to help them purchase a home. The US Department of Housing and Urban Development (HUD) is the branch of the federal government that plays a key role in the housing market. The Federal Housing Authority (FHA) is a unit of HUD that insures loans made by private lenders, such as banks. That is, if the borrower fails to pay the loan, the FHA (backed by the credit of the US government) will ensure the loan is paid. Due to the government support, you can often purchase a home even if you don't have a great credit score, one as low as 580. Banks will not only consider your credit score when applying for a mortgage but also your income and assets relative to the size of your planned mortgage loan. A rough rule of thumb is a bank will give you a mortgage loan 3–4x your gross income. That is, before any taxes are taken out. So, if your income is $50,000 and you have a good credit score, you can typically get a mortgage for $150,000 to $200,000.

The FHA offers programs that allow first time homeowners to put down as little as a 3.5% down payment and also provides the homebuyer with up to 6% of the value of the home for closing costs. Closing costs include things such as paying for the first month's mortgage and property taxes in advance, homeowners insurance, title insurance, and attorney fees. Homeowners insurance covers problems with the home due to fire, vandalism, lightning, wind, hail, and several other reasons. Title insurance is designed to protect the buyer in the event that the seller didn't own the home “free and clear” before it was sold. Since purchasing a home is a huge financial commitment, most people enlist the services of a real estate attorney to help them with the legal paperwork.

Paying for a Home: The Mortgage

Few people, especially younger individuals, can afford to pay for the full price of a home in cash. The median price of a home in the US is roughly $250,000. In some neighborhoods in Manhattan and San Francisco, the median price exceeds a million dollars! You'd need a Buffett-like wallet to afford them. Most people purchasing their first home borrow anywhere from 80% to 96.5% of the purchase price. A 20% down payment is a good number to shoot for. That would be $50,000 on the median home price of $250,000. That's a big number for most people. By definition, there are 50% of homes that sell for less than the median price in all areas. These are often referred to as starter homes, especially for those at the lower end of the income spectrum. Over time many people trade up to a nicer home, hence the “starter” name. Most mortgages are referred to as conventional, but a large mortgage is called a jumbo mortgage. The definition of jumbo varies by location, but it usually refers to a mortgage of at least $510,400, although it could be as high as $765,600 in higher-priced areas, such as New York City, Los Angeles, Miami, and San Francisco.

If you purchase a home by putting less than 20% down, you usually have to purchase private mortgage insurance (PMI). Some real estate professionals use the term “lenders mortgage insurance” (LMI), but we'll stick with PMI in this book. PMI protects the lender in the event the borrower doesn't pay the mortgage. The insurance pays the lender in case the borrower is unable or unwilling to make a payment. PMI typically results in an extra expense of 0.5% to 1.0% a year on the amount of the mortgage.

Once the equity (i.e., the value of the house minus what you still owe on the mortgage) in your home is at least 20% of the value of the home, you typically can cancel the PMI, since the lender would now have a sufficient cushion in case you didn't pay on time. You can get to the 20% threshold by paying your mortgage on a regular basis and also by having the house go up in value. If your cash flow is great, you can even pay more than your required payment to get rid of your PMI as soon as possible. Most houses do appreciate over time, roughly 2–3% per year, but the numbers may vary dramatically by location, bringing to mind the real estate slogan, “Location, location, location.”

It pays to shop around for the lowest mortgage rates. A small difference in mortgage rates can really add up over the life of the mortgage, typically 15 to 30 years. A $200,000 mortgage at an interest rate of 4% for 30 years results in a monthly payment of $955 and total payments of $343,739. Increasing the interest rate just 1%, to 5% on the same property, results in a monthly payment of $1,074 and total payments of $386,512. We're sure you could find good use for that extra $40,000+ difference. Popular search engines that help you sort out mortgage rates offered by banks include LendingTree.com and BankRate.com.

A “House Hack”: Getting Someone to Pay (Most of) Your Mortgage

What's better than getting a home at a good price? Having someone pay the bulk of your mortgage, legally. Real estate investor and author Brandon Turner uses the term “house hack” to describe the case when someone purchases a multi-family home and rents out part of it. It's easy to envision this scenario in the case of a duplex, which is a house divided into two apartments or condominiums, with a separate entrance for each. If you have more money, you could purchase a triplex or fourplex—residences for three and four persons/families, respectively. The basic idea is the rent-paying person pays enough money to cover all, or part, of the mortgage of the full property. Full payment of the mortgage may be hard in a duplex, but it's possible in a triplex or fourplex. A 3.5% down payment is also possible with some of these multi-family homes.

The downside of a multi-family home, other than the higher price, is that it puts you in the landlord business. You are then responsible for fixing problems with the other units when something goes wrong—a leaky faucet, broken heater, clogged toilet. Of course, you can hire outside plumbers and contractors to fix these problems, but that costs money. What happens if your tenants don't pay the rent or damage the place? Well, you might have to take them to court to have them pay or kick them out. That doesn't sound like a lot of fun to us. Thus, a house hack will work for some enterprising people but not all.

Looking Under the Hood of a Mortgage

Looking under the hood of a mortgage is not as exciting as what you might see under a Corvette's hood. But it's important, since knowing some of the details may save you big money over time. A mortgage, like most bonds, has two parts, principal and interest. Principal in this context is the amount of money you borrowed, at least when the mortgage starts. The amount owed on the mortgage, the principal, goes down a little bit each time you make a payment. As we know, virtually all loans, including mortgages, charge interest. The mortgage servicer is the financial firm that collects your monthly mortgage payment. Besides the principal and interest, the mortgage payment usually includes some other payments—property taxes, homeowners insurance, and PMI (if needed).

Property taxes are used to pay for the services offered by your local city or town. The bulk of property taxes usually go to pay for the public school system, but they also pay for police, firefighters, local government administrators, snow removal, road repair, and many other services. Property taxes are usually paid quarterly, and your mortgage payment usually occurs monthly. The mortgage servicer keeps some of the money from the monthly payments in escrow, in order to pay the property taxes when they are due on a quarterly basis. Escrow is a legal term that means money is held by a third party (the mortgage servicer in this case) and given to the appropriate firm or person (the city or town) by the due date (i.e., quarterly for property taxes).

Getting back to the main part of the mortgage payment, the principal and interest, the way most mortgages work is that in the early years (i.e., during the first half of the mortgage life) the bulk of your mortgage payments goes toward paying interest. In later years (i.e., during the last half of the mortgage life) the bulk of the payment goes to pay down the principal. The relationship of paying off debt and interest is called an amortization schedule and can be seen in Figure 12.1. Although tax laws are always changing, as of today, interest payments on mortgages (up to $1,000,000) are tax deductible. This means if you itemize your taxes (i.e., list all your expenses), you might save money on your income taxes. All of your itemized deductions would have to be greater than the standard deduction, which is the amount anyone can claim without listing expenses. The current standard deduction is $12,400 for single filers and $24,400 for married couples filing jointly. Property taxes also used to be tax deductible at the federal tax level. They are still tax deductible for paying state taxes (if any). In short, there may be some good tax breaks to owning a home, besides the pride and wealth-building opportunities that usually come with home ownership.

Chart depicting amortization schedule for a typical mortgage depicting the relationship of paying off debt and interest for a period of 30 years. — **Figure 12.1** **Amortization Schedule for a Typical Mortgage**

*Source:* Based on http://www.engineeryourfinances.com/2010/06/how-to-compare-rates-for-mortgage-refinancing/

Most mortgages last for 30 years, but one way to reduce the total amount of interest you pay is to take out a 15-year mortgage. Let's use the same numbers as we did earlier with the 30-year mortgage ($200,000 mortgage, interest rate of 4%), which resulted in a monthly payment of $955 and total payments of $343,739. The difference between $343,739 and $200,000 is $143,739 in interest payments. A 15-year mortgage with an interest rate of 4% results in a monthly payment of $1,479, total payments of $266,288, and $66,288 in interest costs. The lesson is, if you can afford the (54.9%) higher monthly payment, you can save a huge amount in interest costs. In this case $77,451. Sometimes when people pay off their mortgage, they throw a party, often called a “mortgage burning party.” When the biggest expense in your life vanishes, it's probably a good reason to party!

If you own a home through a (15–30 year) mortgage, you aren't locked into it for life. If you sell the house, the price is usually high enough to pay off the old mortgage. The profit on your old home can be tax free if you roll it into a new home utilizing a part of the tax code called a 1031 Exchange. Many individuals can get an exemption up to $250,000 in profit, once every two years, if the home is their primary residence. Check with an accountant or real estate attorney for the nitty gritty details on how to do this exchange while legally avoiding IRS scrutiny.

If interest rates fall, it often makes sense to refinance your mortgage. Essentially, you rip up your old mortgage and take out a new one. Using the example we cited earlier, if the interest rate on your mortgage was 5% and you could get a new one for 4%, it would save you $119 per month. One word of caution. When you refinance a mortgage, you incur closing costs again, such as title insurance, appraisal fees, application fees, and so forth, so you want to make sure the drop in your mortgage payments is enough to offset these costs. It depends on the value of your mortgage, but one rule of thumb is that your new interest rate must be at least 1% less than the rate on your old mortgage for a refinance to make financial sense.

Buffett generally eschews debt but is a fan of mortgages, calling them a “one-way bet.” Since the interest rates on mortgages are fixed, if rates rise, you are fortunate to be locked into the relatively low rate on the mortgage. If rates fall, as we mentioned above, you can refinance and lock into the lower rate. Buffett once had a second home in California and took out a mortgage on that property, even though he could have easily afforded to purchase the home in cash. He used the extra money to buy Berkshire stock, which, of course, turned out to be a huge home run.

Here's his full quote, “If you get a 30-year mortgage it's the best instrument in the world, because if you're wrong and rates go to 2%, which I don't think they will, you pay it off. It's a one-way renegotiation. I mean it is an incredibly attractive instrument for the homeowner and you've got a one-way bet.” Let's try to summarize Buffett's ideas on mortgages with a somewhat wordy Tip.

We don't recommend it, but sometimes your home can become the equivalent of an ATM, if you've built up some equity in it. You can often get a home equity loan against some of the equity that you've built up in your home, usually any equity over the 20% mark we mentioned earlier. We generally don't recommend it since you will then have two payments due on your house, your regular mortgage payment and another payment due to the home equity loan. The exception, of course, is if you already had your mortgage burning party and paid off your mortgage. One advantage of a home equity loan is that the interest rates are usually less than what you can get from borrowing money against your credit card. Plus, the interest paid on a home equity loan is usually tax deductible. Thus, under some circumstances, getting a home equity loan to pay off credit cards or other high-interest debts may make financial sense.

What Determines Home Prices?

The interaction of supply and demand determines the price of virtually everything, including homes. But, to be more specific, several things affect real estate prices. Lower, or falling, interest rates make homes more affordable. Therefore, home prices usually increase more in a low or falling interest rate environment. Homes that are part of a good school district are highly valued by some buyers, especially those with children or who are planning to have some.

Homes close to major forms of transportation, such as a train station, are often in great demand from buyers since it makes it easier for many people to get to work. Using that same line of thinking, homes close to where the jobs are plentiful (e.g., New York City, Chicago, Seattle, Silicon Valley, Boston, Austin, or Washington, DC) tend to sell at higher prices. Most people prefer new or newer homes to older ones, so the age is often a determining factor in price. Old homes, though often unique in character and beautiful, tend to break down more and require more to maintain it. Larger properties—both in square footage of the home and land area—are usually more expensive than smaller homes. Homes with a beautiful view, near a body of water or mountain range, usually sell at higher prices than a “plain vanilla” one or one located on a busy road. Homes tend to sell at lower prices if the features mentioned above aren't in place as well as during recessions. In sum, owning a home is something we and Buffett strongly recommend, but there is a lot of variability in home values, and the home buying process requires a fair amount of homework. The sooner you can get on the path to home ownership and “livin' the dream,” the better, in most cases.

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