BUY A HOME FOR THE RIGHT REASONS

When Harold and Veronica moved from Ann Arbor to Chicago in 2003, they were excited to buy their first home. They were finally done writing rent checks, while their home-owning friends rode the escalator up the housing market.

There was only one problem. They were nowhere close to having the traditional 20 percent down payment. So Harold persuaded his new employer, the University of Chicago, to provide a seven-year $50,000 second mortgage that he could use to purchase a new home. The recruitment deal specified that the university would make all the monthly payments—as long as Harold kept the job. When that $50,000 wasn’t quite enough, Harold borrowed another $5,000 from his sister.

Eager to start house hunting, Harold called a university-recommended bank loan officer. That’s when he got a blast of cold water. “You are not a good customer,” the man bluntly explained. He noted that Harold would be in a bad position if his new job didn’t work out or if the housing market went down instead of up.

Harold responded in the “Don’t you know who I am?” fashion of the newly tenured academic. Then he went mortgage broker shopping. Because this was 2003, he found many happy to assist him. More than a decade later, his home worth about $70,000 less than what he paid for it, Harold realizes that the original loan officer offered him rare candor, not to mention excellent advice.

There is, unfortunately, no way to look into the future to see whether owning a home is the right financial move for you. But there are commonsense questions you can answer to determine if you are ready for the responsibility of home ownership.

OWNING A HOME IS NOT SOMETHING WE’VE ALWAYS DONE

Prior to the Great Depression, Americans were much more likely to be renters than homeowners. Why? Well, for starters, mortgages were limited. Home buyers needed to put up half the purchase price in cash, then pay off the remainder in five to ten years.

The Great Depression changed things. The sudden economic collapse meant that many couldn’t pay off their loans. Foreclosures soared. Real estate prices plummeted. In an effort to stabilize the situation, the federal government introduced the 20 percent down mortgage that could be paid off over thirty years.

The newfangled concept got a huge boost after World War II, when low-rate, low-down-payment federally subsidized mortgages turned millions of returning veterans into homeowners. As the historians Glenn Altschuler and Stuart Blumin note, “Perhaps for the first time ever, a significant majority of American families had realized the dream of homeownership.”

This system was far from perfect; there was rampant and codified racial discrimination, for starters. Yet for millions of new homeowners who benefited, this was a great achievement. They could live in a home and earn money on it at the same time. The downside? Those same millions began to view their homes as can’t-miss investments.

HOME PRICES DON’T ALWAYS GO UP

Home prices can go up, or they can go down. Yet many people don’t quite believe it. Even after the Great Recession’s housing bust, Americans identify real estate as the best long-term investment. According to the February 2015 National Housing Survey, 46 percent of respondents believed home prices would rise over the next year. Only 6 percent believed that prices would fall.

For the majority of Americans, their home is their largest financial asset. The National Association of Home Builders claims a primary residence makes up 62 percent of a median homeowner’s total assets. More Americans own a home than possess a retirement or brokerage account.

Owning a home is almost always what experts call a highly leveraged investment. That makes it a risky investment, even if it is hard to see risk in bricks. How does this work? Well, suppose you have a $200,000 home with a $180,000 mortgage on it. A 10 percent drop in your local housing market all but wipes out all of your home equity. If for some reason you can’t make your monthly payments, you might lose the house you were counting on for your retirement, along with everything you invested in it.

HOME OWNERSHIP: AN EXPENSIVE AUTOMATIC SAVINGS PLAN?

In the best-case scenario, owning your own residence works as an automatic savings plan. You find a home. You put the traditional 20 percent cash down. You get a fixed-rate fifteen- or thirty-year mortgage, which you faithfully pay month after month. Once you have paid off your mortgage, you own a big asset. You never once thought you were putting money in a savings account or investing it. But that’s exactly what you did.

This is the way many of our parents and grandparents bought a home. They had to save up for a 20 percent down payment (more about this in a minute). They then sat down with a banker who evaluated their finances. Only when that bank official said he was satisfied with their finances could they put the money down on the home of their dreams.

For millions of Americans, this system brought powerful advantages. Almost all mortgages were of the thirty-year fixed-rate variety. There were no adjustable rate mortgages that allowed you to only pay the interest for a period of time and then ballooned in payment to compensate.

It was also hard to buy more house than one could comfortably afford. If you couldn’t or wouldn’t document your income, you were out of luck; there was no such thing as the now infamous “no doc” loan. There were few options to put down less than 20 percent on a home. The bank officer would have laughed at the phrase “zero percent down.” Certainly no one was lending you 100 or 110 percent of a property’s value, as happened prior to the housing market crash.

Nor were your grandparents tempted to take a loan out against their home. What we call home equity lines of credit were then referred to as second mortgages, and they were difficult to obtain. You once again had to return to the bank and meet with a banker and explain both your financial need and your plans to pay the money back. If this doesn’t sound too appetizing, that was the point. Putting your home equity “to work” playing the stock market, taking a “must-have” vacation to Fiji, or redoing the kitchen with the latest in Viking appliances occurred to almost no one.

If you followed this plan, your savings—tied up in your home—were in an impressively secure lockbox until you sold the property. This savings plan didn’t rely on people’s remembering to set money aside every month, invest it properly, and leave it alone. By paying down a mortgage, you did exactly that. This was the genius of the system.

That said, home ownership is an expensive savings plan. Sure, money is taken out of your account and invested every month in a way we expect will do well. But home ownership comes with an expense ratio that makes the most expensive mutual funds look like a bargain.

For starters, there are the mechanics of interest payments. In the first years of home ownership, the bank takes the vast majority of your monthly payment as interest, only crediting a small portion toward the principal on the loan. You can likely get some of that back as a credit on your taxes—provided, that is, if you itemize your return.

Then there are various property taxes. While a thirty-year fixed-rate mortgage will remain one fixed amount, taxes almost always increase over time. And you will need to pay that bill no matter what.

Finally, owning a home means maintaining it. Repairing leaky roofs and sinks, painting walls, planting gardens—there is always something, and that something costs money.

RENTING BRINGS RISK TOO

According to Nobel Prize–winning economist Robert Shiller, the S&P composite stock index has outperformed housing by roughly a factor of eight between 1890 and the end of 2014.

Not surprisingly, economists sometimes perform complex calculations to show that renting is sometimes a better overall deal than home ownership. Their advice? Calculate the difference in expenses, and invest the savings in a broad-based stock market index fund. You’ll build more wealth in the long term, they say.

It’s not bad advice. It is an especially valuable reminder that one should not deliberately spend more on a house than one needs in the hopes of a high financial return. But most of us have a way of spending the money one hoped to otherwise invest. Harold and Helaine believe about five people who are not economists or investment junkies have ever run this calculation and rigorously followed through on it. If you are one of those five, congratulations. Make sure to maximize your contributions to your 401(k) and other automatic savings to ensure that the money you hope to save goes straight where it belongs.

Moreover, renting long term comes with risks too. Rents can increase, sometimes dramatically. In many cities, including Los Angeles and San Francisco, rents have soared post-2008. If your salary does not keep up, you could eventually be priced out of a neighborhood where you’ve lived for many years and your children attend school. Currently, half of renters in the United States are paying more than the recommended 30 percent of income for their housing, leaving them on thin financial ice.

There is also something to be said for controlling your own environment. Landlords can decide they no longer want to be landlords, or at least no longer yours. It’s also nice to paint the walls of your home a color of your choosing or simply live with a dog or cat if you wish without asking permission. There are, in other words, practical benefits to owning your own residence.

KNOW HOW MUCH HOME YOU CAN AFFORD

Experts recommend spending no more than a third of your take-home pay on housing. Any more than that, and your finances are going to be tight, leaving you financially vulnerable when something inevitably goes wrong. To be fair, this isn’t always possible. In some places such as New York and San Francisco, it can be all but impossible.

One way to know exactly your home-buying budget is to get your mortgage preapproved by a bank before you look at the first house. Keep in mind, this isn’t an exact science. Banks once overestimated what we could comfortably pay. Now in reaction to the real estate bubble, some underestimate it. Still, preapproval can give your housing budget a dose of reality.

Moreover, settling on a budget for your home is an essential first step. Unless you are a multimillionaire, you will face trade-offs. Decide what you want most before you go shopping. How many bedrooms must you have? Do you prefer an older home you can lovingly renovate over time, or do you prefer a just-built home that only requires you to unpack your boxes? Do you really need four bedrooms, or will three do just fine?

People in sales have a saying, “Buyers are liars,” meaning that buyers might think they want one thing, but they really want another. It’s a phrase that indicates contempt for the buyer. While you might believe you are shopping for the home of your dreams, to the real estate agent you are just another sale. Because real estate agents work on commission, they stand to make more money both by persuading you to buy a more expensive home than you intend and by minimizing the time spent with you.

It’s easy to fall in love with a home. Many come with high-end designer appliances, gussied-up spa bathrooms, or other bells and whistles. But here is what you need to remember: The three most important things in a real estate purchase are location, location, and location. The creakiest home in a desirable neighborhood will likely do better for you—at least financially—over the long run than a gorgeous home in a lesser locale. Homes in highly rated school districts tend to hold more resale value and sell quicker when put on the market.

Many studies indicate that commutes matter too. An easy commute (or no commute) makes people much happier than that fancy kitchen upgrade. Really. A group of economists and psychologists surveyed more than nine hundred people about their satisfaction with various life chores and choices. The activity that made them the unhappiest: their morning commute.

Finally, don’t fall prey to fears or real estate agents’ insinuations that if you don’t buy a home right now, you’ll never get another chance. Try not to get too emotionally attached to any specific house either. There is always another home to buy. It’s easier to drive a hard bargain when you are comfortable walking away. Harold and Veronica made the mistake of falling in love with their current house. By sorting out what you need and prioritizing what you want, you are less likely to make the same mistake.

HOMES ARE FOR THE LONG RUN

Home ownership, like stock investing, works best as a long-term proposition. It takes at least five years to have a reasonable chance of breaking even on a housing purchase. For the first few years, your mortgage payments mostly pay off the interest and not the principal. And there are many costs involved in moving in and selling a home. Unless you handle the sale yourself, you’ll likely pay anywhere between 3 and 6 percent commission on a sale to a real estate agent.

20 PERCENT DOWN IS BEST

It’s hard to save up to 20 percent of the purchase price of a home, especially if you live in a high-cost market. But the closer you can get to 20 percent, the better.

Why? The more money you can put down toward the initial purchase of a home, the lower your monthly mortgage payment. That’s because you will need to borrow less money to finance the home. This can save you tens of thousands of dollars over the life of the loan. You’ll probably get a lower interest rate too. The more you put down, the less likely you’ll ever fall “underwater,” with your home’s market value dropping below what you still owe on your mortgage. Should you ever have an urgent need to sell, this is crucial.

If you put down less than 20 percent, you will need something called private mortgage insurance (PMI). The annual cost ranges from 0.5 percent to 1 percent of your home’s value. That’s more than $1,000 per year on a $200,000 home. You will need to pay that bill in addition to your monthly mortgage bill until the bank agrees that the combination of your rising home value and the amount you’ve paid down your mortgage principal leaves you owing less than 80 percent of the market value of your home. Why do you have to pay PMI? Because lenders believe that people who put less than 20 percent down on a property are more likely to default.

WHAT ABOUT A FIFTEEN-YEAR LOAN?

If you are looking to turbocharge your home equity, you might consider a fifteen-year loan instead of the conventional thirty-year loan. Fifteen-year loans come with a lower interest rate—usually by half a percent or so. The shorter lending period allows you to build up your nest egg faster, making for a better automatic savings plan. Harold has one of these.

Keep in mind, however, that despite the lower interest rate, fifteen-year mortgages require higher monthly payments because you are paying your loan off in half the time. If you don’t have much of an emergency fund and you struggle with credit cards, student loans, or your monthly cash flow, a fifteen-year mortgage is not for you.

PLAIN-VANILLA FIXED RATE IS BEST

If you have good reason to believe you won’t own the home for more than five or ten years, or if interest rates stay quite low, an adjustable rate mortgage (ARM)—that is, a mortgage that begins with a lower interest rate but can increase after a set period of time—might sound appealing. The same is true for interest-only loans, which are sometimes available to people with high income and net worth.

Suppose again that you are shopping for a $200,000 mortgage. You get on the Web and check out interest rates for competing products. On the particular day we looked, we saw the following:

True, you can lower your initial monthly payments by getting an ARM or interest-only loan. Compared with a conventional thirty-year mortgage, the ARM saves you about $70 per month over the first five years of the loan. But there’s a real risk. If interest rates rise, your monthly payment can really rise too.

At this writing, interest rates are near historic lows. There is a serious risk that your ARM will eventually cost more, maybe much more. Why bring more complexity and uncertainty into your life? You could get hit with a significant bill if your plans or circumstances change or the economy doesn’t perform as you expect.

We like what Elizabeth Warren calls the “plain-vanilla” options: the traditional fifteen- or thirty-year fixed-payment mortgage, preferably with 20 percent down. If you can’t afford that, chances are your budget is stretched in other ways too. You don’t want to make yourself more vulnerable to a financial setback.

YOUR EMERGENCY SAVINGS ACCOUNT COMES FIRST

We know how much you want that home. And you have the down payment in hand. But . . . we need to ask, “Do you have a fully funded emergency savings account?” If you don’t, do not pass go. Stop reading this chapter, go back and read chapter 1, and don’t come back until you have a cash stash. And no, your emergency fund is absolutely not your down payment.

Helaine and Harold have owned homes for more than two decades between the two of them. We’ve learned that, well, stuff happens.

Helaine experienced a heater ignition that went dead during a cold snap, not to mention a basement that needed extensive drainage. In one never-to-be-forgotten week, her dishwasher suddenly died, followed a few days later by the equally sudden failure of her apparently bereaved refrigerator; they had shared the same kitchen for many years. Harold had a blown furnace, a basement water leak, eight windows that needed to be replaced, and a raccoon who ate his way into the attic.

Our lives don’t cooperate either. We all receive unexpected financial setbacks. Someone gets sick. The insurance company denies a medical claim. A job is suddenly lost. However life intrudes, the bank still expects to receive our monthly mortgage payments.

Neither our houses nor our lives are fixed. Be prepared. Finance your emergency fund. Then think about purchasing a home. If you don’t have an emergency fund and do own a house, chances are good you will someday find yourself in financial turmoil.

GET YOUR DEBT UNDER CONTROL BEFORE HOME BUYING

When you apply for a mortgage, the bank or mortgage broker will ask you about your monthly debt obligations. That includes credit card debt, student loans, car loans, and any other real estate obligations. If the combination of that debt with the amount you want to borrow exceeds 43 percent of your income, you will have a hard time getting a mortgage. Your “debt-to-income ratio” will be deemed too high, and mortgage issuers—not to mention the federal government—will consider you at high risk for a future default.

In this situation, it will be hard to find a bank to issue you a conventional mortgage. It’s possible you will find someone to issue you what is called a nonconforming loan; that is, a mortgage that does not meet government criteria. It won’t be insured by the federal government, and it will carry a higher interest rate. Banks are not crazy and mean for insisting on these sorts of guidelines. If your debt is high, home ownership is going to be a stretch, and you’re more likely to fall into financial distress if something goes wrong.

SHOP FOR A MORTGAGE

According to the Consumer Financial Protection Bureau, almost half of us do not shop for a mortgage when we begin the process of shopping for a home. We get it. Shopping for one mortgage is intimidating enough.

Comparison shopping is essential. Bank officers and mortgage brokers often have an interest in steering you toward one particular mortgage. They don’t have a fiduciary duty to exclusively pursue your own financial interests. They can steer you into a higher-interest mortgage or one with more fees and closing costs attached simply because it enhances their own or their company’s bottom line.

This can really cost you. And unlike that overpriced $5 latte, you’ll be stuck paying for an overpriced mortgage for years, maybe decades. The difference between a $200,000 mortgage offered at 4 percent and one offered at 4.5 percent comes to about $700 a year. That’s about $21,000 over the life of a thirty-year mortgage. That’s too much to give away.

So shop around. Call more than one bank or mortgage broker. Look at online mortgage comparison and informational sites, such as Bankrate.com and the CFPB’s Know Before You Owe.

RESEARCH REFINANCING OPTIONS

Suppose you already have a mortgage and are living in your home. When should you refinance to take advantage of lower interest rates? The answer isn’t obvious, because you have to pay for a title search, property appraisal, and more. You can generally expect to pay up front at least 2 percent of the value of your mortgage before you are done. Refinancing is rarely worth the hassle if your interest rate drops by less than one percentage point or if you’re planning to move soon. Web calculators can help you weigh the benefits and costs, which depend on your tax rate, how much you owe, and how long you plan to stay in your present home.

It’s easier to refinance if your mortgage obligations are less than 80 percent of the appraised value of your home. That’s not always a firm requirement. If you’ve been keeping up on your payments but the value of your home has declined, you may still be able to refinance at a lower interest rate through the government’s Home Affordable Refinance Program.

FLIP PANCAKES, NOT HOUSES

“MAKE MONEY FROM INCOME PROPERTIES,” read a recent piece of mail Helaine received. “Wouldn’t you like to change the financial course for you and your family?”

There’s a world of seminars and books out there promising you can buy real estate on the cheap, fix it up, and either flip it for a quick profit or rent it out, making a decent monthly income in the process.

Don’t go there. Your house is your home. It is not a speculative investment. Real estate speculation is best reserved for gamblers and the pros.

Handling rental properties is an actual job that requires specific expertise. Professional property managers have ample financial reserves to weather a down market or times when tenants can’t pay their rent. They have the skills, time, or money to replace damaged water heaters or faulty wiring. They can research local markets. They’re the people who recently took a pass on that tempting investment property you’re now considering.

If that isn’t you, don’t dabble. Just step away.

HOME BUYING—A CHECKLIST

We want you to buy a home if you think it is right for you. Harold owns the house he lives in, and Helaine loves her co-op. If you follow the basic rules below, it can be a smart financial decision: