Tag: #mortgage

A Reverse Mortgage for Retirement Planning

A Reverse Mortgage for Retirement Planning

A reverse mortgage can be a valuable financial management tool for seniors and their families.  However, if misunderstood or misused, borrowers and their heirs can encounter any one of a number of different challenges. In this post, I’ll define “reverse mortgage” and provide illustrations of 

Don’t Sweat those Mortgage Terms

Don’t Sweat those Mortgage Terms

A mortgage is key to buying a residence for most people.  Mortgage loan documents are often lengthy and full of technical terms.  As such, many people either don’t read them in their entirety or don’t understand the details.  As with all contracts, I recommend that 

Flex or Fix in Buy vs. Rent

Flex or Fix in Buy vs. Rent

Your residence is likely one of your biggest expenses.  The most common options for residences are renting and purchasing.  There are costs and benefits to both approaches, some of which depend on your lifestyle and goals and some of which depend on your finances.  In this post, I’ll explain many of the factors that can influence the decision to buy vs. rent.  In this post, I provide a detailed cost-benefit analysis of the buy vs. rent decision showing the best choice from a financial perspective depends on your financial goals.

Keys to Being Ready to Buy Your Residence

Many people feel pressure to buy a residence as soon as possible.  It is my opinion that owning isn’t the best choice for everyone.  People who are ready to buy their residence will generally have some important characteristics.  Specifically, they:

  • Want to own their home.
  • Plan to live in the same place for at least several and possibly many years.
  • Have enough money to pay the upfront costs, including a down payment, closing costs and any repairs that need to be made to the residence after closing.
  • Manage their finances sufficiently well to be able to save for expenses that are not paid every month, such as insurance and property taxes.
  • Have enough in emergency savings to pay for unexpected, possibly very expensive repairs.

Your Lifestyle: Buy vs. Rent

Before looking at the finances of the buy vs. rent decision, it is important to consider your lifestyle and goals.

Do You Want to Own Your Home?

Owning your own home has long been an American dream.  In 1928, President Herbert Hoover’s campaign slogan was “a chicken in every pot and two cars in every garage.”  He thereby implied that every family would not only have two cars, but also a home with a garage in which to park them.

However, not everyone wants to own their home.  Renters have much more financial flexibility and are able to move from place to place more easily as they don’t have the burden of selling their residence first.  Property owners are responsible for all maintenance and repairs, taking a significant burden off renters.

Other people, though, prefer to own their residence.  Reasons people prefer to own their residence include:

  • The ability to build equity.
  • The privacy offered by single family homes (which are much more prevalent among owners than renters).
  • The knowledge that, while many costs will increase with inflation, mortgage payments stay constant whereas rents have a tendency to increase regularly. I note that mortgage payments will not stay constant if you have an adjustable rate mortgage.

How Long Do You Plan to Live at this Location?

As I mentioned above, one of the biggest benefits of renting is the ability to move quickly.  While renters may have to pay one or more months of rent when they move out, homeowners need to sell their residence when they move to another city.

Markets are hot for many price brackets currently, however that won’t always be the case.  I’ve never had a residence sell in less than six months and one took almost two years to sell.

In addition, most sellers use a realtor who takes between 5% and 7% of the purchase price as a commission on top of your other selling costs.  If you need to sell your house within a few years, these transaction costs can more than offset any appreciation in the value of your home and possibly any equity you have built.  As such, how long you plan to live in your current location will influence your decision to buy vs. rent.

Your Current Financial Situation: Buy vs. Rent

There are two aspects of your current financial situation that might affect your buy vs. rent decision, possibly precluding you from owning your own home.  They are your ability to afford a down payment plus closing costs and your ability to tolerate unexpected expenses.

Do You Have the Down Payment?

Most banks require you to use your own money to make a down payment on a residence as a prerequisite to getting a mortgage.  The percentage of the purchase price that you need to pay as a down payment typically ranges from 3.5% for an FHA (Federal Housing Authority) mortgage to as much as 20% for a conventional mortgage.  You’ll need to talk to a lender to get the specifics for your situation.

A higher down payment, as a percentage of your purchase price, typically leads to a lower interest rate on your mortgage.  Also, if your down payment is less than a certain threshold, often 20% of the purchase price, you may incur extra fees.  For example, if your down payment is low and is guaranteed by a Federal agency in the US, your lender or the guarantor may require one or more types of mortgage insurance that could cost between 1% and 3.5% of the loan amount up front plus up to 1% of the outstanding principal annually.  NerdWallet provides more details, but again I suggest you talk to your lender to get the specifics of your situation.

Some people try to borrow money from friends or family members to help with their down payments.  Most lenders are quite careful to look at the source of your down payment.  If you can’t show that you saved the amount of your down payment, you may be required to provide extra documentation confirming that the money was a gift and not a loan.

Can You Tolerate the Unexpected Expenses?

One of the benefits of renting is that the landlord is responsible for maintenance and repairs.  If you own your own home, these costs will fall to you.  When you first buy your home, you can get a sense for the important costs that you might incur in the short term if you have a home inspection.  I strongly recommend a home inspection as a contingency when buying a residence.  When we bought a house recently, we were able to reduce the purchase price by about 3.5% for repairs we were going to have to make shortly after purchase that hadn’t been identified in any of the disclosures.

You also need to be aware that, once you’ve owned your home for a while, things break and they tend to be expensive.  I’ll talk more about the possible amounts of maintenance and repair costs below.  But, before you consider buying your residence, you need to make sure you have enough money in savings or a line of credit that will allow you to pay for possibly major repairs on fairly short notice.  Examples include your furnace (at least a few thousand dollars), your hot water heater or water softener (probably USD1,000 each) and, every 15-25 years, your roof (often USD10,000 or more and possibly up to USD50,000 depending on the size of the house and type of roof).

Costs of Ownership

In this section, I’ll list the important expenses related to owning your residence and provide very rough estimates of their costs where I can.

Down Payment & Mortgage Principal

You need to make a down payment when you buy your residence.  The down payment itself isn’t really a cost of owning your residence, but rather just transfers your cash asset into equity in your home, which is also an asset.  The same is true for the principal portion of your mortgage payments – you are converting cash into equity in your residence.   Nonetheless, your down payment and mortgage principal impact your cash flows.

Mortgage interest

By comparison, the interest portion of your mortgage payments is a cost of owning your residence.  The amount of your mortgage interest will vary based on the original principal on the loan, the interest rate and the term of your mortgage.  My post on loans provides more information about the split of mortgage payments between principal and interest.

Property taxes

Most real estate is subject to property taxes.  In places I’ve lived, property taxes have helped fund local (city or town) and county governments as well as school districts.  In most cases, property taxes are calculated as a tax rate times the estimated market value of the property.  My experience is that the estimated market value is fairly close to accurate when you first buy your residence, but can start to diverge fairly widely.  As of 2018, the average property tax rate in the US was 1.1% of assessed value, but varied from as low as 0.27% (Hawaii) to as high as 2.21% (New Jersey).

Homeowners insurance

Homeowners or condo-owners insurance protects against loss or damage to your residence and its contents.  It also provides liability coverage in case someone is injured or their property is damaged as the result of something that happens at your residence.  The cost of your homeowners insurance will vary widely depending on what perils are present where you live.  For example, insurance is much more expensive in the Southeastern US due to hurricanes and the West Coast of North America due to earthquakes than in most of the rest of the US.  The cost also depends on how much liability limit you purchase.  The data in this article from Business Insider shows average homeowners costs of 1.6% for homes with values less than USD50,000 to about 0.4% for homes with values about USD200,000.

Association Fees

If you live in a condo, townhouse or house that is part of an association, you are likely to have to pay association fees.  In a condo or townhouse, the fees can range from USD100 to USD700 a month.  These fees cover the maintenance, repairs and insurance for the structures, as you usually own from the walls in, and any maintenance and repairs needed for the outdoor facilities, such as road maintenance and plowing, lawn and garden upkeep and any association amenities, such as tennis courts, pools or buildings.

If you live in a house, homeowners association fees tend to be less.  I’ve lived in two houses in associations, one of which has fees of about USD250 per year and the other had fees of about USD2,500 per year.  These fees usually cover the care and maintenance of roads and any association amenities, such as tennis courts, pools or buildings.

Utilities

When you own your home, you’ll need to pay for all of your utilities.  Depending on where you live and your lifestyle, utilities can include electricity, natural or propane gas, water, sewer, trash collection, recycling fees, telephone (cell and/or landline), internet and television.  The monthly cost of utilities varies widely from location to location and from month to month.  As you budget for your utilities, you’ll want to reflect the impact of differences in weather throughout the year on electricity and gas, in particular.

Maintenance & Repairs

Many things in your home will either wear out or break at some point.  Maintenance is the process of making sure that your home stays in its current condition.  It includes cleaning, yard work, painting and replacement of appliances, carpet and other things as they wear out.  Repairs are costs associated with fixing or replacing things that have broken.  I found several articles that indicate that maintenance and repair costs average between 1% and 4% of the value of your home each year.

One of the biggest maintenance expenses is your roof.  While most roofs need to be replaced only every 15 to 25 years, the cost to replace a roof is very high.  For a small home with an asphalt roof, the cost can be as low as USD4,000.  However, for larger homes with metal or cedar shake roofs, the cost can be as high as USD50,000 or more.  Although you won’t incur this expense every year, you will want to set aside money for a roof and other major maintenance expenses every year so you have money available when needed.

Updates

In addition to maintaining your home, it is often important that your home be consistent with current trends when you sell it.  For example, when we bought a home in the late 1980s, colorful carpet, draperies, wallpaper and tile kitchen countertops were very popular.  Although we kept the house in superb condition, it was almost impossible to sell it 30 years later with those features.  We spent a lot of money replacing the carpet with neutral colors and counters with granite, removing the draperies and wallpaper, and painting the walls varying shades of gray.

If you are selling your home in a very hot market or it is old enough to be “classic,” it is only important that it be well-maintained.  However, if your house is not in a niche that is popular, it is critical to either update your home or reduce the selling price enough that the buyer can make the updates.

Sales Commission and Closing Costs

If you use a real estate agent to help sell your home, you will need to pay a commission.  The amount of the commission depends on local custom as well as whether your agent acts as just your agent or also represents the buyer.  I’ve seen real estate agent commission vary between 5% and 7% of the selling price.

There are other closing costs you will have to pay when you sell your home, such as the cost of a title search and insurance and fees to the closing agent.  In addition, in some states, you have to pay excise tax.  For example, in Washington, there is a tax of 1.5% of the selling price of your home.

Costs of Renting

Rent

Rent compensates the owner of the property (also known as the landlord) for all of the costs of ownership plus a profit.  The profit covers the opportunity cost of the money the owner has invested.

Rent is commonly paid monthly.  In addition to the rent, you may need to pay a security deposit and one or more months of rent in advance before you can occupy the premises.

Depending on your agreement with the landlord, the amount of your rent may change over time either on a fixed schedule or at the discretion of the landlord.

If you are interested in some perspective as to how much you can afford to pay in rent, you might check out this calculator from Jonathan at Parent Portfolio.

Renters Insurance

Renters insurance protects you against loss or damage to your contents.  It also provides liability coverage in case someone is injured or someone’s property is damaged (including the landlord’s property) as the result of something that happens at your residence.  Renters insurance is very inexpensive, often less than USD15 a month.

Utilities

When you rent your residence, you many need to pay for none, some or all of your utilities.  It all depends on the agreement you have with your landlord.