Living the American Dream

by Bernhard Krieg

The Math of it all

This is never the fun part, but it's important to get a sense of the financial commitment required to purchase a house or condo.

  House Condo Notes
Purchase Price 250,000 250,000  
Closing Costs 3,750 3,750 1.5% of Price
Down Payment 28,750 28,750 10% Down Payment + Closing Costs
Loan Amount 225,000 225,000 90% Loan-to-Value
Interest Rate 4.5% 4.5% 5 Year ARM
Mortgage Payment 1,140 1,140 30-year Amortization
       
Private Mortgage Insurance (PMI) 113 113 $50/month for $100,000 of principal
Real Estate Taxes      
Assessments - 200 ~1% of value/year
Repair & Maintenance 150 50  
Other Expenses 523 623  
% Other Exp over Mortgage Pmt 46% 55%  
Total Monthly Cost of Ownership 1,663 1,763  

After calculating the expenses on top of the mortgage payment, the initial costs of home ownership increase significantly.

The Myth of the Tax Deduction

What about the magic benefits of that tax deductible interest? There is a government incentive to stimulate homeownership, but it's probably less than you think. Yes, interest expense and real estate taxes are deductible for federal income purposes. What people sometimes forget is that if you don't itemize you are allowed to take a standardized deduction. For a married couple filing jointly that amounts to $9,700 in fiscal 2004. Taking our example above, the mortgage interest is about $10,000 per year and the real estate tax approximately $3,000 per year. That gives you about $3,300 of additional tax deductibility per year. At the maximum tax rate of 50%, that is a whopping $1200 per year or $100/month (less than the PMI).

Planning for the unexpected

Many people believe that bigger is better, particularly when it comes to the place they call home. The pressure to live up to your own and everybody else's expectations is great. This is why your mortgage broker or banker will tell you the MAXIMUM amount that you would qualify for a mortgage. Now, I would highly recommend that you not stretch yourself to that limit. There are two different kinds of unexpected things you will want to leave some room for: the good and the bad. The good things you will want to do include vacations, visiting family and friends, attending weddings, buying toys and gadgets for the house, or staying at home longer with a newborn.

In the bad category we have unemployment, major repairs on a house or a car, providing care for an elderly relative and other unimaginable disasters.

A Home for a Year, a Decade or a Lifetime?

Deciding the number of years you expect to live in your future home is crucial. Normally, the rule of thumb is that it only makes sense to buy if you realistically expect to live in your home for at least 5 years. Some of the reasons for this include the high transaction costs and the time involved in acquiring and selling real estate. The total "roundtrip" costs of buying and selling a home are close to 10% of the purchase price. Therefore, it doesn't make a lot of economic sense to buy a studio apartment today, when you know that you will require a larger apartment in a couple of years.

The other dimension is the term of your mortgage. If you are buying a one-bedroom condo, a thirty-year mortgage might not be the best decision since it is unlikely you will stay there for that long. When you buy a new home you will have to get a new loan at then prevailing interest rates, since mortgage loans are not transferable. You can view the term of the fixed interest rate as a sort of an insurance policy against rising interest rates. Feel free to buy as much interest rate protection as you can, but for only as long as you are likely to stay in the home.

Word has gotten around that we are in a period of historic low interest rates. Please keep in mind that Americans are buying a new house on average about every seven years. Therefore, 5- or 7-year hybrid ARMs (Adjustable Rate Mortgages with an initial fixed interest rate and adjustable thereafter for the 30-year term) make a lot of sense for many folks. Try not to get an adjustable rate mortgage that resets the interest rate every 6- or 12-months, just because the initial interest rate would be lower and you could afford a larger mortgage.

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