Living the American Dream
by Bernhard Krieg
Right now you are in the middle of planning your wedding, or you are about to get married. The next big decision for the two of you is whether you should rent or buy a place you will call home. While experts debate the pros and cons of buying a home at this time, you’re both faced with the challenge of securing a home that allows you the freedom to live and enjoy your life together. At some point you’ll need to figure out how much you can really afford to spend on a house without unnecessary stress and tight restrictions on your financial life.
The True Cost of Buying a Home
Why throw your money away for rent every month when you can buy a similar place for only a few hundred dollars extra every month in a mortgage payment? There are many factors to consider when purchasing a home. First of all there is the down payment. If you are only able to provide a small amount for your down payment, your interest rate and monthly payment will be considerably higher than with a larger down payment. You will also be required to purchase private mortgage insurance (PMI) with down payments of less than 20% of the entire purchase price.
Real estate taxes in Chicago run at about 1-1.25% of current market values per year. This is an expense that will continue to increase at rates significantly above the rate of inflation. Condos are attractive alternatives to entry-level homeowners, both in the city and in the suburbs of Chicago. While they are typically available at lower prices and require less maintenance, monthly assessments can be a substantial amount. This is particularly true for old buildings, such as lofts or high amenity buildings.
New homeowners often underestimate the costs for repairs and maintenance of their house or condo. As you create your budget, I suggest that you calculate about $150 per month for a single family home and $50 for a condo where the association payment covers exterior maintenance. You probably won’t spend this amount each month, but you’ll have a fund to draw from for items that will need to be repaired or replaced.
Closing costs can also add to the purchase price of any home. These costs are not limited to the fees and potential points you are paying to your mortgage lender, but also include city tax (0.75% of purchase price within Chicago), title fees, and professional fees to lawyers or inspectors if you choose to use their services. All of these things add up to monthly cash needs that are 45-55% higher than the mortgage payment alone. (See below for a detailed example.)
After you’ve signed your name on the dotted line, you’ll need to have some money left over for moving costs and home furnishings. In addition to furniture, your list might include blinds, lamps, outdoor furniture, plants, BBQ grill etc. I would suggest that you take your time on those purchases rather than running up your credit card or incurring additional consumer debt. Yes, anything that offers an easy payment plan with no money down is another example of consumer debt.
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.
The Advantages of Renting
Buying a house is a great investment but it’s not the only option for a couple to consider. I believe the biggest and most unappreciated aspect of renting is the flexibility. You only sign a contract for a maximum of 12 months, and normally you can even get out of that commitment on shorter notice without too much financial damage. So, that means that you can change living quarters within your hometown and throughout the United States, and you can also adjust the amount of living space to fit your budget. If you have to relocate for your job or if your financial situation changes for better or for worse, you can adapt to the new circumstances in your life.
Selling a house is not only a lot of hassle, but a significantly more expensive venture. You can always pay a penalty to break a lease when necessary, but selling a house requires a lot of time and energy. If you need to find a buyer for your house, you’ll have to synchronize that with buying your new home. Right now the market is bountiful, but there will come a time when the sellers are plentiful and the buyers are scarce. This means that your residence could sit on the market for 6 months or longer. You’ll also have to pay for the real estate broker commission, which is 5% of the sales price.
The other advantage is convenience. How great is it to just call your landlord or your maintenance staff at the apartment complex and tell them to fix the fridge, air-conditioning, toilet, furnace or whatever else is not functioning? If you own your home or condo, you need to find the right service to fix it, make sure the price is not ridiculous and, likely take time off from work to be there when the repair people come over.
The Sum of it all
I hope this article will help you avoid some of the potential pitfalls when it comes to making one of your biggest purchasing decisions. If you can truly afford it, purchasing a home is not only a good investment choice but will also reward you with pride of ownership and a great sense of home. You have decided you want to spend the rest of your life together, but how and where will be something you two discover throughout your journey.
I will be exploring other topics of financial health for couples in this column in the future, so check back for more soon. If you have done the math and you are ready to shoulder the financial responsibility of home-ownership, enjoy shopping around for your piece of the American Dream!
Resources & Helpful Websites
Homes for sale:
Mortgage Rates & Payment calculator: www.bankrate.com
Taxes: www.irs.gov, www.wwwebtax.com
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