I hear it from financial advisors all the time: “Homeownership is a kind of third rail, an untouchable topic, when it comes to financial planning,” says Jake Engle, a Portland, Oregon based financial advisor. “By the time people come and see me, they’ve already bought a house — and maybe they’ve overspent on it.”

In America, many people consider buying a house as their first stop on the path to financial security. They invest in real estate and then they think about “the rest” of their financial lives. But if the recent housing bust has taught nothing else, it’s that overspending on housing, overestimating ownership investment benefits and misunderstanding how home equity functions can seriously affect homebuyers’ financial futures.

A mortgage broker will tell you what a bank will let you borrow, but a financial advisor will tell you how your housing spending coordinates with your overall financial picture. Here are six questions a financial advisor can help you figure out to determine if buying a house is a smart financial move.

1. How Much Should You Spend on Housing?

Generally, financial experts recommend that people spend no more than 30 percent of pre-tax income on housing. This is a ballpark that renters and young adults hear, and it’s similar to what mortgage lenders like to see at loan origination. There are exceptions — especially for the affluent — since 50 percent of a seven-figure income leaves more spending money behind than does half of $50,000.

But just because you can borrow that much, does it mean you should? Your Money Ratios, by financial advisor Charles Farrell, advocates that borrowers should never have more than twice their household income outstanding on the mortgage, and even then only when under 30. By age 65, the multiple should decline to zero — since few retirees want a mortgage. There are exceptions to these guidelines, however, depending on life stage, assets and other variables.

2. How Much Should You Budget for Home Maintenance?

Most people don’t believe they’ll have to spend up to 2 percent of their home’s purchase price annually on maintenance and repairs — an industry average. While expenses may be minor most years — replacing furnace filters, maybe hiring landscaping help — in other years, expensive fixes more than tote up the average. Fixes such as replacing windows, re-roofing, or upgrading plumbing or electric are often five-figure spends.

3. Is Home Ownership the Right Investment Choice for Me?

It’s not the same kind of investment as shares of stocks or mutual funds or even a CD. Your home is an illiquid asset (not quickly sold), and while generally speaking homes rise in value over time, it’s very hard to predict what value your home will hold during the future year that you sell it. Factor in maintenance, real estate fees, property taxes and the financial “return” for owning typically shrinks. That’s not to say you shouldn’t own, just that you shouldn’t overestimate the financial value of doing so — looking at how far an investment in the market can go versus an investment in your primary home may make you rethink your home purchase outlay.

4. How Does Home Equity Function?

Many people think their home’s market value is the most important number to know — it’s easy to check it on sites such as Zillow.com But for financial planning purposes, home equity is the figure that’s important.

Equity is determined by how much you owe on the property relative to its market value, not simply on purchase price relative to market value. For example, take a home worth $500,000:

  • Owner A owes $100,000 on their mortgage has 80 percent equity
  • Owner B owes $300,000 on their mortgage has 40 percent equity

And what if your home drops in value, say from $200,000 to $100,000?

  • Owner C owes $100,000 on their mortgage, and initially had 50 percent equity, but after the drop in value has 0 percent equity.

5. Is It Financially Smart to Tap into Home Equity?

Mortgage interest rates have been historically modest in recent years relative to the returns on many types of equities. Homeowners with strong equity positions may be tempted to pull out equity — since interest on mortgage debt is cheap — to fund major purchases such as a child’s college education or purchases like a car, items for which financing costs more than the mortgage.

They also may be tempted to keep money in the stock market, where it can fetch high returns, rather than accelerate mortgage repayment on a loan with low rates. It’s vital to debate scenarios with a financial advisor before playing with your equity.

6. What’s Your Exit Math?

Most people don’t think about “exit math” when they buy a home. But they should, because if you had to sell sooner than planned, it’s important to know whether you’d walk away with cash or have to pay to exit.

There’s more to the formula than purchase price minus sale price. You also need to subtract 6 to 10 percent of the sale price for sale-related fees (realtor fees, excise taxes, legal), how much you’ve spent on maintenance over the years, and the mortgage amount outstanding.

For example, say you bought a $300,000 home with a $30,000 down payment, on a 30-year mortgage at 4.2 percent interest, and have lived there for five years. Using an amortization calculator you conclude you’ll owe $244,525 on the mortgage at this point.It sounds like you’ll have a little over $50,000 in equity when you go to sell, assuming the value held, right? But check out these two scenarios, one in which the home’s value has risen and another in which it’s fallen.

Scenario 1: Hot Market and the Value of Your House Rises

$350,000

Sale Price
($244,525) Mortgage Outstanding
($21,000) Six Percent Broker Fees
($5,000) Renovations Needed to Sell
($13,000) Repairs Made While Living in House
($5,000) Fees & Taxes to Sell
($2,000) Closing Concession for Buyer
$59,475

PROFIT


Scenario 2: Slow Market and the Value of Your House Drops

$275,000 Sale Price
($244,525) Mortgage Outstanding
($16,500) Six Percent Broker Fees
($5,000) Renovations Needed to Sell
($13,000) Repairs Made While Living in House
($5,000) Fees & Taxes to Sell
($2,000) Closing Concession for Buyer
($11,025) NET LOSS TO EXIT HOME


Check the math annually, and make sure your savings offsets any potential loss 
you’d take in the event you needed to sell.

For most people buying a house is an emotional decision. And many individuals justify justify over-spending on a property by assuming a that property ownership is always a financially sound investment. By understanding how a house’s value does — and doesn’t — contribute to your financial landscape, you can make a better decision on if buying a house is a smart financial move.

Need help deciding if buying house is right for you? Find a financial advisor at GuideVine.com.

Categories: Real Estate

Jane Hodges

Jane Hodges

Jane Hodges is the author of Rent Vs. Own (Chronicle Books) and has written about real estate and personal finance for The Wall Street Journal, New York Times, Seattle Times, Fortune and many other publications. Follow Jane on Twitter and Google+

1 Comment

Donalf Major · October 31, 2015 at 9:35 pm

My vote is NO! When all cash flows are considered, renting costs less, which means you’ll have more money to save & invest. Over the long run, the stock market averages +10%/yr.

So the 20% downpayment, 3-5% closing costs, 5-6% selling costs every time you move (average US home borrower moves every 7 years), property taxes, maintenance, insurance, is all money that could have been invested.

If you look at everything (all cash flows considered), you spend less money when you rent! Between property tax, insurance, maintenance, mowing the lawn, fixing the roof, etc. etc. plus the extra utility costs you’re spending a lot of money that could be invested instead. What’s wrong with renting??

Learn from the past people! (Of course they look at me like I’m crazy when I suggest they cut a $100+ a month cable bill. Or drive a car that is 3 years old. Or only fill up their tank from the cheapest place according to GasBuddy. Or get $25/month budget car insurance from Insurance Panda. Or cook their own food instead of spending a hundred a week on restaurant food (or far more if they like the bar).)

Nobel Prize winning economist Robert Shiller was one of the few people who accurately called both the stock market crash of 2000, AND the real estate crash of the late 2000s.

And he says that owning a home is a terrible investment.

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