The Amateur Financier

Welcome back for the second edition of Financial Lessons, where you learn everything that should have been taught to you in high school (but probably wasn’t).  Today, our lesson plan includes some of the basics of house buying, a particularly good topic which should have been studied more closely in recent years.  What information about purchasing a home should be shared with people who probably don’t even pay rent yet?  Let’s head back to class (and I promise it’ll be more helpful than dissecting frogs).

The Lesson

Welcome to a particularly pertinent lesson, at least for any of you who hope to own a house one day.  There are numerous advantages to owning your own house, from the financial benefits to the psychological boost of having a place that is all your own.  If you do it right, owning a home can be a solid foundation on which to build your financial future.  This lesson is devoted to helping you do it right.

Home Sweet Home (Ownership)

The first step towards buying a home should be to save up for a down payment.  The days when you could get a good home in a great neighborhood with nothing down are gone.  If you can’t find enough money to save up a substantial down payment while still investing for retirement, building up an emergency fund, and paying for your regular living expenses (including your rent), there’s a good chance you don’t have the discipline to own your own home, with all the maintenance and regular expenses that home ownership entails.  Work to cut down on your monthly spending and start to put money away into a dedicated, non-emergency fund to save for your down payment. (Remember, class: you should always have three to six months worth of expenses set aside to cover emergencies, whether a loss of income or a sudden, larger than expected expense; this money is NOT to be used for your down payment.)  Your goal should be an amount equal to twenty percent of the house prices in your area, but you can get away with having ten percent, or even five percent, provided you can afford some added payments each month.

Speaking of which, while you are saving your down payment, you should try to figure out how much you will be spending each month on your new home.  Mortgage calculators, like this one from Bankrate.com, can give you an idea of what you’ll need to pay each month to cover your mortgage expense.  But don’t think that your mortgage is your only expense as a homeowner; you will have utilities, homeowner’s insurance, and repair costs  added to yur bill, most which would be included in your rental costs.  (In addition, you will also have private mortgage insurance (PMI) or a second mortgage if you put less than twenty percent down.)  Factor them in by learning what the expenses are for your would-be neighbors, or take a conservative guess at your total monthly costs by adding on fifty percent to the cost of your mortgage.  If you can’t afford that amount, you’ll have to work to increase your monthly earnings, decrease your (non-housing) expenses, save up a larger down payment to lower the costs of home ownership, or look at less expensive homes.  A combination of these four methods should enable you to get to the point where you are ready to purchase a home.

Once you have your down payment saved and know how much home you can afford, it’s time to go mortgage shopping.  Unless you are independently wealthy or have very rich, very generous parents, chances are that you won’t be able to afford the cost of even a little starter home at first.  Instead, you will need to go to your bank, credit union, or mortgage broker and borrow money in order to purchase your home.  Your goal is to become pre-approved for your mortgage; your lender will do a thorough check of your finances, to ensure that you can afford the mortgage, and when you pass all the checks they will do, as I’m sure all of my students will be able to do, you’ll have the promise of a loan from the bank to cover the expense of purchasing your house.

There are several types of mortgages, some of which have gotten quite exotic, but the two most basic types are fixed-rate mortgages and adjustable-rate mortgages (or ARMs).  A fixed-rate mortgage is exactly what it sounds like: the interest rate charged on your mortgage is fixed for the life of the mortgage, typically fifteen or thirty years, and won’t be changed at all while you have the mortgage.  This definitely makes planning for future expenses easier; you’ll have the same mortgage charge ten years from now as you have during your first year.  However, the initial costs for this type of mortgage tend to be a bit higher than ARMs.  With an ARM, your rate will start lower than a fixed rate mortgage of equivalent length; however, the rate could change (or adjust) to be higher in the future, after the initial, fixed rate period of the ARM is over (assuming your ARM has an initial fixed rate period; some ARMs do not).  ARMs can save you money initially (and possibly later, if they adjust downward), but are more risky than fixed-rate mortgages, and require more research and consideration to ensure you don’t end up on the wrong end of an adjusting rate.  There are also other types of mortgages, such as interest-only and option mortgages, but they can get rather complicated, and I think you should probably avoid them.  (If your lender hasn’t been scared off of offering them by recent events, anyway.)

Once you have a mortgage pre-approved and plenty of money for a down payment (as well as closing costs, inspection costs, and any number of legal and other fees; buying a house can get rather expensive), you’re finally ready to look for a house.  If you aren’t a seasoned pro at house hunting, you will probably want to hire the services of a Realtor; in exchange for a portion of the final selling price, you will get someone who will help guide you through all the inner workings of buying a house.  You’ll also want to have a home inspector working with you, to ensure that the home you buy meets structural standards.  Finally, you’ll need to make sure you have home owner’s insurance to cover your house before you finally close on the deal.  We’ll discuss all of these issues further in future, as I’m sure you’re already wondering just how long this class period is going to last.  Just remember, even after you have the money side of home buying in the bag, there’s still the actual house that you need to consider.

At this point, you might be wondering just why you should even buy a house.  There are several advantages to home ownership, many of which derive from preferential government treatment of housing-related expenses and profits.  The interest you pay on your mortgage (and in the first few years, most of the cost will be interest) is tax deductible, meaning that you will have a nice write-off on your taxes if you itemize your deductions.  Also, you can currently sell your primary residence and keep $250,000 of the profits without having to pay any tax if you’re single, $500,000 if you are married, provided you lived in the house for at least two of the past five years.

Of course, these benefits are based on current tax laws, and could change (for better or for worse) by the time you are ready to purchase a house.  One thing that won’t change is that over the long term, buying a house is cheaper than renting.  Because most of your home ownership expense is your mortgage, a cost that is either fixed or capped (with ARMs), your monthly expenses will grow at a lower rate than the rental costs for a similar place.  Furthermore, when you pay off your mortgage in fifteen or thirty years (which sounds like a lifetime to you youngsters, I know, but will pass faster than you think), the biggest housing expense you will have disappears, and you are suddenly living for much less than someone who rented for that period of time.  Of course, buying a home means you will also own the home; if and when you sell (or your children sell, if you pass it on to them), you will be able to profit from the sale, while you can’t profit from the rising price of a house you are renting.

All of that said, however, before going through this whole process of buying a home, you have to decide whether owning a home is really a better option for you than renting.  We just finished discussing some of the advantages of home buying, but renting has some perks as well, particularly for young people like yourselves who are just starting out in life and need flexibility.  It can be cheaper to rent than to own, at least in the short term: as we mentioned, there are expenses beyond the mortgage to consider when owning a home, most of which (with the exception of utilities, in many cases) are covered by your rent.  It’s also much easier (and cheaper) to move when you rent; just give notice to your landlord, pack up any belongings, try to clean the place up to get your security deposit back, and head out to your new home.  When you own your home and need to move, you’ll need to put it up on the market, wait for buyers, and have to pay out a substantial portion of the price to brokers (as well as paying closing costs and other expenses on a new house, potentially).

For these reasons, renting makes sense for those times when you aren’t going to stay in the area for long, if you are attending college for four years and are then planning to move away from your alma mater when you finish, for example.  You should obviously crunch all the numbers for yourself whenever you are making big decisions about your living quarters, I just don’t want you to take away the message that everyone should buy a home, as soon as possible (if not sooner); that’s simply not the case.

Alright, students, that’s enough talking from me for now.  You have plenty to think about if you are looking into housing, and hopefully, you’ll be able to sort through all the hype you’ll read in the media about houses, for better or for worse.  *The school bell rings; several students say ‘Finally!’ as they quickly get up*  Have a good day of learning, all of you!

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