MISCONCEPTIONS ABOUT BUYING A HOME

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Everybody wants to buy a home. There is an allure to home ownership that is difficult to describe.

Is owning a home the American dream? Maybe. It may not be “the dream” in the way that it used to be.

Does owning a home make life better or more idyllic? Probably not. Unfortunately, human beings have problems no matter where they live.

Is owning a home a financially optimal decision? Tough to say. In some cases it might be, but it is not always the case. This probably goes against what most people would say about owning a home.

The common narrative around buying a home is overwhelmingly positive. Most people are in favor of buying a home in nearly every circumstance, situation or life stage. “It is just what you should do,” they’ll say.

Unfortunately, this narrative is fueled by some misconceptions and half truths. Although owning a home is an important step in your financial life and the right decision for some folks, you shouldn’t feel rushed or pressured to make a purchase.

Let’s discuss and debunk some of the common themes of home ownership and certain misconceptions around purchasing a home.

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The Down Payment

Before you officially enter the home buying process, you will begin to save funds to make the down payment.

This factor will determine, in part, how much your monthly mortgage payment will be and the total price of your future home.

You can use this simple formula to get started.

** $ Amount Saved / $ Price of Home = % Down Payment **

Many financial pundits recommend that you save 20% of the home’s cost as a down payment. This is a conservative rule of thumb. It is simultaneously difficult to reach this level of savings, specifically for first-time home buyers.

By reaching the 20% mark, you will save on private mortgage insurance. PMI will cost approximately $30 to $70 for every $100,000 borrowed. This is admittedly a benefit of making a 20% down payment but not a large enough incentive to make someone forgo buying a home if their life needs warrant it.

First-time home buyers should take comfort that a 5% down payment is sufficient for the first home purchase. When you decide to upgrade your housing situation in the future, then you should adhere to the 20% down payment rule.

The rule helps keep you from over-purchasing and justifying a home purchase that is probably more of a “want” than a “need.” As with many tangible purchases in life, the home can easily be a vanity purchase. The phrase is overused, but “keeping up with the Joneses” is easy to do when you are in the market for a home.

For the vast majority of first-time home buyers, a 5% down payment will more quickly facilitate the purchase of home. If you have always wanted a home and your life requires it, you might consider this route instead of the more traditional 20% down payment.

Misconception: Always save 20% of home’s cost for your down payment.

Debunked: First-time home buyers can take advantage of the flexibility of a 5% down payment, then jump up to the 20% on all ensuing home purchases. This helps to control overspending and to keep your wealth building journey on track.

Impact of Interest Rates

The interest rate on the 30-year mortgage has a serious impact on your housing budget. It will not only impact your monthly mortgage payment but also the total cost of the home you can afford.

With higher interest rates, mortgage payments will be higher. If you try to hold your mortgage payment constant as a percentage of your monthly budget, the total cost of the home will be less.

Basically, you must choose. You can have either the same payment and a cheaper house or a higher payment and the same home price. These factors are working against each other.

Mortgage rates have been on an upward trend in recent months which has slowed the housing market to a degree. If this relationship persists, home prices may fall as fewer buyers compete over homes for sale.

It is difficult to forecast any market, but guessing where the housing market will be next month or next year proves to be nearly impossible. This doesn’t mean that the information provided by the mortgage market and interest rate environment is useless though.

If you are on the fence about buying a home, it is okay to take some cues from a reliable resource. The interest rate is more important than many realize, so it makes sense to reach out to a trusted source.

Misconception: Interest rates should have little impact on your home buying decision.

Debunked: Because interest rates can hugely affect the amount you spend on a home and thus the quality of the home, you should at least consider the interest rate environment when buying a home.

Mortgage Payment

Your down payment and income will determine the proper mortgage payment. As discussed, the interest rate is factored into this equation to help determine your overall housing budget.

Typically, your monthly mortgage payment should be 25% to 30% of your monthly income. This is a standard rule of thumb recommended by nearly all resources. The lender will use this approximate percentage to determine what loan amount you will qualify for and your monthly payment.

Your mortgage payment will be sent to the lender each month, part interest and part principal. The interest portion of the loan is compensation for the lender, and the principal payment is intended to repay the actual amount of the loan.

Many believe that as soon as you buy a home, you will start repaying principal and building equity, the amount of the home you truly own outright. This isn’t really the case. The vast majority of your monthly mortgage payment will be used to pay down the interest portion of your home loan, especially in the early months/years of the loan term.

For a quick example, you can use this calculator, known as an amortization schedule or calculator. (I set the ‘Loan Amount’ = $400,000, the ‘Interest Rate’ = 6.75%, and the ‘Loan Term’ = 30.)

The monthly mortgage payment for the loan is $2,594.39 and will be paid each month over the life of the loan. In the first month, the interest portion is $2,250.00 or 86.7% of the total payment. With the 120th payment (year 10 of the mortgage), the interest portion is $1923.05 or 74.1% of the total payment. This is pretty staggering!

Interest payments will be the majority (greater than 50%) of the monthly payment until approximately year 20 on a 30-year mortgage. Over this time, you will still be paying down principal but building equity slowly. Your monthly payment is mostly a function of paying down the interest portion of the loan for the first 20 years.

It is not bad to buy a home with the intention of building equity. With each payment, some principal will be re-captured. This process happens much more slowly than many people realize.

Misconception: Your monthly mortgage payment immediately allows you to build equity in the home.

Debunked: In reality, the first several years of mortgage payments will only marginally increase your equity in the home. It takes longer to build equity than many people realize.

Lack of Tax Benefits

Many people say, “You can deduct the interest payments on your mortgage so you should buy a home!”

This is true to a degree but misses an important element of tax planning. In order to receive this deduction, you will be required to itemize your deductions. Many potential home buyers do not realize this caveat.

Since the majority of people (approximately 90% or so of all tax filers, especially since the Tax Cut and Jobs Act) will not itemize deductions but will instead use the standard deduction, most will not receive this benefit.

Generally speaking, when a first-time home buyer purchases a new home, the cost of the home may not warrant deducting interest payments for tax purposes. The standard deduction is typically more beneficial.

These calculations, estimates, and conjectures are subject to change since they are dependent on the current tax environment. As we all know, tax law changes frequently. To address your specific situation, you may be required to do a small amount of math and consult a tax preparer/CPA to decide what is best for you and your family.

Misconception: You can deduct the interest portion of your mortgage payment and lower your taxes.

Debunked: You only take advantage of this feature of home ownership if you itemize your deductions. The vast majority of folks will use the standard deduction and will never deduct interest payments.

Tail Risks and Maintenance Costs

The monthly mortgage payment is an obvious cost of owning a home. It is easy to see, and you will encounter it each and every month over the life of the loan. There are other costs that tend to fly under the radar.

When you own a home, you are exposed to a number of low probability but high cost events like some of the following:

1/ Repair or restore a damaged roof.2/ Remove moisture from a crawl space/basement.3/ Replace inefficient, non-compliant HVAC systems.4/ Replace out-dated, inefficient, or otherwise broken appliances.

These events can be costly, possibly tens of thousands of dollars. Although none are inherently likely, there is a reasonably high probability that you will experience at least one of these tail risk home repairs. The old saying, “When it rains, it pours,” feels especially applicable to home ownership.

Even if you do not have an expensive tail risk event, you will still be exposed to the regular costs of maintaining a home. Most people overlook or forget these costs despite their significance. What might you have to do to maintain a home? What are a few of the expenses?

1/ Spend for pest control.2/ Maintain HVAC systems.3/ Purchase a lawn mower/other yard tools.4/ Clean/repair gutters and maintain other “curb appeal” elements. (e.g., flower beds, driveway, siding, etc.)

In this category, the cost of each individual maintenance item may be nominal. These become more significant in the aggregate, though many folks do not even realize it. The average non-homeowner would never be able to guess the amount an average homeowner pays in maintenance each year.

In addition to the regular maintenance expenses you will encounter, you will be required to pay property taxes on your home. All of these expenses add up quickly! The cost does not stop at the monthly mortgage payment. There are other items to be considered.

Misconception: The mortgage payment is the true monthly cost of owning a home.

Debunked: The potential for tail risk events is not high but incredibly costly. One or more of these events alongside the ongoing cost of regular maintenance/taxes is often forgotten but still an important component of your overall financial life.

Home is NOT an Investment

Many people get excited about the opportunity to buy their first home and “start to invest” in the housing market.

A home is a place to live, not an investment. A true investment must satisfy two criteria.

1/ Provide regular income.2/ Provide capital growth over time.

The primary residence does not truly accomplish either of these components. If you own and live in a home, it will not create income. Not only will a home not produce income, a home will require regular expenses (as we discussed).

Although there is potential for capital growth (buying at one price now and hopefully selling at a higher price in the future), most sellers only inspect the gross gain. It is easy to say, “I bought at $400,000 and sold for $580,000. I made $180,000 by owning a house!”

Will it account for the time value of money? Will this calculation include the cost of maintenance? Will it factor in the effects of inflation? Many folks fail to factor in these costs, which will reduce the overall return from buying and selling a home. The net gain of buying/selling a home is rarely considered.

A home is valuable because of what it does for the owner, not because it creates an investment opportunity. Hopefully it is comfortable, providing a place can be comfortable and enjoy with family and friends.

Misconception: Buying a home is an investment.

Debunked: Buying a home is a solution to the need for shelter. You may “make” money after several years of owning a home, but you must factor in the cost of ownership and the opportunity cost of using funds to purchase a home instead of investing elsewhere.

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TL;DR

Although buying a home is presented as a solution to all personal finance and wealth building problems, many reasons offered in support of this argument are misleading (at best) or blatantly false.

The decision to buy a home should be based upon your life circumstances and specific needs, not a careful financial analysis.

In this case, it is typically best to optimize for your desired lifestyle rather than your financial situation.

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People buy homes all the time. Share the post on LinkedIn or someone you know who is in the process of buying a home.