Buying a house: What you need to know about home ownership
At a glance:
Why invest in a home?
Expenses involved in buying a home purchase
Summary of buying a home
It is part of the American dream — your own slice of the Earth all to yourself.
Home ownership carries a whole host of personal, social, and family advantages. It is deeply ingrained in our psyches and in our communities as an important goal to work toward. You also are making a big investment, and there are many factors you will need to consider.
Why invest in a home?
There are lots of reasons to buy a home: the pride of ownership, the freedom of owning your own lodging, and the comfort of moving out of a cramped apartment, to name but a few. But what makes home ownership a good investment?
Homes typically increase in value
To begin with, homes often increase in value over long time periods, creating perhaps the most common source of capital gains.
The demand for housing has never been greater — especially with the rapid population growth of the last half-century — and that demand has fueled consistent growth in real estate prices. Home prices typically appreciate in times when the local and global economies are doing well.
However, one should be wary that past growth is no guarantee of future growth.
You can build wealth by making house payments
Generally, your wealth increases as you make mortgage payments.
Although the interest belongs to the institution that made the loan, the principal portion of the payment belongs to you, and it may accumulate — like a savings account — over time.
Your accumulated principal plus the appreciated value of the property is commonly referred to as your home equity, or the amount you actually own (as opposed to what you owe the bank, credit union, or mortgage company).
You can get tax deductions for the interest and property tax you pay
But even what you owe on a house has its advantages.
The biggest advantage is the mortgage interest deduction for taxpayers who can itemize deductions. Generally, you can deduct the interest paid on certain loans secured by your home (or second home).
These loans can be the mortgage to purchase the house, or in certain cases a loan or line of credit borrowed against your home equity.
You can deduct interest paid on mortgages up to $750,000 if you are married and file taxes jointly, or $375,000 if you're married and file separately.
The interest deduction for home equity loans — which was previously limited to home equity loans up to $100,000 ($50,000 if you are married and file separately) — was limited even further by the recent tax law, beginning in 2018.
It now applies only to using the loan proceeds to buy, build, or improve the home that secures the loan, as opposed to paying off other debts, buying a car, taking a vacation, paying for education, etc. Grandfathering rules for use of the old limits and rules apply.
You can also deduct the property taxes you pay, if you itemize deductions, subject to the overall $10,000 limit for state and local taxes. And when your family decides to sell the house, the first $500,000 in capital gains ($250,000 for single taxpayers) is generally tax-free. Special ownership and use rules apply, however.
Expenses involved in buying a home purchase
How much does a home cost? Before you get too comfortable with the asking price in the real estate ad, you should be aware of all the expenses you will be expected to pay.
Paying for the home itself
First, there is the price of the home itself.
The seller offers his or her house for sale at the asking price. This price may be negotiable depending upon the condition of the home and other factors. After the negotiations are done, the agreed-upon price becomes the cost of the home.
To secure this cost, the buyer is expected to make a non-refundable payment to the seller. This is called earnest money. This amount will be deducted from the amounts paid when the sale is completed.
There are other fees involved beyond the loan
Most people finance their home purchase through a mortgage loan from a bank, credit union, or other lender.
Many mortgage lenders require a fee that may include the cost of the application as well as appraiser fees, credit reports, and costs to acquire the loan, such as a loan origination fee and "points," a fee as a percentage of the loan amount.
Mortgage loans rarely cover 100% of the purchase price, and a cash down payment is expected at the closing, when the transaction is finalized.
Title and hazard insurance will likely be required
The lender may also require that you have the title to the deed insured, in order to guarantee that someone else cannot claim the property from you after the sale.
Title insurance guarantees that the seller is the real owner and has all rights to transfer ownership. You pay a premium to the title insurance company for this service.
You may be required to insure your new purchase with hazard (i.e., fire, earthquake, flood, etc.) insurance.
You may also be requested to purchase mortgage life insurance (optional) and private mortgage insurance to protect the lender from default due to your insolvency.
Other points to remember
Real estate transfers are complex legal matters in most states.
You may have an attorney to advise and help with negotiations and paperwork leading up to, and including, signing of all agreements. You will also need additional cash at the closing to cover fees for recording the new deed to your home, as well as a deposit for real estate taxes.
Together, all of the costs involved in closing a home purchase can add anywhere from 3% to as much as 10% to the cost of the home, in addition to the actual down payment applied to the purchase.
Mortgages 101: The basics
Presuming you do not have a very large supply of cash on hand, you will have to finance your home with a mortgage. A mortgage loan is essentially a secured loan that uses the home as collateral.
Mortgages are typically paid in monthly installments over several years — usually 15 or 30 (40-year mortgages do exist, but they are not offered by every lender).
Every mortgage consists of principal and interest
Mortgages contain two distinct parts:
Principal. The amount you need to borrow to pay for your home and closing costs.
Interest. What you pay the financial institution for the use of its money.
Your monthly payments will be based on an amortization schedule in which the percentage of each payment that goes to interest gradually decreases as your equity in the property increases.
Fixed or adjustable?
You can also select between a fixed-rate mortgage — locking in your interest rate for the life of the loan — and an adjustable-rate loan, one in which the interest rate may fluctuate from year to year.
There are advantages and disadvantages to each. You need to compare the rates and make a guess of how future rates will move, as well as how long you plan to stay in that same home.
Lower loan rates often require that points be paid up front. A point equals 1% of the loan's principal and represents pre-paid interest.
Balloon payment option
Balloon financing is another way to decrease your monthly payment.
Basically, this type of financing offers a below-market interest rate for a predetermined amount of time, with a balloon payment (the balance of the loan) paid at the end of the term.
You have the option of an interest-only loan
Interest-only loans have become popular in recent years.
They are a variation on balloon financing and resemble how a bond works. With an interest-only loan, the borrower pays only the interest on the loan each month. At the end of the loan term, the borrower repays all the principal.
The advantage of an interest-only loan is that the payments are lower than those of a regular amortized loan. Because no principal is paid each month, buildup in equity is slower, and if the property value declines, the borrower may be faced with insufficient equity to repay the principal.
Interest-only loans may be fixed, but are usually offered as variable-rate loans.
First, you must get pre-approved for a loan
In order to know how much home you can afford, you will want to be pre-approved by your lender. In the pre-approval process, your lender will examine your gross monthly income and your long-term debt, using a set of loan ratios.
For instance, to figure your total loan amount, a lender will calculate 33% of your monthly income and subtract your monthly long-term debt (loans, credit cards, car payments, etc.). That number will be compared to 25% of your gross monthly income. The lower of the two numbers will be considered the maximum monthly mortgage payment you can afford.
The total amount you can borrow will be calculated from that figure.
How to increase the value of your home
Unlike with many other kinds of investments, there are a number of things you can do to increase the investment value of your home.
You can get capital gains when you sell
This increase in value can result in a capital gain to you when you sell your home.
Your capital gain is the amount you sell your home for, minus your cost basis. Your cost basis will be the principal amount you paid for the property, plus the value of any substantial capital improvements (e.g., building a patio, additional bedroom, etc.) you may have invested in, but not including the cost of ordinary repairs and upkeep.
The good news is that most people who incur capital gains upon the sale of their personal residences will not have to pay tax on the gains, due to the current exemption limits.
The old adage that the three most important attributes of real estate are "location, location, and location" is worth remembering when you buy a home.
Some factors that can make the value of your home go up
If you buy or build in an area that is attractive to other homebuyers, chances are that the market value of your home will increase more rapidly. Important location factors can include:
Proximity to cities and other focal points of economic development
Quality schools
Availability of public transportation
Overall prosperity of the community
Buying a home at different points in the housing market cycle also affects how the value of your home appreciates. If you buy at the beginning of a housing boom, your gains may be rapid indeed.
Business and finance magazines often run articles about communities that are becoming popular places to live. Many of them will be in the early stages of a boom, while others will have already been caught in the wave.
Capital improvements add value
Upgrading your house can also increase its market value.
Capital improvements you make will increase the appraised value of your home and help you sell it for a higher price. Capital improvements can include adding additional living space — adding a porch, room or other addition, or finishing a basement or attic — or major refurbishing of existing space, such as remodeling the kitchen or bathroom.
These kinds of improvements can increase your home's value by 15 to 20% or more.
However, not all improvements add value. Some may even make selling your home more difficult, especially if they make your home "the most expensive house on the block" or cater to peculiar tastes.
The value of elbow grease
While repairs do not add value as capital improvements do, they are essential to maintaining the value of your basis in the house.
Leaky roofs, cracked foundations and the like can detract significantly from your home's market value, since buyers will either request that you repair them before the sale is closed, or deduct the estimated cost of repair from their offer.
Buying or building in the right location and keeping your home in good condition will maximize the return on your home investment.
Summary of buying a home
Home ownership has its pitfalls.
You will have that mortgage for a long time — unless you need to move, in which case you may have trouble selling quickly at a good price. Indeed, if you build a new home and move soon after, you could actually lose money.
Finally, you will not be able to count on the landlord anymore to make repairs, mow lawns, and paint siding.
Still, for most people, home ownership is part of the American dream. Not only do you get to live in your own "castle," you own an investment that can grow in value, helping build your wealth and providing a source of capital.
But be sure you understand the full costs of buying a home, and the many factors that can influence its value, before you pick up the real estate ads.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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