Many people go through a checklist that tells them how much house they can afford and then run out and buy without giving it any more thought. This might be very wise, but it could also be a huge mistake.
There is no question that the housing market is experiencing new signs of life. Housing starts, building permits and builder confidence is growing albeit slowly. According to MKM Partners, new-home starts were up 15% vs. a year ago and new-home sales are up 20%. But does this mean you should plunge back into the real estate market now?
Maybe. But if you do, be very cautious. From a macro standpoint, the recovery in property has been far weaker than usual. That should instill suspicion in investors. The situation is still very tenuous. So while there are great opportunities to be had, you still have to tread very carefully. This is true if you are buying your residence, a rental or just want to flip a house for profit.
Here’s how to know if it’s the right to buy real estate in your community.
1. Where Do You Plan on Buying?
Prices are much lower across the board now than they were 7 years ago, but you still have to evaluate your local market. According to the California Association of Realtors, the first-time buyer’s housing affordability is 81% across the United States. But there are wide variances in this number depending on where you live. For example, in the Inland Empire of Southern California, 83% of first time buyers can afford to buy a home. But in San Francisco only 58% can.
Do a search for “housing affordability index” in your community to get a sense of what is going on in your market.
2. Can You Afford It?
It’s nice to know the statistics for your community, but it’s more important to know if you can afford to buy a house or not. Even if it is a great time to buy real estate in general, it’s a terrible time to do so if you can’t afford it.
Part of the cost of ownership is your mortgage, taxes and insurance, of course. But the cost of owning a home goes far beyond that. Don’t forget about maintenance, utilities and depreciation.
And there are other costs you shouldn’t overlook. You’ll probably upgrade your furniture and appliances when you buy a home, which is expensive. And you also have to consider the cost to maintain or replace parts of your house that wear out over time like the roof, furnace and plumbing. On top of that, you have to calculate the opportunity cost of what you could earn on the money you used for the down payment. It was probably hard to save money for your home purchase. You could have used those funds for your retirement or for other purposes. That’s why you have to consider the earnings you forgo as a cost of home ownership.
I’ve been a homeowner for more than 20 years. On average, I spend the equivalent of 2 months’ mortgage every year on unexpected repairs and I set up an emergency fund to do so. If you can’t afford such unexpected costs, reconsider buying real estate.
3. Should You Rent Instead?
Many people make the argument that it’s always smarter to rent than to buy real estate. Certainly over the last 7 years, this would have been a good strategy. But accepting this mantra as always true is a huge error. Most of the richest people you know made their money by owning property.
And this might be one of the best opportunities in your life to own real estate because of the deflated values and low interest rates.
But this “rent vs. buy” is a valid question, and to answer it you must be region-specific. According to the Department of Numbers website, some metro areas are a screaming buy as compared to renting — and others are not. In Atlanta, Ga., for example you’ll pay 163% more in rent than if you buy the same home. But in Honolulu, Hawaii, you can rent a home for half as much as it will cost you if you buy it. Tally up all the costs of home ownership and compare it to the cost of renting after you consult the website above. This is important information.
But your analysis shouldn’t only consider current costs. You also have to figure in the tax benefits of owning property and the possibility for appreciation if you want to compare owning vs. renting.
4. Is Appreciation Really Possible?
Of course right now it’s tough to imagine real estate prices actually rising, but they will at some point. Seven years ago, nobody imagined that real estate prices could possibly drop — and they did. The longer you own property, the better your chances are for appreciation.
Certainly it would be silly to count on prices rising over the next few years. But if you plan on holding on to your home for more than 10 years, it would be a huge mistake to completely dismiss the possibility for significant price improvement.
And remember to compare your risks. Assume the average cost of ownership (mortgage, interest and taxes, maintenance and repairs) is $2500 a month after tax. Also assume you can rent the same house for the same cost. In that case you should buy if you are going to stay in the house for 10 years or more.
Why? Because the odds are good that prices will rise over 10 years (although there is certainly no guarantee). Also, when you rent, you have little control over your future. What’s to keep your landlord from increasing your rent? Nothing.
In short, if you are in a situation like that, you take greater risks if you rent than if you buy.
Image: morticide, via Flickr