Letter to a First Time Home Buyer

For all the 20-something’s out (or older) who are looking at dismay at the current housing market and wondering "How can I afford to get into my first home?"  This article’s for you! 

My sister’s friend Leah recently came up to Seattle (from her home in sunny Los Angeles) to visit and the talk later turned to real estate – how to get in in these expensive markets…

Here’s a peek-behind-the-window: My letter to Leah as she considers buying her first home. 

Hi Leah,

Thanks for your email. I do have tons of books on real estate – unfortunately, most of them are geared toward "creative" real estate investing, which is probably not going to be helpful when you buy your first home.  However, our friend the Library would probably have a number of good books which could give you general advice.

I will share my tips for you to buy a home and figuring out the ‘real cost’ of home ownership, but a few caveats before we get started…

1. Real estate that you live in is probably something you should look at as a "consumption" item rather than an investment… 
   Although your personal residence can help you build equity and contribute to your net worth, that doesn’t really "get" you anything unless you cash out of your home and move to a less expensive area, or tap into your home’s equity to pursue other investment options.  (Many people are not comfortable with the risk this creates and can find it challenging to find investments that offer a rate of return consistently higher than the cost of the financing… however this can be a good strategy for the bold investor.)

   Consider the possibility that buying a home is like buying a car – an "expense" rather than an investment… if you can keep your home price lower, you’ll keep your cost of living lower, which will give you more flexibility if you ever want to change jobs, save more money, etc.

2. Owning real estate is a fairly "illiquid" investment. 

   When you’re ready to sell a home it can take 6 months or more from the time you put it on the market to the time you find a buyer who can close.  This varies in different market places, of course.  Also, up to 10% of the purchase price can be lost to "transaction fees" such as paying a realtor’s commission (6%), closing costs (the seller generally has fewer than the buyer, but there are still some), taxes, getting the home ready to show, having it empty for a few months if you’ve moved, etc. 

   Let’s look at an example.  Say that you buy a home for $360K… you’ll probably have to sell it for about $390K to break even… that means you probably should be very careful about buying something you don’t plan to stay in for at least 5 years.  That will give it time to appreciate up to $390K (hopefully), that assumes it goes up in value at about 2% per year. 

3. Take a look at the real estate market where you live…

   In general I hear that California is soft/going sideways or down right now – this can mean some relatively "good buys" in the marketplace, but if you’re not seeing the break-neck appreciation that the area has experienced in the past, it may be that there’s no rush to enter the market, and a home you purchased wouldn’t necessarily go up in value very quickly. 

   In other words, don’t bank on appreciation making you a fortune in the next couple of years… do some demographics research on sales volume and price appreciation trends in the area where you’re shopping.

4. Finally – Let’s consider the opportunity cost of buying a home versus renting. 

   In California you can rent a place for MUCH MUCH cheaper than you could own the same property.  With a $350K purchase, your monthly PITI payment would probably be in the vicinity of $2,000/month if you put 20% down on your loan.  Let’s say you could rent the same unit for $1,500/month.

   If you invested that $70,000 down payment and $500/month you’re saving by renting, in the stock market (or some similar vehicle) and earned a 10% rate of return… how would that compare to the gain in value in the house over the same period of time  (especially after you factor in your $30,000 disposition costs…)

   In 5 years, that "saved" money would be worth $154,329.

   If you put it into the house, and the house was going up 3% a year in value, the house would be worth about $405,000 in five years.  If we subtract $30,000 for sales costs – that gives you a net equity position in the home of $95,000 and a profit of $25,000.

   Clearly, that number would be higher if the home appreciated faster, and lower if the home was not appreciating.

   I think you’ll see that if the home is appreciating quickly, you’ll do much better with the investment in the home, but if the home is not going up in value, you can do better with the stock investment.  This is all a bit of a "what if" scenario, but I think it’s important to look at.

   Run your own numbers on this cool compound interest calculator.

   A lot of people tell you you’re "throwing your money away" if you rent, but there are actually many, many cases in which it makes more economic sense to rent than to buy…

Sooo… with all those warnings under our belt, let’s assume you want to buy a home.  Here’s a look at the costs you’ll need to plan for when you’re deciding what your budget can absorb.

1. The realtor will charge a 6% commission to the SELLER of listed property, so this fee will not come out of your pocket.  You’ll pay the price you agree to pay for the property… the seller will get that money and use it to pay their mortgage, the realtor, their portion of closing costs, and then keep whatever’s left.

   If you want to buy below market value, consider looking for a "motivated seller" – foreclosure properties, bank owned properties (REO’s) people who have already transferred to a new job out of the area, estate sales, homes that need fix-up work, etc. can all be significant bargains if you’re willing to hunt down the owners and negotiate something that works for both of you… 

   That’s what I do in my real estate investing… it would probably relatively easy to find something at about 80-90% of fair market value right now… still not a huge deal, but perhaps walking into a nice equity position would make it easier to stomach such a large investment.

2. When estimating your monthly costs, the interest rate and balance of your mortgage is only one thing to consider. 

   As Laura mentioned, if you finance more than 80% of the purchase price, the mortgage company will usually break up your loan into multiple mortgages:  A "standard" 80% mortgage, and then a 20%, 15%, 10% or 5% mortgage to pay for the difference (depending on if you put 0% down or 20% down)…  These 2nd mortgages are considered "higher risk" and will generally come with a higher interest rate. 

   You can also get one big loan for 90% of the purchase price – something Ben and I just did with an investment property we bought.

   I wouldn’t "rule out" these "low money down" possibilities – you won’t know for sure what the loans will cost until you talk to a mortgage broker.  We just got an investment loan at 90% of the purchase price for 5.875% interest rate, so good loans are out there if you have good credit.    Bankrate.com can tell you the going interest rates for different types of loans.

   The thing that can "surprise" you though is PMI – Private Mortgage Insurance – because it doesn’t show up in the monthly payment calculations of so many mortgage calculators. 

   PMI is nasty, but necessary these days… If you borrow more than 80% of the purchase price of the home, the mortgagor (the bank) will get an insurance policy to protect itself from your default and they pass on the charge for the insurance policy’s premium to you.

   The amount this PMI policy costs varies, but it could add $100’s to your monthly payment, so be sure to ask the mortgage broker about that…

   Those are your monthly loan costs.

3. In a condo, you’ll also have HOA dues – which the realtor should be able to disclose to you, but could always go up in the future. 

   Condos can raise the dues at any time and also make special assessments.  An assessment is a 1-time bill that often demands a significant amount of money.  For example, if the Home Owner’s Association didn’t save up enough to fix the roofs on the complex, and now they’re leaking, they will get them fixed and bill all the home owners an extra 1-time fee to pay for the cost.

   HOA dues will be higher in buildings that have a lot of amenities like a pool, tennis courts, a clubhouse, etc. so if you don’t plan to use those things, consider whether you want to pay for them. 

   Also beware of HOA’s that have dues that seem to low… the association might be under-budgeting and setting themselves up for an assessment down the road.

4. Property Taxes – These are a matter of public record and the realtor should also be able to get this information for you.  These will probably go up a little bit every year, or a lot every few years, depending on whether tax rates change and if your property tax value is re-assessed by the town or county, thereby increasing the taxable basis for the property.
5. Property Insurance – when you’re in a condo, often the HOA dues will cover the insurance on the exterior of the property… check into that.  In our condo, we pay for "the sheetrock in" and we carry a small ($10/month) policy on our personal contents.  Our little insurance policy would pay for things like interior cabinets, toilets, sinks, etc. in the event they were damaged by fire, theft, accident, etc.  Be sure to find out if you have insurance for earthquakes as sometimes that is covered separately.
6. Utilities – Utility costs are often a "hidden" expense… you may have gas, electric, water, sewer, cable, phone, etc. to pay for in your new residence.  Talk with a few residents in the building you’re interested in to get a feel for what utilities may cost there.  This is often more of an ugly surprise if you’re moving from a small apartment to a big house, and didn’t consider the cost of heating or cooling all your new square footage.

   That’s all I can think of for monthly payments.

As far as closing costs, I’ve had several mortgage brokers tell me to estimate about 4 points (that’s 4% of the loan balance) for my closing costs.  That’s a little on the high side, but you’ll want to shop around for a mortgage broker or bank who’s not going to charge you a lot to get the loan done.  Often, though, you’ll have a trade off between a slightly higher interest rate and fewer points to the mortgage broker or a lower interest rate and more points.  Ask the broker or bank how they get paid!

The 4% you budget for closing costs, in addition to paying the mortgage broker, will also go toward things like inspections, appraisals, title policies, attorney’s fees and so forth… but most of it is for the mortgage broker – so beware!

Also… YES – the realtors and mortgage brokers are salesmen.  Shop with your guard up and don’t take their word for anything they say.  Some people will tell you what they think you want to hear when their commission is on the line.  Be a careful shopper and take your time, don’t be in a hurry to buy anything.  Educate yourself about the marketplace and see how the purchase works into your financial plan.

I love talking about this stuff, so please keep me in the conversation and I’d be happy to chime in on any future questions.   Have a great week!

Emily

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