Buying a Home
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Buying Real Estate
Most of us don’t think of ourselves as high stakes investors, yet every day, thousands of American households invest a significant percentage of their net worth into a single hard asset. What’s more, the asset offers no diversification, is costly to maintain, bears steep transaction costs and is ‘illiquid”, meaning that it can be nearly impossible to get your money out in a hurry.
On average, four out of five dollars paid to purchase this asset are usually borrowed money. Paying off the debt typically takes thirty years and at least in the early years, it will eat up close to a third of the family’s income.
Sound risky? It is … but millions of US households who are currently homeowners don’t think of it that way at all. Quite the contrary, they think it’s the essence of stability, the cornerstone of the American dream. But buying a home is a significant financial decision. That’s true whether you are a first-time buyer, an experienced homeowner looking to move up to a larger home, or a retiree looking for a smaller, more manageable home.
Home Buying From a Financial Standpoint
Fortunately, buying residential real estate has been a winning bet over time. Aside from giving pride of ownership, and a place where families can prosper these properties have sheltered hard-earned dollars from the tax collector, putting more money in the homeowners pocket at the end of the year, hedged against inflation, and helped to build wealth and security for retirement years.
From a financial planning standpoint, few things can rival home ownership as a good savings discipline. Even if home prices were never to rise, paying down the mortgage creates a nest egg of home equity that can be tapped in the future for income in retirement, or it can provide a handsome legacy for heirs.
Home Price Growth
Far from standing still, home prices have typically marched steadily higher through the years. During the past 150 years, owning one’s own piece of real estate produced a “real”, or after-inflation return of about 2.5% a year. Of course, during some periods, property investments have returned much more than that. For instance, in the heat of 1980’s real estate boom, home prices in the New York market were doubling every three years. In the early 2000’s we’ve seen 20 to 25% annual appreciation in some markets. Even during the collapse of the commercial real estate market starting in the late 1980’s, average US house prices continued to advance about in line with inflation.
What’s the Potential Profit to Owning a Home?
The potential profit in owning a home is greatly enhanced through the use of mortgage debt. Thanks to this leverage, homeowners in good times stand to pocket returns that are many times higher than the going market rate. It works like this: When buying a property, the average US homeowner pays 20% of the purchase price as an initial down payment. There are programs available where you can pay as little as 3.5% of the purchase price as your down payment. So, on a $400,000 home, the amount of one’s own money at risk is $80,000, or as little as $14,000 with 3.5% down, with the bank’s money making up the rest.
Now consider that the home’s value increases 20% over five years so that the home is worth $480,000 at the end of the period. At that point, assuming for a moment that there are no transaction costs and paid down principal on the mortgage, the owner can sell the house, pay off the mortgage, get back their initial $80,000 down payment and still pocket another $80,000. Viola! Through the magic of leverage, the homeowner has changed a 20% price gain into a 100% profit. In the case of 3.5% down, it would be 57% profit!
Of course, this leverage can quickly become negative when prices go the other way. For instance, if a home’s price falls 20% over five years, the owner’s initial stake can be wiped out. If prices fell more than that, the owner could owe more than the house was worth. Consequently, if the homeowner found themselves in a position where they were forced to sell their home during such a decline, they would suffer significant financial loss.
However, for those owners who already have built some sizable equity in their home, and are not in a rush to sell, the loss is less worrisome, as it becomes a loss only if they decide to sell during that market downturn. As an example, the California real estate downturn of the late 1980’s provided owners who rode out the market decline with handsome rewards of appreciation that has since occurred.
Homeowner’s Tax Savings
Uncle Sam adds some icing on the cake. Since the government subsidizes the cost of a mortgage by making the interest paid tax deductible, these are some of the best deals on the market. In effect, you pay off your mortgage in pretax dollars. The tax savings means that a 30-year mortgage rate of around 5% amounts to an after-tax borrowing cost of around 3.8% for someone in the 22 to 24% bracket.
To make the deal sweeter, since 1997, when you sell your primary residence, a seller can take up to $250,000 in profit if they are single, or double that if married, and not pay any capital gains taxes on your profit. Think about that…in the 22 to 24% tax bracket, a home seller effectively pockets his or her money tax-free without paying Uncle Sam a nickel! Many sellers are surprised by this break, and what’s better, there are no limits to the number of times you can use the home-sale exemption. As long as the home is your principal residence, meaning you live in it, and you’ve lived there at least two of the last five years before the sale, you would be eligible for the exemption. But of course we are talking about taxes, so there are some rules to this game. Make sure you know them before placing the for sale sign in your yard!
1% Credit Back
And best yet, when you are represented by one of Carriage House Real Estate’s licensed professionals, you will receive a 1% (of the purchase price) credit back at the close of escrow. On that same $400,000 home, that amounts to $4,000 back to you merely choosing the right real estate brokerage to represent you!
To Buy or Not to Buy a Home?
In making the ultimate decision “to buy or not to buy”, smart investors will take the trouble to do their research. For starters, it pays to do the math in order to analyze which is the wisest strategy for you: buying or renting.
Finally, once you’ve made the commitment to purchase a home and have succeeded in building up equity, you have many options available in order to tap into that equity nest egg for income or investment. Careful tax and estate planning with accredited professionals will help ensure that you and your family make the most of your housing dreams.