Thursday, March 29, 2012

Rule of Thumb - Housing

Over my short lifetime I have lived in several places.  We have also purchased several homes.  We have bought a mobile home, a condo, and four houses.  The mobile home we paid in cash, however we made some pretty large mistakes when it came to financing houses.

When it comes to our finances, most of us probably learned from our parents.  If our parents weren't doing something right then the wrong knowledge is passed along.  From my reading and experience I have learned a few critical things when it comes to purchasing a home.

First of all, in almost all cases you would not want to finance a home with a 30 year mortgage.  This mortgage can wreck havoc on your financial future.  First housing rule of thumb...just say no to a 30 year mortgage.

Thanks to the Census we have information about how much people move.  According to the U.S. Census people move on average 11.7 times in their life.  This is a lot of times.  I am above average on the number of times I have moved.

Because many of us move so frequently it can be difficult to find a place to stay for the long term.  The mood has changed in the last few years regarding housing.  It used to be that owning a house was a smart financial decision.  However, with the massive losses in real estate many people are realizing or have realized that your house is not always an asset.  With people unable to sell without taking huge financial losses.

Renting much like owning has pros and cons.  A rule of thumb that I wish I had about 4 years ago for at least one year before deciding to purchase a house when moving to a new area.  When I got my new job as a stockbroker within a month I purchased a new house.  Within 6 months I had taken a new job and needed to move back.  We ended up having to carry that house for 6 months and sold it for a loss of about $15,000.

My second housing rule of thumb is if financing...use a 10 or 15 year fixed mortgage.  If you can get a better interest rate with a 10 year, go for it if you can afford the payments.  If you cannot get a better rate with a 10 year, then choose a 15 year mortgage.  Why not 30 year?  Well, I know quite a few late 50s or 60 year old people who have not paid off their house.  It will difficult to have a good retirement without your primary house paid for.

The third housing rule of thumb is to not pay more than 2 times your gross salary for a house.  This means if you make $50,000 per year then you shouldn't purchase a house more than $100,000.

The fourth housing rule of thumb is to put down 20%.  Over leveraging is a bad thing.  In business, banks typically will not loan money to a business that doesn't have sufficient capital.  Typically 5% or 10% will not cut it.  Not having enough capital to put down on a property can leave you in financial ruin.

My last housing rule of thumb is a bit tricky.  In my opinion when purchasing a house you should have an exit plan.  Selling a house may not always be the best option.  In fact, many people have realized that they cannot sell, and have decided to rent their house.  People in the last several years had paid too much for housing.  The last housing rule of thumb is the purchase price of the house should be able to bring in 1% in monthly rent.  $100,000 x 1% = $1,000.  If the house you are thinking of purchasing can yield 1% in rent then chances are you are in good shape.  Obviously if you can rent it for more than 1% the better.

Why the 1% rule?  If you purchased the $100,000 house and put 20% down and got a 15 year mortgage your monthly payment for mortgage only would be $581.78 @ 3.75%.  Add property taxes of $180 and insurance of $50 per month.  This totals to $811.78.  You can make money renting out your house using this formula.  Your principle payment would be starting off at $332 and would increase each month.  This means your financial gain barring no maintenance is $520.22 per month or $6242.64 per year.  This doesn't include the added tax benefits.  Doing a simple Return on Investment calculation by dividing $6242.64/20,000 = 31.2%.  However, to be a true accounting ROI you must subtract out depreciation.  The 31.2% is misleading.

When purchasing real estate you have building an land.  The IRS rules for depreciation states that you cannot depreciate land.  Using 20% for land and 80% building gives you $80,000 to depreciate.  IRS rules says that for residential properties you use 27.5 years.  Simply take 80,000/27.5 = $2,909.  You will need to subtract out the $2,909 from the $6242.62 giving you $3333.62.  Divide this amount by your investment $3,333.62/20,000 = 16.67%.

If you think you can get this kind of return in your first year of renting your house think again.  First year rental start ups can be large, and typically result in a loss (at least for tax purposes).  Plus this is not cash flow.  Cash flow is critical to your financial well-being.  Remember, it is your life blood.  Over half of the money was principle being paid off.  If you use strictly cash flow and subtract out depreciation your return will be -734.36/20,000 = -3.67%.

With real estate like many investments you look at the long term.  Will rents be higher in 10 years then they are today?  More than likely the answer is yes.  Will your principle be paid off in 15 years?  Yes, unless you refinance.

One final not pay too much for closing costs.  There are many places that can save you money on closing costs.  Shop is worth it!  Take your time when you are shopping for a house.  This is a major financial decision and the ramifications can be huge.


  1. The bigger the better is my motto!

    1. Would you mind expanding your comment as to what you mean by bigger is better?


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