Investing is like life: nothing ventured, nothing gained.
If you’re planning to buy a home, you probably have good reasons for your decision. It may be that you share the feeling that owning your own home is a key part of the American dream. But there are also financial issues involved in buying real estate that you need to consider as well.
From one perspective, a home is an investment, maybe the single largest one you’ll ever make. Like certain other investments, real estate has the potential to increase in value over the years, so that you can sell it for more than you paid. It can also lose value, sometimes dramatically. If you need to sell when real estate prices have dropped, you may have to settle for a lower price than you’d like, or even less than you paid to buy the home.
But unlike investing in equities such as stock or mutual funds, which you buy as a way to achieve your financial goals, most people consider owning a home as an end in itself.
There are strong emotional reasons for buying a home — and potentially stronger financial reasons. Owning can help you feel grounded, and part of a community. It can provide a sense of accomplishment and a place to build family traditions. Often, you have more space than you would in a rental unit that costs the same amount of money. And owning can save you money.
That’s because you can deduct interest on existing mortgage debt of $1 million and up to $750,000 of mortgage debt on loans made in 2020 and later. On your primary home and a second home when you file your federal income tax return. You can also deduct up to $10,000 in taxes you pay to state and local governments. Those deductions have the potential to reduce your taxes, especially in the first few years after you buy when the bulk of your mortgage payments goes to pay interest.
On the other hand, you might decide to rent rather than buy a home for practical and financial reasons. If you’re on your own, for example, getting together a down payment and managing the expense of a mortgage, taxes, insurance, and upkeep may put too great a strain on your budget. And having all your assets tied up in your home has serious drawbacks. Among other things, it limits your ability to invest enough to meet the other goals that are important to you.
Another reason to rent is a job that keeps you on the move or requires you to relocate periodically. It’s not always easy to sell when you’ve transferred or change jobs. While your employer may help out with the cost of selling one home and buying another, you can’t count on it. And the most expensive part of buying is the one-time, up-front costs.
If your parents or grandparents are willing and able to help you out with buying a home, each of them can give you a tax-free gift of up to $15,000 in 2020. If you’re married, they can give your spouse an equal amount. It’s a case where a timely gift may make a lot more sense than a future inheritance.
Be careful, though. Gifts over the annual tax-free limit may be taxable for the giver. And loans from family members earn imputed interest if the lender doesn’t charge you any—or enough—interest. This means he or she has to pay income tax on the interest that normally would be paid even though you didn’t pay it. One exception occurs when a parent’s loan enables a child with no investment income to buy a home.
There are usually three distinct phases in buying a home: accumulating the down payment, finding a mortgage, and building your equity by paying off the mortgage loan.
- Generally you need a down payment of at least 10% and sometimes as much as 20% of the purchase price available in cash in order to buy. But you can investigate some federal and state programs, like those run by the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA), which require a smaller amount up front or sometimes no down payment at all. Your attorney or real estate agent should be able to tell you about special programs. You can also do some research online, starting with the website of the US Department of Housing and Urban Development at hud.gov.
- Check your credit report to be sure there’s no negative information that may make it difficult to borrow. Everyone is entitled to one free credit report each year from each of the three major credit reporting agencies. To access your report go to annualcreditreport.com and follow the directions. It may be a good idea to ask for one report at a time, and return to the site four months latter to access a report from a different agency. This way you’ll know if something negative shows up on your credit history during the time you’re looking for a home, and you’ll have time to get it resolved. It may also make sense to purchase your credit score. However, you should check with potential lenders to find out which credit score they use in making home lending decisions, since scores from different providers tend to vary.
- When you have enough for a down payment, you can begin looking for a home and a mortgage. A mortgage is a long-term loan that provides the money you need to buy the home. You pay the loan back, usually in monthly installments over a 10- to 30-year period.
- When you’ve arranged your mortgage and bought your home, you gradually build your equity, or ownership, by paying off the mortgage. In most cases your monthly payment will also include enough to cover the real estate taxes and insurance on the property. In fact, you may run across the acronym PITI to describe your payment, representing principal, interest, taxes, and insurance.
Play around with different payment terms and see how long it would take to pay off your mortgage with this early pay-off calculator.
If you’re planning to buy your first home, you’ll have to decide how to invest the money you expect to use for a down payment.
Timing is a major consideration. The sooner you plan to buy, the fewer risks you may want to take. You probably don’t want to be in a position to have to sell investments if their prices drop suddenly or risk having to postpone your plans. On the other hand, the more price-stable an investment is, the less you’ll earn on it.
One technique is to split up the money you are accumulating, putting part in mutual funds and stocks, and the balance in more conservative interest-bearing investments, such as certificates of deposit (CDs) or US Treasury bills that you can rollover as they mature until the time when you plan to buy.
You could also set goals for equity investments, in either price gain or total return, and sell if an investment reaches that level. That’s a different approach from buy-and-hold investing, but it could help you to build your down payment. For example, if you buy a stock whose price increases 15%, you could sell, reinvest the principal in another stock, and put your profit in a CD or other stable value account.
It is illegal for lenders to consider your age, race, gender, marital status, or religion as factors when evaluating your mortgage application. If you believe you’ve been discriminated against, take action. File a complaint with the U.S. Department of Housing and Urban Development, report the violation to the appropriate government agency provided by the lender, or check with your State Attorney General’s office to see if the creditor violated state laws.
If you’re turned down, ask why. The lender should tell you which credit score and credit report it used to check on your credit history, and you should request a copy of both. They should be free of charge since you’ve been turned down. If there are any obvious errors, follow the instructions on the report to have them corrected and check up on your request. If the negative information is correct, and your credit history has flaws, at least you’ll know the factors that may be blocking your application and can begin to strengthen your credit credentials.
Sometimes you can make out better applying to a bank or credit union where you already have a relationship. You might also work with a mortgage broker who specializes in finding interested lenders. But be very careful. These brokers may make a profit by guiding you to unscrupulous lenders. You might also consider a private arrangement with sellers who would be willing to finance the purchase—although you don’t want to do that without the advice of a real estate lawyer you trust.