LESSON 2.
WHEN IT MAKES SENSE TO RENT
It used to be, not all that long ago, that renting was something you settled for if you couldn’t afford to buy a home. Renting was a way station en route to buying, a rite of passage. My, how times have changed.
These days, in my opinion, renting can be the end in itself, a far better move, depending on your personal circumstances.
To those of you currently renting who are wondering if now is a smart time to buy because you can get a good deal on a house, I want you to first make sure you can answer yes to every item in my checklist:
My 5-to-7-year rule is to help you avoid the likelihood that you would someday sell your home and have less in your pocket than what you paid. What you must realize is that when you go to sell you will need to spend about 8% to 10% on settling all your selling costs. The way the real estate system works, the seller pays all of the agents’ fees; typically that is 6%. On top of that you may have to pay a transfer tax to your state or county that might be 1% or more of the sale price. If you live in a condominium, cooperative, or other development that has a homeowners’ association, you could even encounter a fee when you sell; this practice has become more common as a way to discourage investors who buy with the intention of flipping a property. Then there is the cost of moving. Add it all up and you can see why I say you need to plan on giving up 8% to 10% of your sales price to make the move. Given that we may still have a few years ahead of us before the market stabilizes, I think buying today with anything less than a 5-year to 7-year time horizon is risky. Over a shorter period we can’t confidently assume you will get anywhere near enough price appreciation to cover the 8% to 10% cost of selling.
Your job outlook is another important factor as well. If you have any reason to expect you might need or want to relocate within the next five to seven years, then renting can in fact be the far better option for now.
I also think renting is smart if you have yet to save up a 20% down payment. I am well aware that loans insured by the Federal Housing Administration (FHA) come with very low down payments. But as I explain later in this chapter, your housing dream will be more sustainable if you can make a 20% down payment.
Another important consideration is whether you really, truly, deep down yearn to be a homeowner. Don’t listen to anyone else. Do not feel like it is something you should do. Your new dreams must be as firmly rooted in emotional truths as in financial truths. If you are scared of buying, then embrace the truth that you are meant to rent. If you don’t really care that you can’t renovate the kitchen or that you might have to move in a few years if the landlord raises your rent too high, then renting is right for you. Respect your feelings; they have as much sway here as your finances.
THE MATH OF RENT VS. BUY
There are of course many factors that come into play when deciding whether it makes financial sense to buy or rent. At the top of the list is what it would cost you to rent a comparable home that you are considering buying. Then you need to factor in the purchase costs (closing costs on your mortgage can equal 5% or more of your purchase price) and the eventual cost of selling as well. While you are an owner you will have the benefit of some tax breaks, as well as full responsibility for maintenance and property tax.
At the same time, I want to make sure that renting is not overplayed as the “best” solution. As with all financial decisions there are trade-offs. And with renting you must prepare—and budget—for the possibility that the landlord will raise your rent, or decide to sell the home, and the new owner imposes a big rate hike at the next renewal. And you must put a personal price on how important or unimportant it may be to you to know you can stay put and renovate the home to your choosing.
The Best Buy vs. Rent Calculator:
The New York Times
has a free online calculator that allows you to build a very customized calculation based on your personal circumstances. The calculator will show you an expected break-even date where the cost of buying (and eventually selling) makes more sense than renting. No calculator can perfectly capture every nuance of each individual situation, but this calculator does an excellent job of making sure key costs are accounted for. Give it a spin and see how long you would have to stay put before the cost of buying would be worth-while. Go to
www.nytimes.com/interactive/business/buy-rent-calculator.html
.
Tips for Using the Calculator
ADVICE FOR OWNERS WHO NOW WANT TO RENT
I know that many of you who own a home are questioning whether it makes sense to sell and go back to renting. In the “What to Do if You Are Underwater” lesson later in the chapter I share strategies for homeowners who now have a mortgage that exceeds the current value of their home. But I also want to address those of you who have equity in your home but are now wondering if it makes more sense to sell and rent. Again, I am going to come back to the fact that you must shape and follow your own personal dream. If you are considering a move because of a life change—the kids moving out, you’re ready to retire and downsize, or you recently ended a relationship—then by all means it makes sense to run the numbers and see if renting is right for you. But do not gloss over the potential drawbacks of renting as well. Think through the trade-offs and make an informed choice.
If your issue is that you just feel overwhelmed by the cost of the mortgage and maintenance and you know you can indeed save more by renting, then you are absolutely to stand in that truth. There is nothing wrong with changing your mind; if your new dream is to rent rather than own, then that is the right dream for you. Just promise me you will factor in the 8% to 10% cost of moving. That is not a reason to stay put, but if it adds up to more than you can cover from the gain on the sale, I want you to plan for how you will cover the costs. You may need to head back to
chapter 2
to find ways to boost your savings for the next six months or year so you can cover the cost of the move.
LESSON 3.
THE NEW RULES OF BUYING A HOME
For renters who are eager to buy now that prices have come down, and for owners who are looking to make a move, I have rules I want you to follow so your new housing dream will give you security, not stress.
SET A BUDGET THAT SATISFIES YOUR NEEDS
Remember the credo of
chapter 2
?
Live below your means but within your needs
. Now is the time to embrace that phrase and make it a governing principle of your life. I do not want you listening to a mortgage lender who tells you what you will be allowed to borrow, nor do I want you to follow the advice of a real estate agent who insists the bigger, more expensive house is a better value. Listen only to yourself. This is your dream, and so it must be rooted in what makes sense for you. I want you to seriously think through how much space you need. The size of new homes has increased about 35% over the past three decades, yet household size has declined. I want you to be comfortable, I want you to enjoy your house. But a smaller home that fits your needs means a more manageable mortgage, a lower property tax bill, lower utility costs, and likely less time and effort to maintain. And lower housing costs leave more income for your other important dreams, including funding your retirement or saving for a child’s college education.
KNOW YOUR INCOME LIMITS
Lenders are now back to calculating how big a loan they will offer you based on your income, a practice all but abandoned during the housing bubble. The two standard calculations are:
There is leeway in those numbers; if you have other assets or make a big down payment you may be able to run past those limits. And in high-cost areas, the 36% debt-income ratio often is stretched past 40%.
My recommendation is that you never exceed the 25/36 rule. If you think that’s impossible, then I ask you to return to another tenet from an earlier lesson:
Sometimes when we feel stuck we must change our perspective
. If 25/36 seems out of your reach then you have two choices: Hold off purchasing until your finances make 25/36 doable, or shop for a less expensive home. The quickest way to buy an affordable home that meets the 25/36 test is to lower the price tag. That is the essence of living below your means but within your needs.
First-time homebuyer alert:
Please do not think that you can afford a monthly mortgage that is equal to your current rent. There are many additional costs that come with homeownership that can add 30% or more to your monthly base mortgage rate. In The Classroom at my website you will find information on how to figure out the true cost of homeownership and how to test whether you can honestly afford to buy. Go to
www.suzeorman.com
.
AIM TO MAKE A 20% DOWN PAYMENT
Are you thinking that sounds crazy given that we all know you can get an FHA-insured loan with a 3.5% down payment? So why, you are wondering, should your dream of homeownership be delayed by that 20% obstacle? I know all about the FHA program. I am well aware of what you can get these days. My job is to teach you what I think is best for your long-term security. In my opinion, if you cannot afford a 20% down payment, you cannot honestly afford to buy a home. During the 2000–2006 stretch, if sizable down payments had been required we would not have had such an inflated bubble and its painful deflation. Down payments below 20% also mean you must purchase mortgage insurance; whether through the FHA-insured program or private mortgage insurance, this adds to your housing costs.
A SPECIAL NOTE ABOUT FHA-INSURED LOANS
Before the financial crisis, mortgages insured by the FHA accounted for about 5% of the new loans doled out in any given year. In 2010 the FHA insurance program accounted for about 30% of loans for home purchases. How come? Well, lenders are making it tougher to qualify for a conventional mortgage and are all too happy to steer clients into FHA-insured loans given the fact that the federal government is in fact
insuring
that it will pay off the loan if the borrower runs into trouble.
I have to say that I am not a huge fan of FHA-insured loans. The fact is, they perpetuate many of the problems that got us into this housing mess. For starters, until 2010, the FHA didn’t require a minimum FICO credit score to be eligible for a mortgage. And it wasn’t until last year that it set a FICO credit score floor. But that floor is a score of 500! If you can make a down payment of at least 10% and your FICO credit score is between 500 and 580, that’s good enough for the FHA. And if you have a score above 580 you are eligible for an FHA-insured mortgage that requires just a 3.5% down payment. That said, many lenders that offer FHA-insured mortgages are applying their own FICO score rules, and require a FICO score of at least 620–640. But any FICO credit score below 700 is in fact a sign that you have some financial issues to address. Yet 40% of FHA-insured loans in 2010 were given to borrowers with FICO scores below 680. Consider that for a regular conventional mortgage, most lenders these days won’t give you the time of day if you have a FICO credit score that low.
At the same time, a 3.5% down payment just strikes me as dangerously low. When you put down 10% or 20% the simple truth is that you will think longer and harder about what you are doing. Putting so much of your own money on the line forces you to stand more solidly in your truth. And that large down payment gives you downside protection if, God forbid, anything were to happen and you needed to sell the home at potentially less than your current mortgage balance. Let’s say you made a 20% down payment and values are 5% lower when you go to sell. Well, you still walk away with 15% equity; that’s more than enough to cover your closing costs and the agent’s fee. But if you put down just 3.5% to 5%, you will find yourself owing the bank money to move, or face the foreclosure or short-sale process. As I explain below, that’s not a scenario you want to find yourself in.
I also want potential borrowers to understand the cost of an FHA-insured loan. At the time of the loan you will owe an up-front insurance fee equal to 1% of the loan amount, and then there is an ongoing annual insurance premium equal to 0.90% of your loan amount. You owe that ongoing fee until your equity in the home reaches 22%. As we discussed earlier, that could be many years, given that appreciation rates over the long term will likely be modest.
So am I against FHA-insured loans? It depends. If you are considering an FHA-insured loan because your FICO credit score is low due to your own self-induced overspending or poor payment habits, then I absolutely will not condone buying a home with an FHA-insured mortgage. Just because you can do something does not mean you should. And please don’t hide behind the notion that because the federal government says it is okay, it is. Look, the federal government has its own agenda: By expanding the FHA-insured loan program, it is trying to keep the battered housing market from bigger losses. But your agenda is to stand in your truth and make financially sound decisions. If you can’t get a conventional mortgage because of your own poor choices, then the only honest action to take is to wait until you repair your credit score, or save up enough for a bigger down payment so you can in fact qualify for a regular loan.