8 Home Buying Mistakes to Avoid
May 20, 2013Exactly one year ago, our family completed a crosstown move in Charleston, South Carolina to get closer to family, my wife’s business, and our children’s schools, and thankfully, within a short little drive to Folly Beach. Any planned major purchase can add significant joy (and stress) as well as some expected and unexpected financial challenges and this was one was no different. Our new home was purchased through a short sale and although it was left structurally sound when we moved in there, there was a long to-do list related to cosmetic repairs, appliances in need of replacement, and an exterior in need of pretty significant landscaping and TLC.
Well, it’s always amazing how quickly a year can pass by. (I say this all of the time and mean it more and more as the kids keep growing like the weeds in our backyard.) Anniversaries provide a good chance to reflect on past decisions and I’ve been thinking about our home purchase recently, primarily because over the past couple of weeks, I’ve fielded many questions from stressed out homeowners facing foreclosure and optimistic potential buyers wondering if now is a good time for them to enter or re-enter the housing market. Here is a list of home-buying mistakes that I’ve encountered in my experiences as a financial planner (and some mistakes I’ve made personally):
1. Relying on a lender’s formula to determine how much house you can afford. One of the worst ways to approach the mortgage pre-qualification process is to focus on the maximum monthly payment you can afford. The general rule when home shopping is to keep your debt-to-income ratio no higher than 36% (some lenders allow debt-to-income ratios as high as 40%). But this doesn’t mean you should necessarily use a 36% debt-to-income ratio as your goal. Focus on your other financial life goals (i.e., saving for retirement, paying off student loans) and stick with what works for you rather than some financial institution’s risk parameters.
2. Depleting retirement plans and IRAs in order to make a down payment. The IRS permits penalty-free withdrawals from an IRA up to $10,000 if you haven’t owned a home during the past 2 years. These withdrawals are still subject to federal and state income taxes (unless it’s a Roth IRA that you’ve had for 5 years) and the biggest downside is that your retirement nest egg just got a setback. Another potential area or vulnerability is related to 401(k) loans. Many of these retirement plans have loan provisions that allow you to access 50% of the account balance up to $50,000. Sounds great, but when you factor in the opportunity cost of that money no longer staying invested and harsh taxes and penalties on the unpaid balance 60 days after you leave your employer, 401(k) loans are risky and should be viewed as a last resort.
3. Not taking into consideration the importance of having a little flexibility. Depending on your career path and other life goals, the decision on where to create your nest can have a huge impact on future decisions. Buying tends to outperform renting in the long run, but if you need flexibility then renting may not be so bad after all. Most financial planners advise staying in a home at least 5-7 years to offset borrowing and brokerage costs as well as the risks of having to sell the home in a down market. But if you have an unstable work situation or simply don’t plan on staying at a residence too long, then renting will give you more short-term options and flexibility.
4. Neglecting to create a revised spending plan prior to moving. It’s one thing to put a budget in writing. However, living and experiencing the reality of a spending plan is what matters the most. If you plan on taking on a new mortgage payment (or any loan for that matter), it helps to get used to that payment before your first statement arrives in the mailbox. Create a personal spending plan that factors in your future mortgage payments. For example, if your rent is $1,000 per month and you are expecting to make payments on a $1,500 mortgage in the near future, you should go ahead and automatically shift the difference into savings each month to prepare yourself financially and psychologically for the coming change. This is the good old fashioned concept of “paying yourself first.”
5. Emptying the emergency savings fund to pay for the house. This happens all of the time. The excitement of finding that home and the sense of urgency to take advantage of low interest rates, rising optimism, and some of the great deals out there can lead to impulsive decisions. Many employees that I’ve been talking to lately with significant debt problems lack an emergency fund. Without a rainy day fund, homeowners are more vulnerable when things simply don’t happen according to plan. It’s best to avoid the temptation to raid an emergency fund to make a down payment on a home. That’s why I always recommend keeping the savings for a down payment and the emergency fund in separate accounts. How much should be kept for emergencies? Anywhere from 3-12 months of basic living expenses is the general rule these days.
6. Not paying attention to the total costs of home ownership. Owning a home involves more than just “PITI” (principal, interest, taxes, and insurance). In many areas, there are HOA dues, regime fees, lawn care, repairs and maintenance. All of this is after you have just paid 3-5% of the total loan amount in closing costs. (Oh, the joys of homeownership!) I’ve seen far too many people fail to include the unexpected and non-routine costs of owning their own castle into the household budget.
7. Overestimating the tax benefits of owning a home. For many, the mortgage interest deduction is an influential part of the home buying decision. Not only do you get to own an asset that is appreciating (hopefully) and be king or queen of your own domain (I’m looking at you nosy landlords) but the IRS will actually give you a tax deduction. But in some cases, it’s very easy to overestimate the benefits of the mortgage interest deduction. Take for instance the standard deduction of $12,200 for married couples in 2013. The average mortgage interest rate in the U.S. is currently 3.51% with the average loan balance just under $150,000. This average loan balance on a 30 year fixed mortgage at that same 3.51% interest rate would result in a $3,056.70 mortgage interest deduction- well below the standard deduction amount. Yes, you still get to add in other potential deductions such as property taxes, state income taxes, and charitable donations (to name just a few) but there is still a good chance the standard deduction may still be best for many homeowners. The bottom line is to be careful not to overestimate the mortgage interest deduction and never let the tax tail wag the dog.
8. Allowing emotions to rule the decision. This is the final but most crucial mistake to avoid. When emotions and money mix, this volatile affair can be costly. But it is human nature that they will be present during this important financial decision. So keep them in check with a financial plan and get those personal finances in place before you ramp up the search. Otherwise, you may later deal with negative emotions such as regret.
Financial planners and counselors have heard far too many horror stories surrounding bankruptcies and foreclosures over the past few years. Unfortunately, these challenges still exist for many Americans. The benefits of home ownership still can far outweigh the downside risks and potential negative outcomes though. For potential home buyers ready to get back in the game, interest rates are near historic lows and now may be a good time to buy – as long as you avoid these common mistakes and make an informed purchase that fits your plan. Personally, I have no regrets about our recent move. I just wish that I’d done some better planning when it came to the amount of time needed to get our backyard jungle under control so the kids (a.k.a. the “monsters”) can have a fun place to roam.