To Buy or Not to Buy
July 18, 2013I was reflecting on my “best investment decision” from my post last week and realized that the same caution that led me to not buy a home at the top of the real estate bubble also made me miss buying a home near the bottom of the real estate market last year. I looked at several properties that I liked and they were priced low enough that I could have easily more than covered the monthly costs by renting them out if I had to. However, there were so many good options that I suffered from “analysis paralysis” and ended up not buying any of them.
It’s clear to me now that this was a mistake since San Diego is back in a seller’s market. With a low inventory of properties for sale, many are quickly snapped up by the top all-cash bidder and the rest are largely overpriced in the hope of tempting a desperate buyer getting tired of being outbid. Meanwhile, interest rates and housing prices are steadily rising. If I had bought last year, I would have been able to lock in an interest rate at or near historic lows, buy something at a very reasonable price, and be one year into the two years I would need to live in it before I could sell it without paying any tax on up to $250k of gains.
While some financial mistakes are purely analytical, I would guess that the majority are more emotional. After all, we humans are primarily motivated by emotions, especially whenever money is involved. That’s why we all need to be aware of our personal emotional biases and how they can lead us to poor decisions. In my case, it was a perfectionism that can lead to procrastination and inaction.
I should have known this because it’s the same mistake I used to make as a poker player. (Playing poker is a much cheaper way to learn your emotional weaknesses than playing the stock or real estate markets.) I had a tendency to play too conservatively, waiting for that perfect hand that never came, and then, as my stack slowly dwindled, I was prone to another mistake: trying to make up for it with a big bet on a not-so-great hand. This often marked the end of the game for me.
If you’ve been thinking about buying a home, you may be facing a similar dilemma. You want to buy before interest rates and housing prices are likely to be higher. At the same time, you don’t want to rush into buying a place that doesn’t make financial sense either. Learn from my mistake and buy once you’ve met the following criteria:
1) You have no high interest debt. If you can’t handle credit cards, what makes you think you can handle a mortgage? Paying it off will also improve your credit score and your debt/income ratio, both of which can mean a lower interest rate on your mortgage.
2) You have enough savings. By “enough,” I mean enough to put down 20%, pay closing costs, and still have money left over to furnish your place and cover potential emergencies (at least 3-6 months of necessary expenses, including your new mortgage payment). This is the biggest obstacle for most people. Ideally, you would have enough saved outside your retirement accounts but if not, you can tap into Roth IRA contributions plus up to $10k in Roth earnings or pre-tax IRA money without a penalty for a first-time home purchase. If you’ve had the Roth IRA for at least 5 years, the $10k of earnings are tax-free as well. Your employer’s retirement plan may also allow you take a loan with an extended payment period for a home purchase.
3) You can comfortably fit the new mortgage payment in your budget. The higher expenses are somewhat offset by the fact that the mortgage interest and property taxes reduce your taxable income but only to the extent that they (along with other itemized deductions like charitable contributions) exceed your standard deduction. You might want to get a quote on a monthly payment from a mortgage company (don’t forget to add in HOA fees and other maintenance costs and possibly higher utility bills), compare it to your current housing expenses, and then try setting aside at least the difference every month into savings (see #2) to test if you can really afford it.
4) You’re prepared to keep the home for long enough to make it cheaper than renting. Generally, that’s at least 5 years. Otherwise, the transaction costs can eat up any financial gains from owning the property. Plus, you’ll want to be able to ride out another possible downturn in the real estate market.
You don’t have to actually live in it for that long though. You could always rent it out but try to live in it for at least 2 years so you can qualify for the lower mortgage rate for homeowners vs. investors and have up to $250k (or $500k for a couple) of gain tax-free if you sell it within 3 years of moving out. If this is your plan, just be sure you’re prepared to be a landlord.
5) You find someplace you really like. After all, this isn’t a purely financial decision. You’ll also want a place you’ll actually enjoy living in.
Once you’ve met all those criteria, don’t make my mistake. Go ahead and make your bid. You might not be dealt as good a hand next time.