The statistics above state why I am such a fanatic about following specific rules when you purchase your home. I know that one of the four d’s (death, divorce, disease, disaster) could cripple you down the road. While many renters feel their entire rent is going down the drain, in reality only a small portion of the rent money is paying down the house. When I purchased my first home, I estimated only saving $70 a month based on tracking expenses, even after factoring in the equity being built (this is plenty when you are actually ready to buy, because you will be getting rich slowly). In addition, renters have the flexibility to move in case they lose their job and they can find a cheaper place to live if necessary. So here are my rules of thumb for buying your home:
- Only purchase after your car loans, student loans and credit card debt are paid off.
- Don’t purchase over 3 times your annual household income.
- Put 20% down on your home.
- Don’t pay over 200 times the monthly rent in the area.
- Put 25% down.
- Don’t pay over 100 times the monthly rent in the area.
During March 2012, the California median home price for single-family detached homes was $291,080 and average interest rates for thirty year fixed mortgages were 3.95 percent (reference). So typically, people are paying $1381.28 for 360 months. That is $497,261 it total payments and $206,181 in interest over 30 years.
Interest rates these days are very low but historically, they have not always been this low. Holding a 9% interest rate would mean paying 190% in interest which means almost paying 3 times what the home is worth over 30 years!
California counties collect an average of 0.74% of a property's estimated fair market value as property tax (reference). The average home insurance rate was $803 (reference). Average maintenance costs for home owners are about $672 for the year (reference). In addition, home owners tend to tack on projects around their home, which I will assume cost about the same as maintenance. Based on these numbers, one can expect to spend 1.5% of their home price yearly to cover property taxes, insurance and maintenance.
Suppose you see a home that rents for $1455 a month and you are interested in purchasing this home for personal use. Then, I would advise not paying over $291,080 for this home, using the 200 factor from the 100-200 rule. The reason is that every month, you should expect to pay $1381.28 to your mortgage company and $363.85 for additional expenses. This is a total of $1745.13 a month. Many people make the mistake of thinking that since the mortgage is lower than the rent, they have a good deal. Making a mistake here and losing this home would cost you about 11% of your home price (loan closing costs, legal fees, buyer and seller commissions) which would be about $32,019 for an average home in California.
Following my 100-200 rule gives you staying power. It allows you to hold the home long enough to have something great happen, like appreciation. Banking on appreciation because you know house prices will go up is gambling. Doing the numbers ahead of time and make sure you can afford the home is good business. Later, people will say that you are lucky, when you know different. You have planned ahead of time, just in case you hit some hard times. Doing this, I have no doubt you will get lucky and when you move into a bigger home, you will have rental property which still fits the numbers. This means rather than selling and losing that 11%, you now have an investment property, adding an asset to your collection.
As a landlord, one should factor in repair costs, appliance costs and additional costs (changing tenants, new carpet, painting). A renter should also assume 2 months of vacancy per year. If property management is involved, one might also include a $300 lease fee and 10% of the monthly rent going toward property management. In addition, unlike owning the home, an investment property should make a return like 2.5% of the property’s value (this is 10% of the 25% down). Using the 100 factor from the 100-200 rule, the same home which rented for $1455 a month, should not be purchased for more than $145,500 as an investment if you expect to make a good profit. Many investors just hope to make some profit. However, it is a good idea to compare to expected returns with the returns expected from other investments.
In terms of taxes, rental income may be considered active income if this is your job. Otherwise, it is passive income. This is important to calculate your depreciation deduction. In general, active income can offset active income and passive income can offset passive income. If you make major decisions, you might say that you actively manage your properties, but the income is still considered passive. This is a whole blog topic in itself, so I won’t cover it. In either case, both depreciation and appreciation should be considered icing on the cake and should not be factored into the equation, because one might not ever see these benefits if they can’t own the home long enough to see them.
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