Photo courtesy of Oracio Alvarado

Over the last couple months two long-held truths of the financial world have been turned on their heads.  One, money market mutual funds can’t lose money, and two, the value of real estate always goes up.  Unfortunately, many have discovered neither of these “truths” have ever been 100% true, just assumed.  And you know what assuming does.

Has the American Dream Been Oversold?

For years the “American Dream” has been to own your own home.  The notion itself is a little absurd.  After all, you never really own your home outright.  Don’t believe me?  Try not paying your mortgage for a couple months.  But you own your home free and clear you say?  Well, try skipping out on property taxes this year.  No, we never really own our homes completely free of any obligation.  However, to a lot of people “owning” a home represents the pinnacle American financial experience.

Realtors and Brokers and Politicians, Oh My!

So who has been perpetuating this idea that owning your own home would somehow complete you, financially?  Realtors have certainly played their part.  Let me make clear first, I am a fan of realtors.  I think there are some truly great real estate agents out there who have their buyer’s (or seller’s) interest at heart.  But I think there is an even larger number out there who signed up clients for mortgages they knew they couldn’t afford, and did so by conspiring with banks and mortgage brokers to work “creative financing” for their clients.  In other words, since the buyers couldn’t qualify using standard mortgage practices they had to “get creative,” which led to a variety of bad loan options such as adjustable rates and  interest-only loans.

So realtors and banks played their part, but the government isn’t off the hook.  For the last two decades administrations have pointed to increases in home ownership as evidence of a strong economy, and a happy citizenry.  The Clinton administration called for increased loan options for lower-income families, particularly those who did not have funds available for down payments.  Bush furthered the problem by calling for an “ownership society” early in his first term.  It seems both administrations were caught up in the idea that home ownership was a proper measure for our fiscal health.

We’ve now discovered many homeowners would have been better off continuing to be renters.  Despite what others tell you (particularly those associated with the real estate industry), renting is not the equivalent of “throwing money away.”  Renting a house is a viable option for providing safe shelter for you and your family.  There should be no shame associated with it, and in fact, in many cases it is much smarter to continue renting than opting to buy real estate.  After all, a house is just sticks and bricks, but a home is where you make it.  And it doesn’t matter who holds the mortgage on that “home,” you or a landlord.

Often times mortgage brokers run numbers and say things like, “Well, for the same amount you are throwing away in rent each month, you could be making a mortgage payment!“  Unfortunately, the real world tells us that rent and mortgages are not equal, in terms of the financial risk associated with each.  If you buy a house with no emergency fund and the hot water heater bursts sending gallons of water over your flooring, guess who gets to pay for the cleanup and repairs?  If that same scenario happens in a rental home, your landlord is on the hook for necessary repairs.

Owning a home is still a worthwhile goal as real estate prices do typically increase over the long term.  However, it’s best not to jump into home ownership solely for the investment potential.  Leveraging too much of your life by over-buying a house can wreak havoc on your family’s finances for years to come.  Renting has its downsides as well, but they are typically more inconveniences (fluctuating payment amount year to year, having to move if owner wants to sell or reoccupy, etc.) as opposed to the uglier potential negatives associated with mortgages.  Can you say “foreclosure?”  So, if you are in position to buy a home, make a frugal purchase and enjoy your new humble abode.  If you are not in position (no down payment, no emergency fund, etc.) then simply rent a space and keep plugging away at building savings–no shame in that game.

A Frugal Dad reader (Tracy) recently wrote to get my opinion on a housing dilemma she and her husband find themselves in. To summarize, the couple recently relocated to be closer to both their jobs and bought a “fixer-upper” that turns out to need more work than they originally thought. The purchase was made a bit hastily because their home sold quickly and the buyer wanted to take ownership in just three weeks. With buyer’s remorse setting in, and the couple finding themselves quickly outgrowing their space, they are wondering if a remodel/expansion is in order, or if they should try to find something else to buy (which is difficult given the options in their immediate vicinity).

I asked for Tracy’s permission to post her story here and allow Frugal Dad readers to offer their advice. I’ve provided my response below her original email, and hope you will do the same in the comments section.

From Tracy:

I have a burning question that ties in with a topic you’ve touched on before; your advice was, (I think I remember this correctly): When purchasing a home, “buy a starter home and stay there.” In our situation, our starter home was in a small, suburban tract community about 40 minutes away from my work and an about an hour from my husband’s. Throw in some heinous weekday commuter traffic and a couple of daycare stops (after a couple of years) and we decided we were spending way too much of our lives in vehicles. So, we purchased a 30-yr-old fixer much closer to our places of work and now our commutes are down to about 20 minutes each, one way. Right now, that’s about the only good thing we can say about the place!

We sold our first home much quicker than anticipated, and our buyers were relocating and really wanted to be in our home in three weeks. So we had to find a home and move in very little time. We’d narrowed down our choices to two houses in the same neighborhood. We made an offer on one, a sprawling ranch with an open layout that we both loved. The inspection came back with structural damage, as well as a number of other costly items; the seller was not willing to negotiate the price to offset fixing the items, nor was she willing to fix them, so we rescinded our offer. The other home came back with a clean inspection, but had many cosmetic issues such as 30-yr-old green shag carpet, layers and layers of floral wallpaper, etc.

Now, three years later, we’ve made a few updates but still have a long way to go. The kitchen, which I thought was “quaint” when we were under the gun to find shelter, is actually barely functional and doesn’t really meet our needs as a family of four. It has one operating drawer for utensils, and only about six cabinets for dishes, pots, pans and food. There is no pantry.

The huge yard with lots of flowering shrubs (mostly azaleas) was a big plus when we were buying the place, but last summer they contracted a disease and promptly died, leaving us with gaping holes in the yard after mercifully putting them out of their misery earlier this year. There are also drainage issues with the property that we’ve been told would cost about $3500 to correct. Also, our minivan barely fits in the narrow one-car driveway, and when people stop by to visit–forget it. We’re forever moving vehicles to prevent blocking someone in.

The other items add up to about $14,000 in repairs/upgrades: Painting or removing the dark paneling in the den, replacing the green carpet with hardwoods or laminate, adding a freestanding pantry to the kitchen, replacing cracked tile in the bathrooms, replacing a cracked shower door, widening the driveway, etc.

We’ve only been there three years, so we don’t have a lot of equity to tap into for a second mortgage, nor do we want the added expense. Our current mortgage is about $1300. The average cost of homes in the neighborhood is around $190,000 (up from $165,000 when we bought the place). Most of the homes for sale in the neighborhood are about the same age with virtually no upgrades; ones that are fully updates go for much more, around $250,000, which is out of our price range. Newer homes in our range are generally about 30-40 minutes away, which would put us back at square one.

What do you recommend? My husband is reluctant to move, knowing that it’s a stressful ordeal, and often costly, even if the new mortgage ends up being less than what we’re currently paying. Thanks for any help!

Tracy, your story is probably not that uncommon from others around the country. I’ve known people who have taken on “fixer-uppers” for a variety of reasons and suddenly they find themselves without the motivation or means to continue. It’s a cautionary tale for taking on such projects, but you are here now, so let’s consider your options.

I guess my first question would be how much of the “cosmetic” issues could you live with, in the short term? Ugly carpet, a narrow driveway, and paneling in need of paint are certainly not ideal, but far from untenable. I’d recommend prioritizing these jobs and saving for them in a dedicated savings account. Things like drainage issues and leaky shower doors should be a priority as they can lead to further damage, while cosmetic items can be prioritized much lower.

Depending on how handy you and your husband are, perhaps some of the work can be done yourselves. House painting is a relatively low-cost project that can make dramatic changes to a space without much investment, assuming you don’t have to pay a paint crew to do the work. I’m not particularly good with flooring and tile work, so I’d probably have to hire someone for those projects. Ask around at work or at church to see if you can find someone reputable to do the work, or perhaps find a colleague who would like to tackle the project on the side.

Basically, my advice is to move slowly. What’s gotten many of us into trouble as a consumer society is impatience – the need for instant gratification. It sounds like you aren’t interested in taking on new debt, and that’s a good thing. Stick to that! It will take longer to make these repairs if you have to save up the cash, but at least you will own your new driveway, new floor and additional pantry, outright.

For the benefit of other readers, this is a good example of why I stress that there is no shame in renting. I’m not sure it was even an option in Tracy’s case, but assuming her and her husband had rented for six months to a year they could have bought some time to fully explore all available options before buying their next home. What would be your advice to Tracy and her husband?

I know a guy who just got married and has already started the obligatory house-hunt exercise with his new bride. He asked me about the timing of buying a house in the context of overall market conditions and I asked him if he was financially prepared for homeownership. “Not really, but we’re married now and I just hate throwing money away on rent.” Renting a house is one of the smartest things you can do early in your marriage.

“Renting is like throwing money away every month.”

This is a fairly popular idea sold by the anti-rent crowd, including realtors, mortgage brokers and banks. In fact, there are many times when renting makes the most financial sense, particularly when you consider the costs and added risk of mortgaging a house. My newlywed friends have some debt to pay off, and have very little in savings. Just because they technically qualify (according to a bank) for a mortgage loan doesn’t necessarily mean they should take one.

“If I rent I won’t be building equity.”

Building equity in a home is not the only way to grow your net worth - there are plenty of other investment opportunities. Some could make the argument after the recent housing bubble burst that real estate is no longer a “sure” investment, even though I believe over the long term it is certainly safer than others. Think about it – there will always be new companies, new technologies and new services created over the years, but as far as I know we haven’t figured out how to invent new land. It is this limited supply that causes real estate to appreciate at a fairly reliable rate over the long term.

So renters cannot participate in this appreciation. Worse things could happen if you buy without adequate savings established. You could buy more house than you can afford and eventually be forced into foreclosure. You could buy a house that requires costly repairs at your own expense (versus passing the repair bills on to a landlord). You may be required to buy private mortgage insurance on top of your payment, homeowner’s insurance and taxes, making for a costly monthly payment. The potential negative consequences for premature home ownership are endless. Conversely, renting frees you from many of those consequences. You do not need to worry about large repairs, taxes, PMI, and homeowners insurance (although renter’s insurance is a good idea to protect your contents).

“Homeownership is the American dream.”

I know it is, and a noble one. However, it is not wise to dig too deep a financial hole for yourselves early in a relationship. The first couple years of marriage are tough enough without struggling to meet a mortgage payment. The average home buyer commits thirty years to a mortgage payment of nearly $1,000 a month. Thirty years is an awfully long time to commit $12,000 a year (or more). Consider renting the first six months to a year to get to know each other, and the area where you decide to settle.

“Rates are at an all-time low.”

True, but even the lowest rates don’t make sense if you are really stretching to take on a mortgage payment that you cannot afford. Consider lowering the bank’s suggested 28/36 debt-to-income/obligations ratio to a more comfortable level based on your income. In the book The Ultimate Cheapskate, author Jeff Yeager advocates “buying a starter home and staying there.” Over time you may make improvements to the home, or expand if necessary, but your goal should not be to trade up every few years, a practice that continues to push your mortgage payments further into the future. I personally think this is great advice, and something many newlyweds should strive for. If you cannot initially buy a starter home, look for a starter rental and move up when you can, but then stay put and pay off your mortgage early to speed up your plans for financial freedom.

As I mentioned a few weeks ago our family is considering a move to smaller, more affordable housing in an effort to pay off our remaining debts, and finance a few larger expenses coming up with cash. If we stayed in our current home we would likely have to finance those expenditures (orthodontics, replacement car for my wife, etc.) and I would consider that a move in the wrong direction.

We are willing to sacrifice just about anything but school zones, as education is important to us and private schools are an expensive alternative to a quality school system in our current area. It isn’t easy to buy smaller, because most people see that as a step back, when the “American dream” is to constantly buy bigger and better. However, for us it is a personal decision at our family level and we are not overly concerned with what others think. Besides, if we do buy a smaller home and pay it off early, imagine the wealth building we could do with no house payment and no other debts!

The thought of packing, moving and unpacking makes me cringe. When we moved to a new city a few years ago I swore I would never voluntarily move again because it is just such a hassle. However, times have changed and I now see the value in downsizing. I imagine much of what is in our current home will not fit in the homes in our price range, and that’s fine. We’ll have a few yard sales, donate to worthy causes and give away remaining items to friends and family.

On the flip side, downsizing our living quarters should help reduce our monthly bills. Lower house payments, lower utility payments and less maintenance costs should help increase our monthly cash flow towards debt repayment and savings. Our long term, seven-year plan is to pay off this house and our remaining debt and then build wealth like crazy. We’ve lost some ground thanks to bad financial decisions in our 20s, but plan to make up for it this decade by making some sacrifices early on. A paid-for, appreciating home will be a valuable asset in the next decade as the housing market rebounds (and it will). We will then be in a better position to buy or build what will likely become the home we “retire” in.

While we are still a few months out from making a move, a drive around our city Sunday confirmed the neighborhoods we are interested in. We saw several homes in our price range for sale that appeared to be just what we were looking for, but we still have some work to do on our current home before we can pull the trigger. Driving by the houses I could almost feel the “house fever” building inside of me, and I had to remind myself that impatient, impulsive decisions are almost never the right decisions, especially as they relate to finances. We are doing things the right way, and at the right pace.

Image Credit: D’Arcy Norman

My wife and I have recently been discussing purchasing a home, and in the process have become a little sticker-shocked over the local housing prices. The target amount we had in our head doesn’t translate to enough house for our family, so I went back to the drawing board to determine how much house we could afford. I found out that mortgage lenders have their own set of rules, but if followed could leave you house poor. After running the numbers, I’m starting to think there is nothing wrong with renting a house indefinitely!

The 28/36 ratio – the 28% rule. Mortgage lenders would like for your new housing payment, including taxes and insurance, to be less than 28% of your gross monthly income. That means a family earning $50,000 a year should not spend more than $1,167 on housing. That number seems a bit high to me, considering after taxes that family is probably only bringing home around $3,300 a month. When you back out other payroll deductions such as health insurance, FSA contributions, etc. that doesn’t leave much disposable income after an $1,100 mortgage payment.

• Frugal Dad’s Rule: A more conservative ratio of around 20% of monthly gross income going to housing costs would leave a larger cushion.

The 28/36 ratio – the 36% rule. In addition to the 28% rule, mortgage lenders also use a 36% debt-income ratio based on monthly income and debt expenses. Using our same $50,000 a year family as before, their total debt payments each month (including the new mortgage) should not exceed 36% of their monthly gross income, or $4,167. If our family fully maximized the 28% rule and took out an $1,100 mortgage that would only leave $400 in additional allowable debt payments to stay under the 36% rule. A couple credit card payments and/or a significant car payment could easily push them over the 36% rule.

• Frugal Dad’s Rule: In this case I actually like to use the mortgage lenders 28% rule for the total amount of debt you should carry, including your house payment. Revising the 36% debt-income ratio down to 28% forces you to either look for a much cheaper home, save up for a larger down payment, or become debt free before buying a home. In either case, you will have more money left over each month to finance your remaining financial goals by following Frugal Dad’s maximum mortgage calculator.