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21.0 Introduction
I don’t need to know you to know you. You want to buy a house. You may not be able to express why, but there’s a drive or even an inevitability to home ownership. Don’t believe me? Picture yourself at age 40… think about the life you are living. You own your home, right? I thought so. In this chapter, I’ll tell you as much as I can about the process of buying a house. And in doing so, I hope you at least entertain the possibility that being a lifelong renter (or at least delaying the purchase of a home) is a reasonable option for many financially savvy individuals.
21.1 The Basics of a Mortgage
First things first, let’s discuss financing. Because homes are so expensive, it is rare for folks (especially young people) to buy a house with their own money. Rather, the purchase of a home is funded via a loan, called a mortgage. At its core, a mortgage is a simple financial instrument where banks lend money to new homebuyers, who must gradually repay the loan, with interest, over the coming years, via monthly payments. If you fail to make payments on your house, there’s a good chance that the house will be confiscated by the bank and sold via a foreclosure sale. Thus, the house acts as collateral in the mortgage process. This is good news for you. Because banks can recapture a home in the case of an unpaid mortgage, mortgage lending is relatively safe for banks. Thus, interest rates on mortgages are quite low:
As indicated in the graph above, interest rates for mortgages are typically below 10%, but vary based on the economic situation at the time. During the peak of Covid, the Federal Reserve engaged in aggressive stimulative policies to drive interest rates down and stimulate economy activity. In 2022, the Fed sharply raised rates to fight inflation. These rates, which are largely outside of your control, will likely play a major role in financial trajectory should you choose to be a homeowner. While mortgages rates are at relatively high levels at present, they are still lower than interest rates for other common forms of borrowing like car loans, credit card debt, and personal loans.
Although interest rates are largely driven by current economic conditions, you will have some control over the terms of the mortgage. Unless you are a current or former member of the U.S. armed forces[1], your mortgage will require a substantial downpayment. A downpayment is an initial payment that is made by the aspiring homeowner to initiate the mortgage. A downpayment is an important part of the vetting process for banks—a person that can afford a downpayment is probably financially stable and likely to repay their loan. The lowest possible downpayment is 3.5%. This means that a person buying a $400,000 home would need to pay $14,000 to the bank upfront to initiate the loan; thus, the bank would make a $386,000 loan to the homebuyer. For such a loan, the individual is required to pay primary mortgage insurance (PMI). Effectively, this means that homebuyer will need to pay an extra 0.5% to 1.0% in interest to the bank to be permitted to borrow with such a low downpayment.[2] These PMI payments persist until the homebuyer has paid-off about 20% of the home’s value.[3] A home loan with a downpayment below 20% is called a Federal Housing Authority (FHA) Loan. To avoid PMI, the borrower/homebuyer will need to make a downpayment of at least 20%. On a $400,000 home, this means a downpayment of $80,000. By contributing at least 20%, the homebuyer has engaged in a traditional mortgage.
For many young homebuyers, an FHA loan is a necessity. Accruing enough cash for a 20% downpayment is a steep hill to climb. But, even if a person has loads of cash, the decision of whether to choose a traditional or FHA loan can be difficult. While an FHA loan includes an extra expense (PMI), the low downpayment enables the homeowner to have more cash-on-hand, which frees-up cash for investing. On a $400,000 home, an FHA loan requires a $14,000 downpayment while a traditional mortgage requires $80,000. By choosing an FHA loan, the borrower could invest the unused $66,000 and potentially come out ahead. Mathematically, this is often an optimal decision. But it’s risky (the investor is effectively investing with borrowed money) and only works if the investor is diligent about saving (many will spend some of the $66,000 or spend more of their working income since they know they have accessible investment funds). So, if a person has enough cash to put down 20%, my typical recommendation is to do so.
In addition to choosing a downpayment size, one must also select the duration. In the United States, the 30-year mortgage, which is typically the longest duration available, is the most common. It’s popular for a pretty simple reason; the longer the mortgage, the smaller the monthly payment. A low monthly payment is attractive to many. For the financially unstable, a low monthly mortgage allows the homebuyer a better chance to attain the necessary funds for each payment. For the financially savvy, it’s often a strategic choice. By minimizing the monthly mortgage cost, the homeowner has more money to toss into tax-advantaged retirement accounts. But there is a downside to a 30-year mortgage—typically longer duration loans have higher interest rates and mortgages are no exception. Loans of 10-, 15-, and 20-year durations are also common. When selecting a loan, it’s smart to inquire about the interest rates for different loan durations just in case there is a duration that has significantly lower rates at the time of application.
A borrower must also choose the style of mortgage. Many opt for simple fixed rate mortgages. As implied by the name, fixed rate mortgages have a fixed interest rate for the duration of the mortgage. As such, the inherent interest rate risk is absorbed by the lender. If interest rates increase after the mortgage is established, the lending bank is stuck with the low interest rate mortgage it provided to the homeowner. Furthermore, if interest rates in the economy fall, you have the option to refinance, which means that you would effectively start a new loan at a lower interest rate.[4] For a borrower using a fixed rate mortgage, the monthly payment amount will be constant for the duration of repayment (unless one chooses to refinance).
Alternatively, you might consider an adjustable-rate mortgage (ARM). For ARMs, the interest rate risk is held by the borrower. If interest rates rise, the loan is adjusted, and the borrower pays a higher interest rate. Well, maybe they will. It depends on the specific of the loan and there are many different variations of ARMs. Nowadays, the most common adjustable mortgage is a hybrid ARM, where the loan has a period of fixed interest (“teaser period”) before the adjustable component kicks in. A common version is the 5/1 ARM, where the interest rate is fixed for five years (5) and then can be adjusted once per year (1) after this period. Since ARM loans are less risky for the lender, the teaser period interest rate is usually lower than for fixed rate mortgages. Thus, it’s usually advisable to choose an ARM if you think you are buying a house that you will sell in just a few years.[5] While there is often no right answer regarding the type of loan you should choose, it’s probably best to choose a fixed rate mortgage when interest rates are low to “lock in” the low rate. The table below displays average mortgage rates for various loan types at the time of writing:
As is typical, the longer the loan the higher the interest rate, with 30-year fixed rates charging a premium of 0.57 percentage points relative to a 15-year fixed rate mortgage. FHA loans have slightly lower interest rates, but the borrower will be required to pay PMI for these loans, which is not included in the rates listed.[6] The ARMs listed above, which have a duration of 30 years, have slightly lower introductory (teaser) rates than traditional mortgage rates, since the borrower absorbs the interest rate after the teaser period.
What can you do to ensure a low interest rate? Not a whole lot, but banks and other mortgages lenders will generally be most generous to customers that are viewed to have a high likelihood to repay a loan—those with a high credit score, high income, high net worth, a variety of liquid assets, etc. Usually, credit scores get all the attention but once a person reaches a credit score of about 750, there is little value in increasing it further... squeezing the credit score lime doesn’t produce any more reduced interest rate juice. Truthfully, if you have been saving money and repaying debts appropriately, you won’t have trouble getting a loan for a house that is within your means. So, live a financially sound life and you’ll be just fine.
21.2 Wild Swings in the Effective Price of a House
Because homes are so expensive and home ownership usually necessitates borrowing, the effective price of housing is an extremely important detail in one’s financial well-being. As an example, consider my current home. I purchased the house back in November 2020, when interest rates were at historic lows (this was pure luck). With a $350,000 purchase price and a 20% downpayment ($70,000), I borrowed $280,000 at 2.875% interest, using a 30-year fixed-rate mortgage. Four years later, my house is now worth $500,000 and the current interest rate on such a mortgage is about 7.0%. The table below compares four different scenarios.
These four scenarios should give you a nice snapshot of the impact of housing prices and interest rates on overall house payments. I assume a 20% downpayment (traditional mortgage) with a 30-year payoff period in each case. The monthly payment is the total payment per month (on the loan only), total interest is the total interest paid over thirty years if I pay the monthly payment each month (I don't make extra payments), and the total cost is the sum of the total house price and all interest paid. Scenario 1 is my real-life mortgage. I pay $1,162/month and will ultimately pay $138,212 in interest.
Now, let’s compare. In scenario 2, I imagine buying my current house for $350,000 (the 2020 price) with current day interest rates. By adjusting the interest rate from 2.875% to 7.04%, my monthly payment is 55% higher and my total interest paid over 30-years rises by $241,075.[7] This overall cost is significantly higher than scenario 3, which includes the current-day value of my house ($500,000) and 2020 interest rates (2.875%). As you can see, the impact of interest rates on the overall cost of a home is massive! The monthly payment in scenario 2 is much more than scenario 3 even though the loan amount is $130,000 less! Finally, scenario 4 shows the current situation for my house as of 2024. If I were to buy my house today, my monthly cost would be $1,510 more than I’m actually paying! Over the course of my 30-year mortgage, I would pay $423,695 in additional interest if I were buying my house today, relative to my actual purchase in 2020. As indicated, the volatility of home prices and interest rates leads to sensational swings in the effective cost of a home, when utilizing a mortgage.
The terms of a mortgage can create some interesting incentives. At present, I feel I can’t even entertain the possibility of moving—the effective cost of buying a house today is so much higher than it was in 2020. If I move, I will lose my low-rate mortgage! Furthermore, I have no desire to pay off my mortgage early. With a 2.875% interest rate, the interest I’m being charged is lower than what I can earn with a zero-risk investment like a government bond or high-yield savings account![8] If I can borrow at 2.875% and invest at 4.00%, it would be a terrible move mathematically to pay off my mortgage early. Alternatively, if I were buying a house today (at 7% interest), I would consider making extra payments on my mortgage. By paying off a 7% interest, it’s like I am earning a 7% risk-free return (since I am eliminating a 7% interest charge). The terms of my mortgage have long-lasting implications on my future residency, job, net worth, etc.! But, because interest rates and home prices are hard to predict, it’s difficult (impossible?) to time the market and buy a house at the ideal time.
Want to play around with numbers? Here is a simple and effective mortgage calculator.
21.3 The Homebuying Process
To fully understand the trials and tribulations of home buying, one must live it. As someone who has bought four homes (a fact I’m not proud of), I can give you a synopsis of the process. It’s a lot of tedious and frustrating work, but it can also be quite exciting. Here is a rundown of the process:
0. Pre-planning: In the months leading up to buying a house, you should avoid substantial borrowing or other activities that will adversely affect your credit score. It is probably fine to apply for a new credit card, for example, but do you really need to? You should also think deeply about your current and future job prospects, relationship goals, family goals, housing needs, etc. Buying a home is not a decision to be made lightly.
1. Attain a pre-approval letter: Before contacting a realtor, you will first want to get pre-approved for a loan. Typically, a pre-approval letter is most easily attained through a bank with which you have an established account. To start the process, you will provide documentation, such as bank statements (which your bank should already have), tax returns from the last two years, employment information, and more. Once these documents are collected, you can inquire to be pre-approved for a loan of $X. For example, you might ask for a pre-approval letter to borrow up to $500,000. If everything is up to snuff, the bank will happily comply. If not, it’s back to the drawing board for you. The complete pre-approval letter does not guarantee that you are approved for a loan, nor does it bind you to borrow from this respective bank, but it does give your realtor and the potential seller confidence in your capability to attain funding.
2. Find a Realtor: Now that you’re pre-approved, it should be easy to find a realtor that will help you buy a house. In most housing markets of Georgia, the buying and selling realtor each charge a 3% commission for home transactions, meaning that a $500,000 home sale will gross $15,000 for each realtor. That’s a large fee, but well worth it in my opinion. Realtors know the market better than you and will help you emotionally and strategically as you navigate the process. While many newbies view realtors as nothing more than a salesperson or home-marketer, the realtors I’ve used had a keen understanding of every step in the process. Maybe I was just lucky…? Regardless, I can’t imagine navigating the home-buying process for the first time without a realtor. Ideally, you should find a realtor that you trust, but how? Word of mouth goes a long way here. Try to find a close friend, family member, or colleague to provide a recommendation if you don’t know a realtor personally.
3. Look at Houses: Everyone’s different, but this was quite fun for me! In addition to physically visiting homes, I’d recommend spending some time on Zillow.com or Realtor.com to view homes in the area. Even if you aren’t considering buying a home now, it’s useful to browse home listings in a desired area to develop an understanding of the market. If you have a good realtor, they will also keep a watchful eye for new listings, price reductions, etc.
4. Make an Offer: Once you’ve found your dream home, it’s time to make an offer. Perhaps your potential home is listed for $410,000… how much should you offer? Every market is different. Your realtor should help you land on a dollar-amount. But, be careful. Realtors’ income comes from home sales, and they make more money when the buying price is high, so they are incentivized for you to make a high-dollar offer to ensure the transaction moves forward. So, it is useful to understand your housing market before submitting an offer. Home offers include lots of details, such as:
Home Price
Expiration Date of the Offer: For example, you might state the offer is valid for 48 hours.
Due Diligence Period Details: In your contract, you must specify the start and end date of the due diligence period (discussed later), which is often 7 to 14 days.
Earnest Money: The seller wants to know you are serious about buying the home and they don’t want to get burned if you back-out at the last minute. As such, expect to promise earnest money to the seller. This earnest money (usually around 0.5% to 1% of the home price) is held by a third-party after the initial offer is accepted. If the homebuyer backs-out after the due diligence period, the seller may be entitled to collect the earnest money. So, it’s an insurance policy of sorts. If the home transaction moves forward as expected, your earnest money will be contributed to the house purchase.
Closing Costs: When a house is transacted, there are many transaction costs to pay (e.g. attorney fees, loan origination fees, title application fees, etc.). Who will pay these fees—you or the buyer? In your offer, you must specify. For example, your offer might state that the seller will contribute $10,000 to closing costs.
Closing Date: When will you buy the house?
Appliances and the like: What is included in the purchase—do you get the washer and dryer? How about the microwave? These things need to be clearly laid-out in the offer letter.
Improvements: It’s common for the buyer to ask for improvements or repairs. If you find rotting wood on the exterior or clogged gutters, it’s completely reasonable to ask for repairs. Your realtor should help you here.
5. Additional Rounds of Offers: Rarely is the first offer accepted as-is. The seller will ask for more money, reduce their contribution to closing costs, etc. There may be several rounds of offers and counter-offers before a contract is accepted.
***Under Contract: Once both parties have signed the contract, you are said to be “under contract”. The buyer is now in the position of power as the buyer can still back-out but the seller (usually) cannot.
6. Due Diligence Period: The due diligence period is a period in home transactions when the buyer can back-out for any reason. During this time, the buyer will pay for a home inspection, where a specialist will provide a thorough report of the home’s condition, complete with pictures and recommended repairs. If the housing inspection goes poorly, it is fully in your right to back-out of the transaction (I’ve done this twice). Contracts often fall apart here. As a buyer, you should use the due diligence period to your advantage and back-out if you are not completely satisfied with the massively important purchase you are on track to make.
7. Additional Rounds of Offers: After the home inspection, it’s very likely you will find some problems that need to be addressed. For example, on my most recent home purchase, we discovered that one of the hot water heaters didn’t work at all. So, following the home inspection, we voided our contract and drafted a new one to ask for a working hot water heater (and a few other easy fixes). The sellers happily accepted our requests. Even though it may feel like you’re back to step 4, you’ve gotten much closer to finalizing a deal. The due diligence period and home inspection do not need to be repeated, so if a contract is signed by both parties now, the contract will be conveyed. There is no backing-out now!
8. Attain a Loan: This may come earlier in the process, but at some point, you’ll need to agree to a home loan. You need to be thorough and aggressive. Seek multiple sources for a loan, not just your bank. Then, have the lenders compete for your business. When buying a home, I send emails like this (below). Sometimes it works, usually it doesn’t. But it’s worth a shot!
9. Appraisal: At some point following the finalized contract, the lender will seek an appraisal of the house. Suppose you’re under contract for a house, paying $280,000. The lender wants to ensure that this is a good deal since the lender is effectively buying the home and will become the de facto owner if you fail to make your payments. The appraising firm will compare your homes to similar ones (“comps”) and provide an appraised value. If your house appraises for $280,000 or more, all is good, and the contract moves forward. If the house appraises for less than $280,000, the contract is voided (and you will not lose your earnest money). The buyer and seller will need to negotiate yet again to land on a new price or the buyer will need to pay the difference between the appraisal price and the contract price out of pocket. Rarely does a home fail to meet the appraisal, so this is unlikely to be a sticky wicket.[9]
10. Closing: The big day is here. You’ll go to an attorney’s office for a couple of hours and sign various forms and documents. You’ll get the keys to the home and celebrate!
11. Buyer’s Remorse: You’ll realize home ownership isn’t special and doesn’t make you happier. When the A/C breaks two weeks after moving in (this happened to us), you’ll cover the expense out-of-pocket. You’ll look back with fondness on your younger days when you lived a more carefree life, unattached to your residence. A piece of your innocence is forever lost. I’m exaggerating, but it’s very common to regret a home purchase. It didn’t take me long to absolutely hate my first home. But you live and you learn.
Run back through those. Do you really want to attempt this without a realtor?
21.4 Why a house is a terrible investment.
You’ve probably been told that buying a house is an important step in life and that renting is “throwing money away”. This is a load of garbage, in my opinion. In this section, I’ll explain why buying a home is often not a great financial choice. You’ll still buy a house one day, and that’s fine!
Homes are extremely illiquid: Investments are most valuable when they are easy to liquidate. Roth IRAs, for example, allow investors to withdraw contributions for any reason without taxes or penalties. Brokerage accounts are even more liquid, but less tax efficient. Homes are sensationally illiquid. If you need cash to pay for a new car, you can’t just sell your home overnight.[10] Selling a house can take years.
Homes reduce diversification efforts: A typical middle-upper-class 30-something American has $200,000 in stocks/bonds and is paying a mortgage on a $400,000 house—the house represents 2/3 of their wealth. That’s a lot of wealth to tie into one asset. Unless you are very wealthy and/or buy a cheap home, your house will inevitably make up a large share of your overall wealth, exposing you to substantial risk. Furthermore…
Home values may be closely tied to job prospects: Home values are sensitive to economic conditions in your locality. This is especially true in small towns and I’m a classic example. My wife and I both work for a university, the largest employer in the county, in a small town. If our university unexpectedly shuts down, we both lose our jobs, and our home value would plummet.
Home prices rise slower than stock prices: Everyone knows that homes are getting more expensive over time, but housing inflation is much lower than stock appreciation. Since 1990, home prices have increased at an annualized rate of about 5% per year. That’s far below the annualized growth of stocks (about 10%). But this figure overstates price increases since the median home today is much larger and has more features than in year’s past. Furthermore, homes require updates and repairs. Obviously, stocks do not. A homebuyer’s downpayment is inherently invested in the home, while a renter is free to invest a larger share of their net worth in stocks.
Owning a home creates risk: When something breaks, you must fix it. As a renter, you do not bear the cost of a broken furnace. Thus, the cost of living is more variable as a homeowner. While the inherent cost of repairs are baked into rental costs, the variability of said costs are not.
Buying a home leads to tax inefficiency and low-return investing: To save money for a downpayment, one must generally earn money in a tax-inefficient way. Downpayments cannot be paid with an HSA, 401(k), etc.[11] So, to save for a downpayment, prospective home buyers cannot fully utilize these tax shelters. Furthermore, homebuyers are usually unwilling to fully invest in the stock market since they need a stable cash fund to make their purchase. This reduces future net worth.
Homeownership comes with additional fees: When you own a home, you are required to pay property taxes and insurance. As a renter, these costs are passed-down to you, but not everyone considers the implications correctly. If you use a mortgage calculator and find that your monthly payment is $1,400, this typically does not include insurance and property taxes.
Buying and selling a home creates massive transactions costs: For a typical house transaction, realtors earn a collective 6% of the house price and closing costs (attorney fees, appraisal fees, etc.) sum to 2% to 5% of the home price. Thus, each home transaction generates a total transaction cost of about 10% of the home price. Stock-investing via index funds has virtually no transaction cost.
For the reasons listed above, it may be perfectly reasonable to rent for as many years as possible or for your entire life! You might be thinking, “No wealthy person I know rents their home.” That may well be true, but that’s not relevant to this discussion. Wealthy people often own a home because they have lots of wealth to spend. But this does not mean that buying a home leads to wealth! Similarly, I bet every wealthy person you know has a nice car. But that doesn’t mean buying a fancy vehicle increases your wealth… no, it reduces wealth.
Interestingly, the value of buying a house is lowest for those that are financially literate. A financially savvy investor knows how to invest in low-cost funds through tax-sheltered accounts. So, attaining $80,000 in cash for a downpayment has a high opportunity cost—this money could be doing so much more! For a less savvy person, the money saved for a downpayment may have been held in a savings account (or spent) had they not used it to pay for a downpayment. In this case, buying a house is an improvement upon what they would have done with the money as a renter. The more skilled you are, the less valuable it is to be a homeowner.
21.5 Why buying a house may be a good financial move for some
But it’s not all bad! There are certainly benefits to home ownership. Here are some things to add to you “pros” list.
Home sales are tax efficient: Selling a residential home often creates no taxes. The 2-out-of-5 rule states that a homeowner can sell their home for a profit tax-free as long as they have lived in the home for at least two of the last five years.[12]
Home ownership reduces the risk of future housing price increases: If you lock in a mortgage now, you guard against the potential risk of skyrocketing rental prices, home prices, or interest rates in the future.
Mortgage rates are relatively low: Mortgages offer the lowest interest rates available to consumers. So, if you’re going to have debt, housing debt is the least detrimental. When mortgage rates are very low (such as in 2020 and 2021), attaining a mortgage is much more financially valuable. At present, I have a 2.875% interest rate on my mortgage. I can invest in assets (even risk-free ones) at a rate that is beyond my current interest rate.
21.6 But let’s be honest with ourselves…
You’re going to buy a house. And hopefully, you won’t be buying because you think it’s a good investment or to make your parents happy. You’ll buy a house because you want a house. Most of the important and worthwhile purchases we make in life are not made to create wealth. When I buy a cup of delicious coffee or spend $200 on a ticket to a football game, I’m not doing so to improve my financial situation, I’m just trying to live a happy life. Homeownership allows one to have complete control in the state and condition of a home and is often inherently desirable. You want a house just because you do.
If home ownership appeals to you, then, buy a house! But view it as consumption not as investment. And maybe consider delaying your purchase. Because of the transaction costs inherent to home purchasing, homeownership becomes more financially sound the longer you stay in your home. So, it’s probably sound to wait until you have some stability in life before you buy. Furthermore, don’t make the common mistake of buying the most expensive house you can afford. Just because you are pre-approved for a $750,000 loan doesn’t mean you are obligated to borrow $750,000. Buying a cheap home (and investing the saved money) will normally generate more future wealth than buying an expensive home.
21.7 A note on real estate investing
While the home that you buy and live in is not a great investment, real estate investing can be extremely lucrative. By attaining low-interest loans and renting-out investment units, one can build their wealth very quickly, perhaps faster than could be generated with only stocks. While real estate investing is beyond the scope of this book, you might consider exploring this possibility in the future, when your net worth begins to grow. Or, if you want to invest in real estate without the hassle of doing any work, you can invest in real estate now, via real estate investment trusts (REITS). REITS offer a return on investment and risk-profile that closely aligns with stock ownership and can be purchased in a brokerage account through most tax shelters.[13]
21.8 Conclusions
Regardless of how you play the home ownership/rental game, your choices will greatly impact your future wealth and life trajectory. So, take your time, be patient, and learn. Learn not just about the homebuying process, but also about yourself. What do you like? Where do you want to be in the future? Do you want a family? As you get older, the answers to these questions will come easier and you’ll have a better chance to buy a house that you can enjoy for years. But I guess this is just my opinion (man).
End Notes
[1] Current members of the armed forces and veterans that served at least 90 days in active duty during wartime are eligible for VA loans, which can be attained without a downpayment.
[2] There’s a lot I could discuss here, but from a personal finance standpoint, there’s not a lot of benefit in learning about the PMI details. Here’s a decent discussion: PMI: A Full Guide to Private Mortgage Insurance | Chase
[3] Because of the front-loaded nature of loan repayments, this can take a long time, often more than half the duration of the loan, to reach. If the house value increases, it may be possible to apply for early PMI termination.
[4] There are fees associated with refinancing since starting a new loan also comes with an upfront cost. Furthermore, some mortgages have early payoff fees. Nonetheless, refinancing is a good option for many when rates fall.
[5] But if you’re going to do that, it’s probably better to rent anyway!
[6] FHA are actually safer for the lender since they are insured. As such, FHA loans often have slightly lower rates, all else equal.
[7] But again, this is unlikely to be realized. Homebuyers rarely stay in a house for 30 years. Instead, they move after 7 or 8 years and sell the house, ending the mortgage. Or, they may choose to pay the house off early, which effectively ends the interest charges.
[8] Of course, you can invest in risky assets too. I’m using a risk-free investment return just to show that a person is better off not paying off their mortgage even if they seek riskless financial instruments. Personally, I invest almost entirely in stocks and do not payoff my mortgage early.
[9] This industry is a scam. If an appraiser assesses the value to be less than the contract price, the contract falls apart and the lending agent doesn’t make any money. So, lenders will generally only hire appraisers that offer high appraisals. Appraisers know the contract price before assessing the homes value and will assess the home value to equal or exceed the contract price unless the buyer is grossly overpaying.
[10] To be fair, you may be able to take out a second mortgage. But, this is more debt… not ideal.
[11] A Roth IRA could be used, but it’s hard to build enough money in Roth IRA contributions to fully cover a downpayment.
[12] This is valid as long as the profit on the sale is less than $250,000 (filing single) or $500,000 (married filing joint). Any profit beyond these thresholds is generally taxable as capital gains.
[13] Sounds great, why don’t I talk about REITS more? Well… for one, if you invest in stock index funds, you are inherently investing in real estate and real estate related companies. Furthermore, most homeowners are already too house-rich and stock-poor. Investing even more money into real estate only exacerbates this problem.
Key Terms
2-out-of-5 rule: Upon selling a property, the seller is subject to no taxes on the profit from the home sale as long as the seller has lived in the house at least two of the last five years. The only exception is as if the profit on the house is very large.
Adjustable Rate Mortgage: Variant of mortgage where the borrower’s interest rate can be adjusted over time based on rules specific to the contract
Appraisal: Before agreeing to financing a home, lenders will require an appraisal of the house to ensure that the house is worth at least the price paid by the homebuyer.
Closing Costs: When buying a home, the buyer will bear costs that are separate from the actual home purchase. These fees are highest when the home is purchased via a mortgage. Fees include attorney fees, loan origination fees, appraisal fees, etc. During closing, the transaction typically also includes realtor fees, but these fees are often not explicably labeled as “closing costs”. While these fees may be directly paid by the buyer or seller, the fees are effectively shared by the buyer and seller.
Downpayment: Initial payment by a borrower engaged in a home purchase to initiate a mortgage.
Due Diligence Period: After going under contract but before closing, the agreed upon due diligence period is a time period where the buyer can back out of the contract for any reason without losing the earnest money. During this period, the buyer will pay for a home inspection and make the final decision of whether to continue forward with the purchase.
Earnest Money: Money paid by the home buyer to the seller shortly after going under contract. If the homebuyer backs-out of the contract after the due diligence period, the buyer may lose this money to the seller. Otherwise, this cash is applied to the home purchase.
FHA Loan: Loan sponsored by the US government, which allows the borrower to attain funding using a downpayment that is lower than what civilians can attain. The downpayment for such a loan can be as low as 3.5% of the home price. As a downside, the borrower must pay PMI until (roughly) 20% of the home is paid-off.
Fixed Rate Mortgage: Variant of mortgage where the borrower’s interest rate is fixed through time; thus the borrower’s monthly payment will not change over time
Foreclosure: When a borrower stops making payment, the lending institution (e.g. a bank) can collect the home and list it for sale. In this scenario, the bank has been foreclosed upon.
Home Inspection: Typically during the due diligence period, the homebuyer will hire a professional home inspector to assess the condition of the home. Based on findings, the buyer will often ask for repairs and/or a price reduction.
Hybrid ARM: Variant of a mortgage where the interest rate is fixed for a period, but becomes adjustable thereafter. This is much more common than true ARMs; thus, when folks discuss ARM mortgages they are often really talking about hybrid ARMs.
Mortgage: A loan made by a financial institution to a borrower (homebuyer) to enable a home purchase. The house is used as collateral.
Pre-Approval Letter: To initiate the homebuying process, a prospective borrower should seek a pre-approval letter, which merely states that the individual is eligible to receive a home loan up to a certain dollar amount.
Private Mortgage Insurance (PMI): For a borrower (home buyer) using an FHA loan, the borrower must pay this special type of insurance to be eligible for the loan. The expense is usually akin to an extra 0.5% to 1.0% interest until 20% of the house’s value has been paid.
Real Estate Investment Trust (REIT): Real estate investment vehicle that is akin to buying stocks, but is fully invested in rental properties and other real estate.
Refinance: When interest rates drop, borrowers using a fixed rate mortgage may be eligible to, effectively, close their current loan and reinitiate a loan with a lower interest rate.
Traditional Mortgage: Mortgage that does not require PMI since the borrower has made a downpayment that is at least 20% of the purchase price.
Practice Problems
I would like to buy a house with a 3.5% downpayment. My credit score is 617? What are my prospects?
I would like to buy a house with a 3.5% downpayment. My credit score is 777? What are my prospects?
I would like to buy a house with a 3.5% downpayment. My credit score is 807? What are my prospects?
Explain why you might want to get a credit card now if you plan to buy a house in five years.
Explain why you might NOT want to get a credit card now if you plan to buy a house in five months.
Explain why you might need to question the motives of your real estate agent when you are buying a house.
Historically, median housing values have increased by about _____ per year.
You buy a house in a traditional purchase in Georgia (buying agent and selling agent each earn 3%). You initially plan to buy the house for $195,000 but your real estate agent is strategic and you are able to only pay $193,700. How much does your real estate agent (buying agent) lose from this reduction in price?
I buy a house for $490,000 in January 2021. In January 2024, I sell it for $549,000. Solve for my annualized rate of return.
Bill has maxed out his HSA and is now saving money for a house, so he has stopped making HSA contributions. Jan has not contributed to her HSA at all and never will (she puts all her savings in a savings account) and is now saving money for a house. Explain why saving for a house is more costly for Bill than it is for Jan, in a subtle kind of way…
I buy a home for $465,000. How much will the closing costs be for this house, roughly? Include realtor fees in your answer.
I buy a $250,000 house and make a $60,000 downpayment. Will I pay interest on $250,000? $190,000? Explain.
If Gary buys a $600,000 home with a $90,000 downpayment, will he be required to pay PMI?
***For the following questions, use excel-mortgage-calculator.xlsx (live.com)***
Jalen buys a $522,000 house, using a 20% downpayment. He has a 6.25% interest rate on his 20-year mortgage.
a. Solve for his monthly payment.
b. How much interest will he pay over the life on the loan if he makes the monthly payment each month?
Refer back to the question above… suppose everything about the loan stays the same, but Jalen is able to talk the seller down and only pays $517,000 for the house.
a. Solve for his monthly payment.
b. How much interest will he pay over the life on the loan if he makes the monthly payment each month?
Refer back to the question above… now suppose Jalen pays the original price ($522,000) for the house, but he is able to negotiation for a slightly lower interest rate (6.125%).
a. Solve for his monthly payment.
b. How much interest will he pay over the life on the loan if he makes the monthly payment each month?
Solutions
I would like to buy a house with a 3.5% downpayment. My credit score is 617? What are my prospects?
Bleak. That score is low enough to either completely disqualify you from loan consideration or will result in high interest rates.
I would like to buy a house with a 3.5% downpayment. My credit score is 777? What are my prospects?
Prospects are great! If everything else on your record looks good (consistent income, adequate assets, no red flags [e.g. a past bankruptcy] to your name), you should be able to get a loan at an industry-low rate.
I would like to buy a house with a 3.5% downpayment. My credit score is 807? What are my prospects?
Same as the answer to #2! Scores of 777 and 807 are typically equivalent.
Explain why you might want to get a credit card now if you plan to buy a house in five years.
Getting a credit card can start your credit history and get a credit score, which will ultimately be necessary for attaining a loan. Furthermore, attaining more credit cards leads to a lower credit utilization rate, all else equal. A low credit utilization rate means a higher credit score. No need to go crazy, though! If you are making good financial decisions, you’ll have no trouble receiving a home loan.
Explain why you might NOT want to get a credit card now if you plan to buy a house in five months.
When you apply for a new credit card, your score drops (slightly) for one year. This is no big deal, but it’s probably best to avoid applying for new cards leading up to a house purchase unless there is a compelling reason to do so.
Explain why you might need to question the motives of your real estate agent when you are buying a house.
Real estate agents make money when they help transact a home and they make more when the sales price is high. So, as a buyer (in particular), you need to recognize that your agent is financially incentivized to close a deal even if it’s not in your best interest.
Historically, median housing values have increased by about _____ per year.
About 5%. (It’s actually a bit less than this, but that’s a nice round number)
You buy a house in a traditional purchase in Georgia (buying agent and selling agent each earn 3%). You initially plan to buy the house for $195,000 but your real estate agent is strategic and you are able to only pay $193,700. How much does your real estate agent (buying agent) lose from this reduction in price?
Original Realtor Earnings = $195,000*0.03 = $5,850
New Realtor Earnings = $193,700*0.03 = $5,811
The realtor only loses $39—not much! Realtors care most about completing as many transactions as possible, and are especially interested in high-value houses. Small differences in closing prices are a minor concern.
I buy a house for $490,000 in January 2021. In January 2024, I sell it for $549,000. Solve for my annualized rate of return.
i = (549000/490000)(1/3) – 1 = 3.86%
Bill has maxed out his HSA and is now saving money for a house, so he has stopped making HSA contributions. Jan has not contributed to her HSA at all and never will (she puts all her savings in a savings account) and is now saving money for a house. Explain why saving for a house is more costly for Bill than it is for Jan, in a subtle kind of way…
The value of a house to either person is roughly equal, but the opportunity cost of the money is very different. Buying the house is “costing” Bill extra money in his HSA, which is extremely valuable! Jan is only losing out on more money in her savings account, which is less beneficial. Since Bill loses more valuable by saving money for a downpayment, buying a house is effectively a worse deal for him.
I buy a home for $465,000. How much will the closing costs be for this house, roughly? Include realtor fees in your answer.
Realtor fees = 6%
Closing Costs = about 4%.
Total = 10% (or $46,500)… this cost will be shared by me and the seller, but it’s not like I’m only paying half of the closing cost for this house. I will pay the other half when I sell it in the future!
I buy a $250,000 house and make a $60,000 downpayment. Will I pay interest on $250,000? $190,000? Explain.
$190,000… that’s the loan amount!
If Gary buys a $600,000 home with a $90,000 downpayment, will he be required to pay PMI?
Yes. His downpayment is only 15% of the house value. One must pay 20% to avoid PMI. But, that’s not so bad! Once he has paid down an additional 5% on the house, he will no longer be required to pay PMI.
***For the following questions, use excel-mortgage-calculator.xlsx (live.com)***
Jalen buys a $522,000 house, using a 20% downpayment. He has a 6.25% interest rate on his 20-year mortgage.
a. Solve for his monthly payment.
Loan amount = $522,000(0.8) = $417,600
Monthly payment = $3,052.36
b. How much interest will he pay over the life on the loan if he makes the monthly payment each month?
$314,965.48
Refer back to the question above… suppose everything about the loan stays the same, but Jalen is able to talk the seller down and only pays $517,000 for the house.
a. Solve for his monthly payment.
Loan amount = $517,000(0.8) = $417,600
Monthly payment = $3,023.12
b. How much interest will he pay over the life on the loan if he makes the monthly payment each month?
$311,948.57
Refer back to the question above… now suppose Jalen pays the original price ($522,000) for the house, but he is able to negotiation for a slightly lower interest rate (6.125%).
a. Solve for his monthly payment.
Loan amount = $522,000(0.8) = $417,600
Monthly payment = $3,052.36
b. How much interest will he pay over the life on the loan if he makes the monthly payment each month?
$307,682.04
Monthly payment = $3,022.01
***What can you learn from these questions (14-16). From my experience, homebuyers are far more likely to fight for a lower price, but will not even shop around to different lenders to attain the lowest possible interest rate. Do both, but remember that shopping around for a lower interest rate will not ruin your homebuying chances while pushing for a lower price could.***
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