Getting in the (Front) Door: Buying Your First Home

Dear Reader,

I'm awfully glad you asked that question because the idea of home ownership has become deeply engrained in the American psyche. And given the dramatic rise in housing prices, particularly in your state, most people assume that buying a home is always a great financial move. But the reality may be different.

Of course I realize that the decision to buy a home is rarely driven entirely by financial concerns. Homes satisfy a lot of emotional needs as well: a place to raise a family and build a life, the opportunity to become part of a community and put down roots. But purchasing a home is a huge financial commitment and, for most people, the biggest financial decision of their lives. So it's particularly important to think through the economic and financial considerations carefully before taking the plunge. Here are the issues I'd want to examine:

Like the stock market, the real estate market has its ups and downs

Although the housing market has softened in the last several months, home prices over the last few years have gone through the roof (pardon the pun). Why? In space-constrained regions, like coastal California and New York metropolitan area, it's a supply/demand issue (lots of people want to live in these areas, and the housing stock is limited). In addition, a lot of money flowed into residential real estate after the stock market decline in 2000 (people took money out of the financial markets and ploughed it into the most tangible investment they could imagine: a house). Finally, low interest rates and less stringent lending standards made borrowing easier.

But booms cannot continue indefinitely, and buying a house today, at least in some markets, may still mean buying near a peak. Of course if you're planning to stay in the house for decades, you may not care about the short-term ups and downs of your local real estate market. Just don't buy assuming you are going to make money on your home in the short-term.

One good way to figure out if local housing prices have gotten speculatively high is to compare the cost of the monthly mortgage payments to a comparable rental. Admittedly, it can be difficult to find comparable rentals, particularly if you are buying a house (with condos, it's somewhat easier), but if you're in an area with a robust rental market, you may discover that the economics of buying just don't make sense.

Owning can be more expensive than you think

Take a good long look at the true costs of home ownership. There's the down payment, of course: at least 10% and preferably 20% upfront, plus any closing costs and transfer fees. Find out what kind of mortgage rate you can qualify for, what your monthly payments will likely be, and how much you'll owe in property taxes. In the recent housing boom, many homebuyers got in way over their heads, taking on highly leveraged, risky mortgages, some with “negative amortization.” Personally I favor the good old-fashioned 30-year fixed-rate loan so that you can accurately predict your costs every month.

Home ownership has additional expenses as well. Don’t forget to budget for insurance, and make a reasonable estimate of maintenance costs, which are often larger than you think (you'll also be investing time and energy in tasks like yard work and repairs). Unlike renters, most home buyers get a tax benefit because property taxes and mortgage interest are typically deductible, but make sure you know how valuable those deductions are going to be for your income bracket.

Be prudent about what you can afford

Conventional wisdom suggests that your total housing costs should not exceed 28% of your gross monthly income, and that all of your debt combined should not exceed 36% of your gross monthly income. This is of course just a guideline, but an important consideration. And I also believe it’s important to have an emergency fund of three to six months’ living expenses, so be careful not to use this fund as part of your down payment. If you can't afford a house now, save your money and wait. Don't stretch yourself too thin to buy a home since being "house poor" can be emotionally—and financially—draining.

Consider your needs over the next few years

If your career might require you to relocate, you might be better off renting until you're confident you'll be living in the same area for several years. Even if you know you'll be residing in your locale for a long time, don't buy a house that will be too small for your needs in the next few years. Houses are what economists call "illiquid"—they're certainly harder and more expensive to sell than a share of stock—and you'd hate to be stuck with an expensive asset you can't sell or can't use. (Now if you are particularly handy and can find a fixer—upper in a good neighborhood, buying with an eye toward renovating and reselling may be a good path to home—ownership. But renovations are expensive and many times they don't generate a corresponding increase in the value of the property.)

Of course, you may think through all these issues and find that that your response to the question "Do I want to buy a house?" is a resounding "Yes!" In which case, I hope you find the house of your dreams and enjoy a long and healthy life in it. Good luck.

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