Budgeting for Real Estate
Real Estate Investing (Part I – budgeting for your primary residence)
Having a diverse set of clients ranging from retirees to those just beginning to establish their nest egg, we see it all. The results of good financial decisions. And the not so good ones. As an advisor I can’t help but notice some commonalities in real estate. It’s often the folks with the largest nest eggs who are well primed for a fruitful retirement own multiple properties. And I can’t count how many times I’ve heard the saying “dang, if only I didn’t sell our old house on Arbitrary street… it’s worth xx% more than for what we sold it for!” Real Estate is such a valuable net worth builder as it provides long-term appreciation (growth), you’re able to use low-interest-tax-efficient loans, and it locks in housing costs on a 30 yr mortgage while rents continue to soar. Real Estate has elements of stock portfolio (growth), retirement plan (tax efficiency), and inflation protection (locking in “rent’). All wrapped in one!
This article focuses on the budgeting decisions that should be considered when purchasing your primary residence and is geared toward our readers considering their first home purchase. Though a useful read for all, we’ll discuss more investment properties of residential real estate in future articles.
The acquisition process starts by accumulating a sufficient down payment. The standard down payment has historically been 20% however, in this current rate environment a down payment of 5-10% is generally preferred. Why, isn’t debt bad? You may ask. Well if you have student debt with 5% interest and you don’t get a tax deduction, and a home mortgage with a 4.25% tax-deductible rate, you will increase your net worth fast by making extra payments on the student debt. A tax-efficient retirement plan contribution will generally outperform paying a mortgage off early too. There are many Dr.-specific loan products out there that allow you to bring less than the standard 20% down and not be penalized with Mortgage Insurance and higher rates. BofA & BBVA are two banks that have been wonderful for this.
Start saving today by setting up a fixed monthly deposit into a high yield savings account. Based on today’s rates, you can get between 2-2.5% interest at Ally, Morgan Stanley and many other online banks! Note that you will not only be striving for 5-10% of your property in savings but banks will also impose liquidity restrictions. We recommend having 6 months of rainy-day cash on hand after you make the down payment which will generally meet bank demands.
As you progress with the savings plan, you will begin to dial in a purchase budget and will need to understand the income requirements of the budget & lending. Though we recommend identifying your own budget and not letting the realtors and bankers do that for you (many people made that mistake prior to 2008) most purchases require bank funding so you first need to understand how a bank determines whether they will lend you the money.
Income requirements for lending
The bank makes the ultimate lending decision on three main factors. 1. the credit worthiness of the buyer (720+ credit score generally affords you best terms), 2. security (the property must appraise for at least the borrowed amount + down payment) and 3. income (this needs more explaining).
Lenders look at your income in a formulaic way using a debt-to-income ratio. What that means is they look at all your existing personal debts, plus the additional monthly costs of ownership (mortgage, HOA, property taxes, homeowner’s insurance), compare that to your monthly income, and express that as a percentage. A 42% debt-to-income ratio is a great rule of thumb. For example, let’s say a client reports $240k of AGI (Adjusted Gross Income) on their taxes, has $2k/ mo in student loan payments, and a $500/ mo car payment. I would predict that their monthly home ownership payments could not exceed $5,900/mo. See math below.
Existing personal debts: $2,500/mo (student loans + car payments)
Plus: monthly costs of ownership: $5,900 (P&I - $4,450; prop taxes - $1,050, insurance - $400)
Equals: total monthly debt obligations: $8,400
Compared with monthly income of: $20k
Equals debt-to-income ratio: 42%
If you understand what monthly payment will be allowable, you can dust off those algebra books, find an online mortgage calculator and calculate an estimated loan amount. In the example above, if the client were to put 10% down, I would anticipate that the bank would allow a purchase for ~$1m since a $900k loan would result in the above calculations. I use a 1.25% of property value expectation for property taxes, and a .5% allowance for insurance for San Diego but those are geographic-specific estimates. Calculating your own debt-to-income budget is super important for you to do in the budgeting process as well, although you will need to add your own personal touches and risk considerations.
Bridging from a debt-to-income calculation to determining your budget
The important factors that the debt-to-income calculation neglects are the buyer’s plans longer-term plans for the house, how that compares to their current rent, and the long-term outlook of your income and related goals. For example, though she’d likely be approved by the bank, I wouldn’t recommend a client who’s in her early 30’s, single, has student debts of $350k and currently only paying $2k/ mo in rent to purchase the above $1m hom. She should consider a smaller house which has suitable rental value, while prioritizing student debt payments and retirement savings instead. Conversely, if the individual is married in their 40’s with 3 kids, less student debt, and is currently paying $4k/ mo in rent, you’ll hear me singing a different tune. Since their family is established with a longer income track record and they can replace such a high rent mark, it makes a lot more sense for this individual.
No matter what you think your plans are, I believe everyone should feel comfortable with the thought of owning the property for at least 10 years. It’s expensive to sell and while we expect long-term growth, prices can fluctuate in the short term. For those who are more established with roots in their geographic region of their choice, who are ready for the “forever home” profile home, they can skew the budget to the higher end of the range. For those with a higher level of uncertainty, they’ll not only want to stay on the lower end of the budget, they’ll also want to do more due diligence on how that property would fare as a rental. I suggest that everyone consider the suitability of their property as a rental to some degree. A property that could also rent out for at least the cost of ownership (mortgage, taxes, insurance) would meet this definition. Think about it this way, if life events require you to move and the ebbs and flows of the real estate market present an inopportune time to sell you can sit on the property, and rent it out, for long enough for the market to rebound before you sell. For those looking at forever home profiles that don’t provide solid rental prospects, I suggest furnishing a larger down payment and keep more cash reserves on hand for protection against selling at a lost. Remember people – buy low, sell high!
Comparing the new house’s payments to your current rental is so often over-looked but I can’t stress its importance. This is key for assessing the properties inflation protection capability since I expect rents to go up by at least 3% annually in most markets while home owners lock in their mortgages for up to 30 years. Your budget should call for a mortgage (plus property taxes and insurance) that is no more than 135% of your current monthly rent. The reason why the budgeted monthly can be higher than your rent (within reason) is based on 3 main factors: principal payments on mortgage, tax deductibility of interest, and the growth of your rental expense vs. stability of mortgage payments. How can you afford an extra 35% in monthly housing costs? Remember, after you purchase, you no longer have to deposit a fixed monthly amount into your down payment savings account. After you factor in loan pay-off and tax deductions, and fixed “rent” you will come out ahead. If not today, then within a couple of years.
Hope you enjoyed this piece on budgeting for a primary residence. Next newsletter I will focus on the investment features and long-term return on investment.