The advantages of buying and owning a home

Over the past three months, I've written a lot about buying and owning a home. Much of what I've written could be construed as anti-homeownership. Hear are some of the articles I've published recently:

Last week, a GRS reader named Carmine left this comment:

I appreciate this and other recent posts on the perils and difficulties of home ownership, but they’re sort of piling up into a major downer as I read them!...Can’t you write something talking about the payoffs that home ownership can bring?

Challenge accepted!

I can understand how Carmine might view all of this as a downer. And I can see how anyone might think I'm anti-homeownership. But here's the thing: I'm not. After all, I own my home, and I like it.

Today, let's take a look at some of the advantages of homeownership.

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Is your home a better investment than the stock market?

I'll admit it: There are times that I think everything that needs to be said about personal finance has been said already, that all of the information is out there just waiting for people to find it. The problem is solved.

Perhaps this is technically true, but now and then -- as this morning -- I'm reminded that teaching people about money is a never-ending process. There aren't a lot of new topics to write about, that's true (this is something that even famous professional financial journalists grouse about in private), but there are tons of new people to reach, people who have never been exposed to these ideas. And, more importantly, there's a constant stream of new misinformation polluting the pool of smart advice. (Sometimes this misinformation is well-meaning; sometimes it's not.)

Here's an example. This morning, I read a piece at Slate by Felix Salmon called "The Millionaire's Mortgage". Salmon's argument is simple: "Paying off your house is saving for retirement."

Now, I don't necessarily disagree with this basic premise. I too believe that money you pay toward your mortgage principle is, in effect, money you've saved, just as if you'd put it in the bank or invested in a mutual fund. Many financial advisers say the same thing: Money you put toward debt reduction is the same as money you've invested. (Obviously, they're not exactly the same but they're close enough.)

So, yes, paying off your home is saving for retirement. Or, more precisely, it's building your net worth.

But aside from a sound basic premise, the rest of Salmon's article boils down to bullshit.

Salmon is extrapolating -- and worse

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“How much house can I afford?”

"How much house can I afford?" Answering this question correctly is one of the keys to building a happy, wealthy life. Unfortunately, there's a vast housing industry in the U.S. that's geared toward providing the wrong answer.

You see, housing is by far the largest expense in most people's budgets. According to the U.S. government's 2016 Consumer Expenditure Survey, the average American family spends $1573.83 on housing and related expenses every month. That's more than they spend on food, clothing, healthcare, and entertainment put together!

Too many folks struggling to make ends meet focus their attention on fine-tuning their budget. They try to save big bucks by clipping coupons, growing their own food, and/or making their own clothes. While there's nothing wrong with frugal habits -- I applaud everyday thriftiness! -- all of these actions combined won't (and can't) have the same impact on your budget as keeping your housing payments affordable.

Part of the problem is what I call the Real-Estate Industrial Complex, each piece of which has a vested interest in convincing consumers that bigger, more expensive homes are better. Real-estate agents, mortgage brokers, home-shopping shows, and glossy magazines all encourage folks to buy at the top end of their budget. But buying at the top end of your housing budget is dangerous.

Buying a home is a huge decision, financially and otherwise. If you're going to purchase a place, it's important to know how much house you can truly afford.

How much house can you afford?

Debt-to-Income Ratio

Economists have used decades of financial stats to create computer models to predict how much people can afford to spend on housing and debt. Banks use these models to figure out how much they think you can afford to spend on housing.

Traditionally, lenders use what's called a debt-to-income ratio (or DTI ratio) -- a measure of how much of your income goes toward debt every month -- to estimate how much you can afford to pay for a home without risk of defaulting. This might sound complicated, but it's not.

To find this ratio, divide your monthly debt payments by your gross (pre-tax) income. So, for example, if you pay $400 toward debt every month and you have an income of $4000, then your DTI ratio is 10%. If you pay $800 toward debt on a $4000 income, your DTI ratio is 20%. The lower your debt-to-income ratio, the better.

Banks and mortgage brokers look at two numbers when deciding how much to loan:

  • The front-end DTI ratio (sometimes called the housing expense ratio), which includes only your housing expenses: mortgage principle, interest, taxes, and insurance.
  • The back-end DTI ratio (also known as the total expense ratio), which include all of the above plus other debt payments like auto loans, student loans, and credit cards.

The key thing to understand about debt-to-income ratios is that they're used to estimate the lender's risk, not yours. That is, your mortgage company uses them to check whether they think you'll be able to make the payments -- not whether you can comfortably make the payments.

If you want room in your budget for fun, you should opt for a lower debt-to-income ratio than your real-estate agent and mortgage broker say you can use.

If you're a money nerd, you can read more about debt-to-income ratios at Fannie Mae's website.

How Much House Can You Afford?

During the 1970s (before credit-card debt was common), DTI wasn't split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance costs were less than 25% of your income, people assumed you could make the payment.

This is still an excellent rule of thumb: Spend no more than 25% of your budget on housing. (In fact, this is the number that money guru Dave Ramsey advocates.)

That said, debt-to-income guidelines have relaxed over the years.

  • When my ex-wife and I bought our first home in 1993, our mortgage broker told us that our front-end DTI ratio had to be 28% or lower, meaning we couldn't pay any more than 28% of our gross income toward housing. The back-end DTI ratio was capped at 36%, which meant that our housing expenses and other debt payments combined couldn't be more than 36% of our income.
  • When my ex-wife and I bought a new home in 2004, the accepted DTI ratios had grown by 5%. "That 28% figure is outdated," we were told. "Most people can go as high as 33%." The back-end ratio had been raised to 38%.
  • According to the Fannie Mae website, in 2018 maximum back-end DTI ratios are up to 45% (and sometimes even 50%). These numbers are insane. Nobody should be spending half of their gross income on debt -- not even mortgage debt! That's a recipe for financial disaster.

Here's a little table I whipped up to show what sort of housing payment you'd be looking at based on your pre-tax income (the left-hand column) and various debt-to-income ratios (the header row):

Debt to Income Ratios for various levels of income

A 5% increase in your debt-to-income ratio might not seem like a big deal. But when you're talking about a house payment, it's huge.

In 2016, the average American household earned $74,664 before taxes. Using this, a 5% change would be $3733.20 per year or $311.10 per month. Many folks lost their homes during the housing crisis because they took on mortgage payments that were just $300 more than they could afford each month.

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The proactive homeowner: How to stay on top of home improvement

Yesterday was an exciting day at the Rothwards household! After three weeks of demolition and construction, we installed our new hot tub.

It took six men an hour of maneuvering before we managed to set the spa into place...but we did it. And we didn't break anything. Now it's a matter of completing the decking and roofing, then Kim and I will be able to enjoy our remodeled outdoor oasis!

Installing our hot tub

We're eager for construction to be over. Since buying our "English cottage" last summer, we've poured tons of money and time into a variety of renovations. It's been a non-stop construction zone.

You see, during the seventeen years the previous owners lived here, they performed very little maintenance and upkeep on the home and property. When we had the place inspected before purchase, the inspector raised a lot of concerns:

Warning from inspection report

The inspection report was so dire that Kim and I almost passed on the purchase.

After we did decide to buy the place, I vowed that I'd be a proactive homeowner. Instead of allowing things to fall into a state of disrepair, I wanted to fix everything that was broken and then stay on top of home improvement in the years to come.

Today I want to share four specific actions I've taken to try to be a proactive homeowner.

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Does the American dream require a big American home?

This is a guest post from Steve Adcock, who writes at Think Save Retire, a blog about early retirement and Financial Independence. Steve and his wife retired in their mid-thirties to travel full time in an Airstream trailer. For more info, check out their YouTube channel.

One of the most deeply-embedded pieces of the “American Dream” is the desire for a large, spacious home with lots of sitting rooms, corners, nooks, and crannies. Large dining rooms and other entertainment spaces! Wrap-around porches! Two- or three-stall garages and one heck of a master suite!

To many of us, a large home is a mark of success. A big house indicate status, and the more space we’re able to call our own, the more successful we look and feel.

But, what if I told you that most of us don’t use even a fraction of that space? That’s not just me talking. A research team affiliated with the University of California studied American families and where they hung out the most inside their homes, how (and where) clutter builds, and the general stress level associated with living big.

The findings were overwhelming: The majority of the space in our homes is wasted.

How We Use Our Homes

As J.D. shared on Saturday, researchers at UCLA conducted a detailed study of 32 dual-income families living in the Los Angeles area, one of the first studies to document so vividly how we interact with the things for which we’ve paid good money. The findings were not pretty. In fact, they helped prove how little we use our big homes for things other than clutter or objects that hold little intrinsic value.

From the press release:

The researchers doggedly videotaped the activities of family members, tracked their every move with position-locating devices and documented their homes, yards and activities with reams and reams of photographs. They asked family members to narrate videotaped tours of their homes and took measurements at regular intervals of stress hormones via saliva samples.

When I originally wrote about the study, I took special note of where families spent the large majority of their time. In the following UCLA-published diagram of one family that was studied, we can easily observe a truth that’s probably common among so many of us: We tend to congregate around two primary areas of the home: food preparation/eating and television.

Time spent in the home

While this diagram only represents a single family, the results of the study suggest that this family is very typical of most of those studied, and the majority of traditional homes.

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Is it better to rent or buy? How to know when renting a home makes sense

I've been a homeowner for 24 of the last 25 years. Based on this, you might think I'm an advocate of homeownership over renting. That's not the case. The older I get, the more I appreciate there's no correct answer in the perennial "is it better to rent or buy?" debate. Sometimes buying a home makes the most sense. Sometimes renting is the smarter choice.

In an editorial in the June 2007 issue of Kiplinger's Personal Finance, Knight Kiplinger wrote, "It often costs less to rent. The annual cost of owning a property, be it a house or a condo, is usually greater than the cost of renting, after taxes." I agree.

Today, let's look at a handful of ways to evaluate the rent versus buy decision from a financial perspective.

The Price-to-Rent Ratio

One way to tell whether it's better to rent or buy is by calculating the price-to-rent ratio (or P/R ratio). This number gives you a rough idea whether homes in your area are fairly priced. Figuring a P/R ratio is simple. All you need to do is:

  1. Find two similar houses (or condos or apartments), one for sale and one for rent.
  2. Divide the sale price of the one place by the annual rent for the other. The resulting number is the P/R ratio.

For example, say you find a $200,000 house for sale in a nice neighborhood. You find a similar house on the next block for rent for $1,000 per month (which works out to $12,000 per year). Dividing $200,000 by $12,000, you get a P/R ratio of 16.7. But what does this number mean?

Writing in The New York Times, David Leonhardt says, "A rent ratio above 20 means that the monthly costs of ownership well exceed the cost of renting." That's a little opaque, I know. Leonhardt is saying that the higher the P/R ratio, the more it makes sense to rent — and the less it makes sense to buy.

The normal P/R ratio range nationwide is between 10 and 14 (meaning it would cost between $1200 and $1600 to rent a $200,000 house). During the 1990s, just before the housing bubble, the national P/R ratio was usually between 14 and 15 (about $1100 to $1200 to rent a $200,000 house). During last decade's housing bubble, national price-to-rent ratios rose to 22.73 (in 2005) then to 24.50 (in 2007) before the market collapsed. As most folks were rushing to buy homes, the numbers said they ought to be renting.

Based on this info, I'd argue that:

  • When price-to-rent ratios are under 12, it's generally better to buy than to rent.
  • When price-to-rent ratios are between 12 and 15, the financial decision is murky.
  • When price-to-rent ratios climb above 15, you're probably better off renting.

Nationwide numbers don't tell the full story, of course. While the national price-to-rent ratio might be around 20, the actual numbers in your city could be very different.

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The high cost of homeownership

This week, Kim and I hired a contractor for what we hope will be the last major project on the "country cottage" we bought last summer. We're replacing our rotting back deck and installing a hot tub. It's an expensive (and extensive) project.

Our deck project

The cost hurts all the more because we've already poured nearly $100,000 into performing needed repairs on this property. (In fact, as you may remember, we considered forgoing the deck replacement altogether.)

Budgeting for this job led me to reflect on the costs of owning a home. Like my colleague J.L. Collins (who believes a house is a terrible investment), I refuse to join to the cult of of homeownership. Yes, I own a home -- and have for 24 out of the past 25 years -- but I'm under no illusion that this is a smart financial move. Kim and I want to own an acre of land in the country, which is why we bought this place. We didn't buy it because we think it'll make us wealthy. (It seems to be having the opposite effect!)

Today, both for entertainment and catharsis, I want to spend some time talking about the high costs of homeownership. And lest you believe the stories below simply prove that I'm a fool with money, I want to point out that my experiences seem typical. Everyone I talk to about homeownership has similar tales to tell. I'll bet you do too!

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Cost of living: Why you should choose a cheap place to live

While visiting Raleigh earlier this month, I spent a morning with my pal Justin (from the excellent Root of Good blog) and his wife. As we sipped our coffee and nibbled our bagels, the conversation turned to cost of living. (Money nerds will be money nerds, after all.)

"Things are cheaper here in North Carolina than they are in Portland," I said. "Food is cheaper. Beer is cheaper. Hotel rooms are cheaper. Your homes are cheaper too. Last night, as I was walking through the neighborhood next to my hotel, I pulled up the housing prices. I was shocked at how low they are!"

"Yeah, housing costs are lower here than in many parts of the country," Justin said.

"Take our house, for instance. We bought it in 2003 for $108,000. Zillow says it's worth around $198,000 right now. But I'll bet that's a lot less than you'd pay for a similar place in Portland."

He's right. Justin and his wife own an 1800-square-foot home on 0.3 acres of land. Their place has four bedrooms and 2.5 bathrooms. There's only one place for sale in Portland right now that matches these stats and it's going for $430,000 -- more than twice the price the same home would fetch in Raleigh.

Housing prices in Raleigh, NC

Housing is by far the largest slice of the average American budget, representing one-third of typical household spending. Because of this, the best way to cut your costs (and, therefor, boost your "profit margin") is to reduce how much you spend to keep a roof over your head.

One obvious way to cut costs on housing is to choose a cheaper home or apartment. But if you truly want to slash your spending, consider moving to a new neighborhood. Or city. Or state. If you're willing to change locations, you can supercharge your purchasing power and accelerate your saving rate.

Cost of living is one of those factors that people seldom consider, but which can have a huge impact on the family budget — sometimes in unexpected ways. According to The Millionaire Next Door:

Living in less costly areas can enable you to spend less and to invest more of your income. You will pay less for your home and correspondingly less for your property taxes. Your neighbors will be less likely to drive expensive motor vehicles. You will find it easier to keep up, even ahead, of the Joneses and still accumulate wealth.

It's one thing to talk about the effects of high cost of living, but another to actually experience it.

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Great small cities for millennials (or anyone seeking affordable urban spaces)

Millennials are weird. I should know; I am one. For years, our unorthodox lifestyle choices and money habits have been confusing to our elders. And perhaps the most unprecedented millennial-ish move we've been making is the avoidance of home ownership.

With home-buying at an all-time low according to the Census Bureau, the finger is easily pointed at us as a likely cause. But instead of leveling the typical charges that we're lazy and stuck in wanderlust as the root of why we still live at home, perhaps it's because we're just trying to learn from the mistakes of the past.

Consider what we've witnessed: As millennials, we lived through the late '90s and early '00s, we've seen our parents go through tech bubbles bursting and the entire housing market crashing. We saw firsthand what can happen if you buy a home when you can't afford it or if your job just suddenly vanishes.

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11 frugal ways to prepare for an emergency

According to the U.S. government, all citizens should have enough supplies to survive for at least three days in an emergency. Depending on where you live, "emergency" could mean tornado, earthquake, blackout, flood, wildfire, hurricane, ice storm or zombie apocalypse.

How ready do you feel?

It is possible to put together an emergency kit without breaking the bank. In fact, you may already have some (or much) of what you need already.

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