Roshani Pandey is a financial advisor and founder of True Root Financial. True Root Financial is located in San Francisco, CA and serves clients across the globe.
If you are looking to buy a new home, you are not alone. Home sales rose in 2020 to its highest levels since the last peak in 2006. While social distancing and working from home due to the pandemic has increased the demand for homes, the ultra-low interest rate has further added fuel to the fire. If you are considering buying a home, here are 5 major areas to consider:
Understand what buying a new home means for your cashflows
Before buying a home, consider the comprehensive costs of ownership and how they may affect your overall finances.
1. Figure out all current and future costs. Here are some:
- Mortgage payment, property taxes and homeowners’ insurance
- Cost of utilities and the cost to maintain the property such as a new roof
- Commuting costs, childcare, private school (if needed)
- Will you be making changes/ improvements to the property such as renovation or additions? If so, assess those costs as well now as well as any expenses in the future
2. Determine how much you should really spend in buying a new home
Many lenders may not issue a mortgage loan if your housing costs exceed 28% of your gross pay. If you have other recurring debt payments such as car payments, student loans, etc., the overall debt payments, including the housing costs cannot exceed 36% of your gross pay. You can use the same guidelines when determining how much to spend. However, a more useful way to determine this may be to look at your overall financial goals, which brings us to point # 3 below.
3. Understand how this purchase affects your other goals
Besides buying a home, you may have several other goals that will have some financial impact. This may include goals such as putting kids through college, saving for retirement and building up an emergency fund. But, it may also include other lifestyle changes you may be foreseeing like becoming a stay-at-home parent or relocating. These goals can have a varied impact on your income and expenses. If you buy a very expensive house, you may not have enough money left for other expenses such as retirement, college tuition or unexpected medical emergencies. So, consider all the tradeoffs of each decision and prioritize accordingly.
4. Do an analysis to see if renting is cheaper than buying
Once you have all the costs of buying a home, compare that to renting and see how long you would have to stay in the home to breakeven. Generally, the longer you stay in the home, the more cost-effective it is to buy. This is because you can spread the initial costs such as the down payment, over a longer period of time. It also allows for more chance of appreciation. However, the longer you stay, it may also mean that the home may need more repairs before you can sell it.
A good rule of thumb is to buy if you plan to stay in the house for more than five years and rent if less. However, the exact number may depend largely on your geography. The more expensive of a home you buy, the longer it may take to breakeven because the initial cost of ownership will start high. This is the reason why when you buy a house in expensive areas such as San Francisco or New York, you may need to stay put in the home longer than if you buy in a less expensive city somewhere in the middle of the country.
Consider mortgage-related issues
1. Get pre-qualified with a lender
Once you decide to buy a home, finding a lender and getting a pre-qualification letter from them should be your first step. This will prepare you for the next step of looking at properties and putting any offers.
- If your monthly mortgage payment (principal & income, taxes and insurance) is 28% or more of your gross monthly income, some lenders may not lend you money
- Similarly, if you have other long-term debts and the monthly debt payments (including the future mortgage) is 36% or more of your gross monthly income, lenders may not be willing to lend
- Check your credit report for accuracy. Additionally, before making a large purchase, opening a new credit card account or closing an account, check with your lender to make sure it won’t affect your mortgage eligibility
2. If you’re a business owner or are self- employed, you may face additional hurdles
One of the reasons for the sub-prime crisis that engulfed the housing market in the 2008 financial crisis was the loose lending standards. As a result, the regulations that followed have really tightened the standards and most conventional loans have strict income guidelines that may be especially difficult for business owners:
- Most conventional loan providers will ask you to provide two years of steady income. So, even if your business may have been profitable, if it’s been operational for less than two years, loan officers may not extend a loan
- Even though you have sufficient assets to pay the loan, lenders still prefer to see an income source to pay for the loan rather than rely on the assets
- You will also need to show a year-over-year consistency of income growth
- Tax deductions may actually hurt you when applying for a mortgage. An underwriter will look at your income after business expenses have been deducted. Hence, they may see a much lower figure than what you actually make
- If your spouse or partner has stable employment and a W-2 income, it may help your case a lot
- Before applying for a mortgage loan as a business owner, get your books such as your balance sheet and income statement in order. Big fluctuations in income, income growth and credit score can adversely affect you
Assess if there are any tax planning opportunities
Making any improvements to the home
If you make any improvements to the home, make sure to track it so that when you sell the home, those expenses can be added to your cost, reducing your capital gains and hence, reducing any capital gains taxes.
Implications of the 2017 Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act doubled the standard deductions. As a result, many taxpayers no longer itemize their personal deductions. This means that a majority of taxpayers no longer benefit from any tax advantages from owning a home. The Tax Cuts and Jobs Act is set to sunset in 2025. So, the laws may change for 2026 and later.
For those that still itemize their deductions, here are some other issues to consider:
1. Will property and state income taxes exceed $10,000?
Previously, homeowners who itemized their deductions had unlimited state tax and property tax deductions. The law now limits this deduction to $10,000. If you live in a high tax state such as California, where property taxes are also high, you will really lose out on this tax deduction.
2. Will the mortgage debt exceed $750,000?
Under previous law, homeowners who itemized their returns were able to deduct interest payments on up to $1 million of mortgage debt. Under the new law, you will not be able to deduct interest on debt exceeding $750,000. This applies to property purchased after December 15, 2017. Any homes purchased prior to this date can still deduct up to $1 million of mortgage debt.
Estate planning issues
Most states require assets such as homes to go through a probate process where the court validates any Will and makes sure any creditors are paid before the asset passes over to the beneficiaries. If you have a trust, your asset bypasses the probate court and goes directly to your beneficiary.
So, to avoid the probate court, if you already have a trust in place, make sure that the trust is listed as the owner in the deed documents. If you create a trust later, you can simply make the trust the owner by changing the deed. Any title company can help you with this.
Insurance and other issues:
- Will your need for life insurance change in light of a new mortgage? If you have dependents, you may wish to update your life insurance so that they are able to pay the mortgage after your passing.
- Will you need to review your home and auto policy? There may be cost savings by bundling with one company.
- Will you need an umbrella policy or need to increase the limits if one is already owned?
- Are there any state-specific issues that should be considered? If so, some states offer state tax benefits for homeowners.
- Is this home purchase a result of an employment change? If so, you may be eligible for relocation assistance from your employer.
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