Those of us who have been in the real estate industry for a long time and have seen high-appreciation cycles before remember an old aphorism: “Real estate is a game of musical chairs, but you have to buy your first chair.”
The Way it “Should” be Done
In an ideal world, a prospective homebuyer would save enough for a 20% down payment while increasing (and stabilizing) their income and polishing their credit scores. Such a buyer has nearly unlimited options for mortgages, and is sure to get an excellent deal if they shop intelligently.
In the real world, most first-time homebuyers can’t save fast enough to get to that 20% down payment. Some just don’t make enough, and some just don’t have that “saver” gene. For them, real estate prices escalate ever further beyond their reach. What can they do?
Buy and Save Now
The quick and easy answer? Buy now, or as soon as you can qualify. Some will point out that it is risky to buy with as little down as possible, and they would be right. However, there is one little-talked-about financial benefit of buying as soon as you can: it is the best forced savings plan ever.
When you buy a home you invariably will pay more for your total monthly expenses – mortgage payment, property taxes, insurance and possibly mortgage insurance and HOA dues – than you currently pay for rent. So when you decide to buy instead of rent you will now be spending and saving less than you were as a renter. Or is that actually true? Let’s look closely at this assumption.
Start Saving With Your Home Purchase
First, while most of your mortgage payment goes to paying interest on the money you’ve borrowed, a portion actually goes to principal. Why is that important? That portion of your mortgage payment which goes to principal is not an expense! Since it pays down your mortgage balance it’s actually an investment – you are investing into more equity in your home. On a typical 30-year $200,000 mortgage at 4.000% your payment (principal and interest) would be $954.83. But only $666.67 of that is interest in the first month. $288.16 is principal, and that number grows slightly every single month. You are therefore saving $288.16 (and a little more every month) in a “forced” savings account.
Your investment in your home is probably earning money through appreciation, too. Let’s say the property is appreciating by 3% per year. Not spectacular, but respectable. In our example we’re looking at a purchase price of about $210,000, so your investment would earn $6,300 the first year.
But wait – you didn’t invest $210,000. Your 5% down payment was only $10,500. Add some closing costs and maybe you’re into the property for about $15,000 in cash. Your first-year return on investment ($6,300 on a $15,000 investment) is 42%! This is called leverage. When you invest using other people’s money the return on your own money is spectacular.
So now we’re “saving” $288 or more each month, and our initial $15,000 investment is earning another $6,300 plus per year. At the end of the year you would have $20,256 in equity. ($10,500 down payment + $288 x 12 principal buy-down + $6,300 equity growth = $20,256.)
If you put $15,000 into a savings account at 3% interest and added $300 per month (to round up) every month for a year at the end of the year you would have about $9,100 in the bank. Not even close, and the difference grows over time.
Home Ownership is Saving
Home ownership is a “forced” savings account because once you own the home, you have no choice – that monthly housing cost has got to be paid no matter what, or your initial down payment and your credit are at risk. You would be surprised at how motivating that can be. Home ownership can be an outstanding way to force yourself to be more frugal in the rest of your spending so that you can save and build equity in your home.
Another great money-saving benefit of owning a home is the ability to write items off on your taxes. Homeowners get to deduct a lot of the costs associated with owning a home.
Interest, property taxes and mortgage insurance are all tax-deductible. We already know that you’ll be paying $954.83 in interest in the first month. Property taxes depend heavily on what state and even county you’re in, and mortgage insurance depends on the amount of your down payment and your credit history. Let’s assume they add up to another $400 per month (give or take). You now have about $1,350 in tax-deductible expenses every month. If you are in a marginal tax bracket of 15% (consult your tax advisor) then you are saving about $202.50 per month on your taxes. When you think about it, Uncle Sam is actually paying for a good chunk of your monthly housing payment this way.
Home Owning is Different Than Traditional Savings
The above example is overly simplified. Home ownership is a sort of forced savings but it is a savings account that you won’t be allowed to touch. For instance, your savings isn’t liquid because you can’t easily access your growing equity, and selling your property eventually will cost money. Your tax situation may make the tax benefits greater or lesser than out example. And of course, real estate doesn’t always appreciate – although lately it’s been appreciating a great deal more than our assumptions.
The bottom line is that you could stuff money into savings and investments – and there’s nothing wrong with that – or you could just go ahead, bite the bullet, buy your home now and live a little more frugally for a couple of years. You’ll not only be forcing yourself to save, but you will have invested in one of the most rewarding and secure investments there is, given enough time.
If you have a highly variable income, or if you have a spending problem or are terrible at managing debt, this strategy is probably not for you. But if you’re wondering whether to buy now or buy later, it’s worth thinking about it – now could be the perfect time.
Casey Fleming, Author
The Loan Guide: How to Get the Best Possible Mortgage (Available on Amazon).