You’ve bought your first home, and you love it! You’ve painted the walls in bright colours, planted a tree and adopted a large dog that most landlords would never allow.
Then, one day, the kitchen faucet springs a leak, and you come home to a small pond on the floor. Your first impulse may be to call the landlord, but then you remember — this is your home, and you are responsible for cleaning up the mess.
As all first-time homeowners quickly discover, the costs of owning a home go well beyond the monthly mortgage payment. Most of these costs are predictable. With research and careful planning, you can be sure to buy a home you can truly afford — even with all the extra expenses.
Relatively low mortgage rates have renewed interest in homeownership, especially among young people who are tired of seeing their rent costs rise every year and like the idea of having equity—an ownership stake—in the place where they live.
A residence can indeed be a valuable asset and a path to a greater financial future. However, novice buyers may be shocked by the bite homeownership can take out of their wallets. In addition to their mortgage payments, the true cost of owning property involves a multitude of hidden expenses. The first three hidden costs are strictly financial; the rest add to money woes the extra stress of home maintenance and repair. Let’s look at the most common and how to deal with them.
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The Case for Buying Instead of Renting
Even though it’s not a tangible benefit, a sense of ownership is one of the best aspects of purchasing a home. Namely, you’re the boss – you don’t have to answer to a landlord who won’t let you paint your walls, install a new fridge, or remodel. When you own a home, it’s yours to do with what you want.
Taxes certainly don’t represent the most exciting part of homeownership, but saving money just might. When you own a residence, the interest you pay on your mortgage is tax-deductible. You can also take a federal tax deduction for real estate taxes paid during the year.
You may also be able to take advantage of a capital gains tax exemption if your residence increases in value and you eventually sell it for again. Note that you can only claim up to a $250,000 gain for a single taxpayer, or up to $500,000 for married taxpayers filing jointly. And you must have maintained the property as your primary residence for at least two years prior to the sale.
Potential Return on Investment
Homeownership isn’t the foolproof investment strategy it used to be. Anyone who purchased a property in the early 2000s and ended up selling for a major loss – or, worse, was foreclosed upon – can attest to that.
However, the other option – spending money on rent – has no investment potential at all. Ownership, despite its risk, at least carries the possibility of return on investment.
Plenty of things can help improve your chances of reaping a return on your home purchase, including taking advantage of historically low-interest rates and buying in an up-and-coming location. Of course, one of the most important things to remember is that you’ve got to buy a house you can afford in the first place.
The “House-Poor” Trap
Are visions of granite countertops and claw-foot tubs dancing in your head? Depending on where you are in life, the ideal home’s characteristics could mean anything from excellent school districts to geographic proximity to a bar with killer happy hour specials.
Of course, big closets, hardwood floors, and garage space are all great, but they mean absolutely nothing if paying for them leaves you flat broke at the end of each month. People who are “house poor” spend a disproportionately high percentage of their incomes on the mortgage and house-related costs, leaving them with relatively little discretionary income. Imagine sitting in your gorgeous 3,000-square-foot home eating ramen noodles every night, and you’ll get the picture.
Whether you’ve watched too many “Real Housewives” episodes, or you’re simply trying to keep up with your friends, there are plenty of reasons people overreach when purchasing a home. First and foremost, there’s a common tendency to conflate buying a house with buying your dream house. The truth is, though, a home – whether it’s your first, second, or third – doesn’t have to be perfect. It just has to suit your purposes today.
Real Costs of Purchasing a Home
Many folks grossly underestimate the actual cost of purchasing a home. Here’s a list of expenses to keep in mind.
The gold standard for a down payment is 20% of the purchase price. On a $250,000 house, that means forking over $50,000 cash.
Prior to the recession, many lenders would let you get away with a much smaller amount, or allow you to rope your down payment into your monthly mortgage payments. However, today, while there are exceptions, almost all lenders require private mortgage insurance (PMI) if you’re making a down payment of less than 20% of the purchase price.
The good thing about a higher down payment is that it reduces the amount of debt you take on purchasing a home. That means less interest and a better debt-to-income ratio.
If you clear out your bank account for a whopping down payment, hold your breath – because there’s more. You’re also expected to show up at closing with an additional chunk of cash to cover certain costs payable to the lender and other parties. These “closing costs,” associated with the logistics of purchasing a house, typically include title insurance, fees for a title search, appraisal, underwriting, survey, and loan origination.
Buyers can generally expect to pay between 2% and 5% of a home’s purchase price in closing costs. For our hypothetical $250,000 house, that translates to between $5,000 and $12,500. Sometimes, buyers can negotiate for sellers to cover these costs, but it’s not something you should count on.
Unless you managed to buy your house with cash, you’ve got to contend with a mortgage payment each month – and several factors contribute to the amount.
- Principal. This is the amount of money you borrowed to finance your home. With a $250,000 house, assuming you made a $50,000 down payment, you would owe $200,000 in principal.
- Interest. Interest is essentially the fee that lenders charge in exchange for the loans they give to homeowners. Mortgage interest rates fluctuate wildly, but at the time of this writing, they were hovering around 3.7% for a conventional 30-year fixed loan, again assuming a 20% down payment.
- Property Tax. Your local government levies taxes on your property in order to cover snow ploughing, street maintenance, tree maintenance, government administration, police, fire department, and other city services. Property taxes also fund public schools, libraries, and parks. These days, lenders generally require borrowers to pay their taxes into an escrow account. Rather than forking over your whole property tax bill in bulk once per year, it’s broken down into monthly amounts that are rolled into your mortgage payment and deposited in a separate account maintained by the lender. When your property tax comes due, your lender pays it for you using those funds. Property tax is calculated as a percentage of your home’s value, and rates vary significantly by location. While 1.2% is a common estimate (when rounding up for our sample house, it equates to $3,000 per year), it’s worth noting that you could pay as little as 0.18% in Louisiana, but more than ten times that by crossing the border into neighbouring Texas.
- Insurance. Your mortgage payment may also include homeowners insurance which, like property tax payments, is deposited in an escrow account. After you take out a homeowner’s insurance policy, your lender can most likely make the payments on your behalf. Lender policies vary though, so be sure this applies to your situation. Unlike the private mortgage insurance mentioned above, homeowners’ insurance policies often cover theft, vandalism, fire, and weather damage. Floods and earthquakes tend to be excluded from standard policies. For a $250,000 house, $1,500 is a solid estimate for annual homeowners insurance.
- Private Mortgage Insurance (PMI). As mentioned previously, your bank is likely to require private mortgage insurance if you make a down payment of less than 20%. If you stop making mortgage payments or default completely, private mortgage insurance helps protect the lender by covering your obligation. PMI is often rolled into your monthly mortgage nut as well, though some lenders permit a lump sum payment. PMI costs between 0.5% and 1% of the loan amount annually.
To sum up, the following represents a monthly mortgage payment on the $250,000 sample house:
- Principal and interest: $931.31
- Property Tax: $250.00
- Property Insurance: $125.00
- Total: $1,306.91
These figures assume that you’ve made a 20% down payment. If you haven’t, PMI costs must be taken into account, which would be $1,250 to $2,500 per year in this scenario.
30 years later, after you finally pay off your $200,000 loan, here’s what you’ll have spent in total:
- Principal: $200,000
- Interest: $135,489.29
- Property Taxes: $90,000
- Insurance: $45,000
- Total: $470,489.29
Add in your $50,000 down payment and closing costs, and you’ve spent significantly more than double your home’s original purchase price – and that’s only if you managed to lock in a good interest rate.
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Costs of Owning a Home
Of course, the actual purchase is just the beginning. Owning and maintaining a home brings plenty of expenses along with it.
If you’ve ever rented, you’re likely accustomed to utility bills. However, chances are some of them were built into your monthly rent. As a homeowner, you’ve got to pay for all the following:
- Trash and recycling
- Electives such as cable and Internet
The hidden cost of owning a home
Once you have moved into a property, it isn’t just the mortgage you have to worry about paying every month. There are all those other hidden costs of owning a home, including:
- Water, gas and electricity bills can be expensive monthly costs, adding up to a few hundred pounds a month for large properties. They are pretty much impossible to avoid, although energy bills can often be reduced (see How can I reduce my water bills? and How can I cut my gas bill?)
- Council tax has to be paid by occupants of properties. It can range from a couple of hundred pounds a year for a small property in low-cost local authorities to several thousand for bigger houses inexpensive councils.
- Buildings and contents insurance can come to anywhere between a few hundred and thousands of pounds a year, depending upon what you are insuring, how much your home is worth, when it was built and from what material, the rebuilding costs, the locks on your doors, your job etc. See How should I insure my home?
- Ground rent & service charge – if you live in a leasehold property, you may have to pay an annual ground rent and service charge to the freeholder. You may also be liable for special contributions to work on common areas or the structure of the building (such as a new roof). For more information, see Leasehold v freehold – what’s the difference?
- Service charges – If you live in a serviced apartment, you may have a regular service charge to pay
- Residents’ parking – in many towns and cities, you have to pay an annual fee to be allowed to park your car in the street, and then buy permits for your visitors.
- Maintenance and building work – repairing the roof, redoing the wiring, or fixing subsidence all add major costs. If the boiler kicks in, there is a leak or the fridge packs in, and you will need to pay, see Find a tradesman.
- Television, broadband, cable and telephone add to the monthly bills see our guide to the best broadband providers.
The True Cost of Owning a Property
This is the most obvious cost that is associated with real estate investing. Therefore, if we buy a $100000 home, we think that we have invested only that amount. When people ask, “How much did you buy it for?” we give the above figure as the answer. However, as we shall discover in the course of this article, the layman’s viewpoint that $100000 is the complete cost of the property is usually incorrect.
To begin with, there are transaction costs that are associated with the purchase. The transaction costs include brokerage paid, processing fees paid to the bank to process the mortgage loan, and the legal charges collected by the government to register the property in the name of the new buyer. First-time buyers have a tendency to underestimate these expenses. However, they can quickly climb up to anywhere between 3% and 5% of the property value. Thus, even if the property’s list price is $100000, the actual price paid by the buyer will be at least $105000!
Most properties that are purchased today are purchased using borrowed money. A mortgage is a new norm! People buying properties with cash down are virtually unheard of today. However, there are mortgage payments and mortgage payments whenever there is a mortgage, including an interest component.
The amortization schedule of any mortgage is such that the banks collect all the interest first and then later collect the principal outstanding. For instance, if your monthly payment is $1000, then $900 will go towards interest itself in the first few months! In fact, during the first five years of servicing a mortgage loan, the borrowers are servicing the interest payments only! Very little principal is reduced during this period. Hence, if these expenses are capitalized, i.e. added to the value of the property, then the value of $100000 goes way above $100000.
Apart from the interest paid, which is an out of pocket expense for the buyers, there is also national interest involved in real estate investing. Most real estate investments require the buyer to put a down payment on the property. This down payment is close to 10% to 15% of the property value. Thus, for a $100000, a person has to offer an upfront payment of $15000. Now, there is an opportunity cost in making this payment. If this money was not used to make the down payment, it would earn interest in a bank or some other investment. However, once it is used to make the down payment, it earns no interest!
Therefore the amount of notional interest lost should also be added to the property value, i.e. to the $100000 that the buyer initially considered was their total investment in the property.
Most mortgage lenders require the buyer to have insurance on the property. This is because, in natural disasters like earthquakes and hurricanes, the property could be destroyed. As such, the borrower will stop making payments towards the property. Therefore, in order to protect their interests, the lenders insist on insurance.
Even apart from the insurance, which covers the house’s value, many homeowners opt for insurance for home contents as well. This is because they spend a significant amount of money doing interiors as well as the need to make sure that their investment is protected in the event of an unforeseen scenario. This too adds to the cost of property ownership.
When we buy real estate, we agree to make a stream of payments to the government every year until perpetuity! These payments are called property taxes, and almost every government in the world levies these taxes. Once again, these taxes contribute significantly to the cost of homeownership. Also, one needs to understand that these costs are often adjusted in value over time. Therefore, these costs rise with inflation, often at the same rate. Hence, while budgeting for buying property, one must take into account the costs involved.
Properties across the world now come with amenities. Gated communities with swimming pools and jogging tracks are common. The idea is to provide the people with a lifestyle and not merely with a home. However, these amenities require a lot of maintenance. Gated communities require scores of employees and equipment to guard the place and keep it clean. As such, these charges are also billed to the homebuyers as a monthly expense. This too raises the cost of investment in a property. These costs can sneak up on an unsuspecting buyer, and therefore one needs to be extremely wary of the same.
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Utilities and Furniture
There are small costs involved with getting the utilities transferred to one’s name as well as furnishing the house. These costs too add to the total cost of homeownership.
Homeownership is, therefore, a complex maze of multiple costs. One needs to be very careful in understanding and budgeting for these hidden expenses as the omission of these expenses can significantly dent your budget in the future.
The mortgage payment is only a fraction of the costs you’ll face as a new homeowner. Make sure you familiarize yourself with all possible related expenses and budget carefully before taking that big leap.