The True Cost of Homeownership

The real estate market is now on the upswing in 2013. A few of my friends have already bought homes this year. My brother is in the process of looking to buy a home as well.

The reason people are feeling confident (again) about home ownership is attributed to the performance of the stock market since the March 2009 lows. Because new homes were not built up during recession and foreclosures have worked their way out, quality homes have been on the short supply. Low inventory of homes coupled with the rising interest rates has forced the would-be homeowners to enter the market. This is an excellent news for the economy, home-builders, and existing homeowners.

I have heard arguments like home ownership is an investment because you're building an equity instead of throwing your money away on rent. So, instead of paying $1000 in rent, you're paying $1000 towards the mortgage. So, what's the harm owning a home, people say.

But, home ownership can be a good thing or a not-so-good thing depending on how you play your cards. I will point out a few of the mistakes people make when buying a home.

Buying a bigger, better, and costlier home

Everybody likes bigger and better. Initially, people start their search at reasonable amount they are willing to pay or afford. But, as the search continues, there is always a house that is slightly expensive, but is bigger and better. Sometimes, it is a brand-new house. Point is, your mortgage is now $1200 instead of $1000 you initially thought.

Getting a 30-year mortgage

In my opinion, 30-year mortgage works against the 'home ownership is an investment' argument.

Let's take a hypothetical example.

Mortgage Amount: $200,000

Loan: 30-year Fixed @ 4.5%

Monthly Principle & Interest: $1013

Total of 360 Payments: $364, 183

Total Interest Paid: $164,183

You see, a $200,000 mortgage costed about 82% more at today's low-interest rate environment. If the interest rates rise, which they are bound to rise, the costs will double. Also, this is just the interest portion. It does not include the costs like property taxes and insurance.

BUT, if you lower your mortgage time-frame to 15 years, you are saving a chunk of money.

Mortgage Amount: $200,000
Loan: 15-year Fixed @ 4.5%
Monthly Principle & Interest: $1529
Total of 360 Payments: $275,397
Total Interest Paid: $75,397

Savings over 30-year mortgage: $88,786


The savings are actually even higher because the interest on a 15-year mortgage is typically lower by a half to three-quarters of a percentage.

Not putting enough down-payment

The housing recession was a direct result of reckless lending by greedy banks to greedy homeowners who were required to little to none in down payments. Banks have learnt a hard lesson. But, schemes like FHA loans that require only 3.5% in down-payment make it too attractive to put very little down-payment. Don't get me wrong, FHA loans make it easier to afford a home people who don't have enough down-payment and would otherwise be forced to perpetually rent. It makes the American dream affordable for people. But, many people simply apply to FHA loans because they qualify instead of applying for conventional loan that requires minimum 20% as down payment on the house.

The result of not putting enough down-payment results in higher mortgage interest costs. The bigger the mortgage, the higher your monthly payments. Because, people were required to put little towards the down-payment, many people buy larger costlier house.

The true cost of home ownership

So, here is real world true cost home ownership. I bought a home in January 2007 during the pre-recession era. The house was a foreclosed and owned by the bank, but was in pristine condition. It came with new interior paint, new carpets, and new appliances. Because the recession hadn't started, as such, it commanded the market rate of houses.

Long story short, we paid $220,500 for the house. We put about $25,000 towards the down payment which comes roughly at 12%. Because, our loan-to-value ratio was at 88%, we had two choices, pay PMI (private mortgage insurance) or get a second mortgage @6.5%. We chose the latter as it costed us less than PMI. For the sake of simplicity, I will ignore the second mortgage and combine it with the first mortgage.

To give you the complete picture, this year our monthly payment is $1,700. This includes escrow payments towards homeowner's insurance ($650 yearly) as well as property taxes ($1600 yearly). We're also on a bi-weekly plan, which means we're paying one extra payment towards the year. So, instead of 12 payments, we're making 13 payments in the year.

Given the above history, here are our total cost of home ownership broken down by the year. I computed this information from the income tax returns.

Year	Mortgage Term	% APR	Mortgage Amount	Principle & Interest
2007	30-year fixed	5.75%	$195500	$1200 (PMI in the form of second mortgage)
2009	15-year fixed refinance	4.5%	$173000	$1323 (No PMI)
2011	10-year fixed refinance	3.37%	$154800	$1600 (With PMI)
2013	10-year fixed	3.37%	$154800	$1500 (No PMI after bringing LTV < 80%)

Year	Mortgage Interest	Property Taxes	Homeowners Insurance	PMI	Total
2007	11421	1803	750	0	13974
2008	10519	1803	750	0	13072
2009	10334	2031	750	0	13115
2010	5908	2031	750	0	8689
2011	7058	1673	445	212	9388
2012	4793	1670	414	511	7388

Our true total cost of home ownership in the last six years are $66,000. This is the money that is never coming back. We'll only receive our principal back if we sell our home at the same purchase price + listing agent's commission + buyer's agent's commission. As you can see, it will take a while to appreciate the house to pre-recession levels.

$66,000 over a period of 6 years translates to $11,000 per year on average and ~$900 per month. This cost will come down as we stay longer in the house and eventually pay that off. Since we're now in a 10-year mortgage, costs have come down significantly in 2012. Our goal is pay off completely in two years. So, we'll see more savings down the road.

This is possible because we chose to payoff big chunks during refinancing and we refinanced to a 10-year mortgage. But, if we had stayed with a 30-year term, our monthly payments (while lower) would have costed us more towards the interest.

Is home ownership a bad thing?

NO, it is NOT. Personally speaking, we've been much happier since owning a home. It brings a certain degree of joy and pride. It also gives a lot of things to do around the house like cleaning, mowing, and decorating. It is your own piece of dream. It also brings me happiness to see our daughter play in the yard. These intangible benefits are worth the costs.

Home ownership is also a forced form of savings. Many people aren't disciplined enough to invest their money regularly in the stock markets. So, having a home means you're forced to pay towards the mortgage. If you bought during recession at low prices, it will also pay off when the house appreciates down the road.

My advice to young buyers would that they buy within their affordability limit. Also, try putting at least 20% in down-payment if you have money saved. Try to get a 15-year mortgage to save interest costs.