Land vs. dwelling. As you contemplate the potential return from owning a home, it’s helpful to distinguish the dwelling from the land underneath it. You can be fairly confident the land will appreciate over time. By contrast, the dwelling itself will deteriorate, requiring regular maintenance and occasional upgrades if the property is to keep up with the broader housing market. The dwelling, however, also provides you with shelter—which is the key reason to own residential real estate.
Rent vs. imputed rent. The return from owning a home comes in two parts: price appreciation plus rent or imputed rent. Typically, the long-term price appreciation is modest. Instead, the biggest component of the return from homeownership consists of the rent you collect as a landlord or the imputed rent you enjoy if you live in the house yourself. To gauge the value of this imputed rent, consider how much you might receive each month if you rented out your home.
Winner’s curse. If you get into a bidding war for a house and emerge as the winner, you may find you suffer from the winner’s curse. This is the risk that you paid too much for the house, because you were willing to pay more than other potential buyers, who were perhaps more prudent. The winner’s curse can also afflict buyers in other situations, such as those who make the highest bid at an art auction or corporations that come out on top in a takeover battle.
Down payment. This is the sum you put down when buying a house, and it represents your initial home equity. During booming markets, it’s sometimes possible to buy a house with no money down, though typically you’ll need to put down at least 3% to 5%.
Private mortgage insurance. If you take out a mortgage to buy a home and make a down payment that’s less than 20% of the home’s purchase price, the mortgage lender will likely require you to take out private mortgage insurance, or PMI. The lender should automatically stop charging PMI once your regular mortgage payments cause the loan’s principal value to fall below 78% of your home’s original purchase price. You might ask the mortgage lender to remove the cost earlier if, say, home prices have increased substantially or you’ve made significant home improvements, and that means your home equity is now more than 20% of your home’s current value.
Closing costs. The expenses incurred when purchasing a home can include legal fees, title insurance, a home inspection and mortgage application costs. One rule of thumb puts closing costs at 2% to 5% of a home’s purchase price, but they can vary widely, depending on whether you’re taking out a mortgage, whether there are transfer taxes involved and whether, in your state, you need a lawyer to complete the closing.
Home equity. To figure out how much equity you have in your home, take your home’s current value and subtract all mortgage debt. Keep in mind that, if you sold your home, the proceeds would be somewhat less than your home equity, once you paid selling costs.
Leverage. If you have a home with a mortgage outstanding, you have a leveraged real estate bet. Suppose you own a $200,000 home with a $150,000 mortgage, so your home equity is $50,000. If your home’s value rose 10% to $220,000, your home equity would climb to $70,000, a 40% increase. Conversely, if your home’s value fell 10%, from $200,000 to $180,000, your home equity would shrink to $30,000, a 40% decrease.
Mortgage interest deduction. You can typically deduct the interest on $750,000 of mortgage debt used to buy, build or improve a first or second home. You used to be able to deduct the interest on $100,000 of home-equity borrowing used for any other purpose, but that tax break was nixed by 2017’s tax law.
Conflicts of interest. When selling your home, real estate agents have an incentive to get you a higher price. But they also have an incentive to get the deal quickly concluded. For instance, if you hold out for a higher price and it takes longer to sell your home, that may mean substantially more money for you. But for your real estate agent, it may not mean a significantly bigger commission, but it could involve substantially more work.
Capital gains exclusion. This is the amount of price appreciation that isn’t taxed when you sell a primary residence. Typically, if you have lived in a house for two out of the past five years, you can avoid capital gains taxes on $250,000 in price appreciation. This figure is increased to $500,000 if you are married filing jointly.
Previous: Retirement Income