Why it is so important to live in a house of our own for most of the people in the world? I spent many days trying to find an answer to this question myself. This is what was my conclusion: Living in our own house is required to satisfy our own psychological insecurities. Think about it. I also realized that many businesses have used our insecurities to sell us dreams. They spend millions of dollars every year on advertising about property for sale. Even governments are part of this. Even though if you want to live in your own house, you must follow the home buying tips used by rich people if you want to beat the system and save ton of money. In this post, I will explain you a process of buying a house to protect you from major losses, so keep reading.
Before we get into home buying tips used by millionaires, we must answer below question:
Is your House an Asset or a Liability?
Let me clear the definitions first:
An asset is an investment that generates income for you and puts money in your pocket.
A liability is an investment that takes money away from you.
Now I ask you again, is your house an asset or a liability?
As you might know that most people buy their houses with help of mortgage. For those who do not know, a mortgage is a bank loan to purchase a real estate property ( home or a commercial office or shop ). Instead of paying entire money down, you would pay mortgage payments to the bank and your bank will hold the lien on your home until entire loan amount plus interest are paid.
While your real estate broker and bank manager approving your mortgage, would tell you that you are buying an asset and it’s a great investment in home; it couldn’t be far from truth.
After making mortgage payments for many years, you would think that you are the homeowner of so-called great investment or asset. But in reality, you are not a homeowner today and will never be in real terms. Ever.
If you don’t believe it, try skipping some mortgage payments and you will see real face of banks. Even if your mortgage is fully paid, you must pay for property tax every year to government. Try skipping 1-2 years of property tax and see what happens.
Well, don’t do it if you are already in their game. Yes it’s their game and you are just playing it.
If you skip few mortgage payments then, the bank (lender) has the right to takeover your property and foreclose it. If you miss few property tax bills, then government has right to issue something called tax lien certificates to general public. Anyone from public can pay your due property taxes and own a lien on your property.
In most states, you must pay lien within 3 years with up to 18% interest otherwise, lien holder has right to call county office to initiate foreclosure process. They can own your property of 100s of thousands of dollars for the amount of 3 years of property taxes.
Yes, same property for sale for which you had paid 20% down and took 80% in mortgage for years.
Do you still Think, its Your House?
Not really, you are basically paying a living tax on the land of the country. You are NOT the homeowner. Think about it.
How can it be an asset if it’s not yours at first place, whereas others (banks and government) have right to steal it away from you anytime throughout your life or from your future generations if they miss to pay property taxes.
I think you might be interested in this, an easy way to get real estate agent’s license.
What can you do about it?
Honestly, not much rather than just minimizing the risk of foreclosure and that’s what we will discuss in this post later. Please remember that my goal is not to discourage you from buying a property for sale and being a homeowner but rather help you with a guide to buying a house so you won’t lose the game that banks and government has set up for you to lose.
Before we proceed, we need to understand the process of buying a house.
The process of buying a house or any real estate property involves a step by step approach. Next I will share a value investor’s perspective on buying a house.
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- 20 Best Ways to Make Money During the Holidays – ideas to make extra cash during holiday seasons.
Home Buying Tips used by Rich People
For most people, buying a house is the biggest purchase of their lifetime. Even if its your first home, the steps to buying your first home need not be different from the steps followed by a value investor. So, it’s really very important to understand the process of buying a house and how to get a good deal for yourself even if you are buying a home for the first time.
As in any other aspect of life, you can surely get very good deals in homes too. Before we talk about numbers, let us first understand how to find an area which is perfect for you and your family to spend large portion of their life at.
Choose State or City
I think the first thing that needs to be decided in the process of buying a house; is selection of city. It’s probably the most important decision to make before starting to look for homes as you would be spending major part of your live in this home and may be pass on your home to your next generations. So, it’s necessary that some serious thought is given to city selection.
Based on your budgets there are various good cities in US ranging from happening cities like San Francisco or Austin to really expensive ones in New York. Business insider has a list of 50 best cities to live in US; which you should checkout. Once you have decided on a city to live in; then move to next step.
Usually the properties near good school districts will be priced higher than rest. That’s actually a good news because good rating schools over the year will push demand for your property as well and hence give your better returns.
I suggest to check all schools that fall into your district and their ratings. It is also important that they had a good reputation for long time and there were no negative incidents or news regarding those schools or employees working in those schools. This will help you in two ways; first overall school rating will push demand for your home and second, if you are a parent, you would know which school is better for our kids to study in.
It is everyone’s dream to live in a peaceful & crime free environment. But in today’s time, it’s very hard to find a city or even a town where no crimes were done ever. CrimeReports publishes a report with list of various crimes in different parts of the country. You should check this report before finalizing on an area.
This information keeps changing so, I recommend to check it often until the deal is closed.
Apart from above listed 3 selection criteria; I believe there are more steps that you need to focus on during the process of buying a house or any real estate property. But above 3 are the most critical ones in my opinion.
Very Important – Next I want to bring our focus to an important part this post – How much to pay for a house or real estate? This is the key question every millionaire or even billionaires think about before putting any dime into it.
How much to pay for a house
Often when it comes to deciding how much to pay for a house, people start talking about “how much house can I afford”. I believe the real question isn’t about how much you can afford but rather how much you should pay for it. This is a very important question that you must ask as part of your process of buying a house or any property. How much you pay for a house decides whether you got a good deal or bad one. As finances are involved in this, next part of the post is very critical for making a good deal while buying a house and trying to be a homeowner.
On a quick side note, always remember that knowledge is the real wealth especially when it comes to your finances. I have talked in more detail about what successful investors know and we don’t in investments.
Before we discuss how to find the true cost of a house, let us take a look at difference between a good and bad deal.
Suppose there’s a property for sale that you love and would do anything to possess it. The only problem is that seller has priced it at $500,000 which is $50,000 higher than the amount that is true worth of this property; which is $450,000. But since you have already lost your heart to his beautiful real estate property, you want it at any cost. So, you said OK to $500,000, a $50,000 price higher than actual worth of it.
Now let’s look at what effect this had on your mortgage payments.
At average mortgage rate of 4.94% as of today, with 10% down and for 30 years, here’s what will be your total mortgage payments.
As seen, you would end up paying $95,969 extra if you decide to over pay for this property; almost double of what you had agreed to pay initially. So, it is very important to find out the true worth of the property and then pay less than that to get a good deal.
For this, we need to calculate the replacement cost which we will do in next section.
Before a value investor buys a house or any property for sale or not, for living or investing purposes, the most important thing that he must do first is to find out the replacement cost of that property.
The replacement cost is the amount of money you would need to reconstruct same property on same piece of land from scratch. As a value equity investor who seeks for intrinsic value in a company’s stock price before making a purchase, you would apply same principles in real estate purchasing. This simple question – What is the replacement cost of this property? makes you think like a value investor.
How to calculate the Replacement cost
Next obvious question is how to calculate the replacement cost of a house or property. It is easier said than done so I will try to keep it as simple as possible to grasp the idea without going into too much of details of building a house.
It consists of two parts;
- Construction Cost
- Cost of Land
Cost of Construction
As of 2018, the national average cost of building a single family house is $295,000 with 2500 sq. ft area. This cost doesn’t include the land acquisition cost which based on locality can go anywhere from couple $10,000 to over a million. For now lets first focus on construction cost only.
This construction cost of $295,000 includes mid-range materials, a normal foundation with full basement, energy-efficient doors and windows, home appliances. In other words, it’s a basic middle class single family home.
At this rate, the average cost per square feet will come around $118. It can easily double based on additional luxurious fixtures and other amenities.
This is your first check while buying a home. How much extra (dollar per sq.ft.) are you paying for your home or property over national average?
After 2008-09 housing market crash in US, most of the houses were selling much below their construction cost alone. This means that the builder or owner was selling at heavy discount to property’s replacement cost. This will be a great opportunity for any value buyer.
Cost of Land
Second major cost in construction of a home is cost of the land over which the property will be built. So, next step is to find out its value as of the day of purchase. As the price of a piece of land may vary based on million reasons, so for sake of this article, we will assume it’s $50,000 for $5000 sq. ft lot size.
Out of 5000 sq. ft lot, you will probably build only 50% and keep rest of the area as open landscape. So, if we run these numbers;
Cost of Land = $50,000
Lot Size = 5000 sqft
Per sqft cost of land = $10 per sqft
Built up area = 2500 sqft
New construction cost = $ 118 per sqft
So, Total Replacement cost = $118 * 2500 + $50,000 = 295,000 + 50,000 = $3,45,000/-
If you can get this house for less than $3,45,000/- then it might be a good deal for you.
Cost of being a Homeowner
Building a home and living in it is one part of the story. The real question is; is it worth to buy a home at certain price considering all future expenses? This is what I would like to find out next. Buying a house or any property on discount is not the end of the process of buying a house. There’s much more to it which we will cover now.
Every home need some maintenance over its lifetime. The real question is how much and how soon you would have to pay it out of your pocket after owning the property.
If it’s an existing property, then before buying it, you must get a thorough inspection done even if it’s at your own expenses. This can protect you from making a wrong deal.
Most home roofs need repair or replacement after 10 years or so. If your home is a new construction, then builder may provide some warranty for couple of initial years.
Also, you should get foundation of the home inspected. This is very important to avoid major expenses later. You should also include electrical wiring, air-conditioning, water pipes (any leakages), etc in list for inspection.
This will provide you some idea on how much and how soon you would have to pay after purchasing the property. If you find out any major expenses related to foundation, electrical or roof repair that must be done before you would spend 10 years living there; you should either skip that property or ask seller to adjust the selling price accordingly.
Most buyers fail to consider the fact that there are recurring costs associated with owning a home. These costs are often neglected in the beginning which leads to unpleasant surprises later. For instance, before buying a home, always checkout following:
- Real Estate Property Tax
- Home Insurance Cost
- Average water bill for community
- Average electricity bill for community
- Landscape maintenance
- Any membership fee that residents must need to pay
The water and electricity bills do vary from locality to locality. So, make sure you are not buying into a community with these bills on higher end.
Also, HOA was one of the prime reason for me to reject many good-looking deals. I had been offered very interesting deals to buy a property in good community for reasonable price. Overall the deals was packaged to be very attractive and if you are amateur home buyer, you would most likely fall for them. Only upon further digging I found out that HOA alone was close to 40-50% of overall mortgage and insurance cost. In some situations, I was offered good homes for as little as $180,000 but what broker didn’t want to talk about was HOA cost associated with them. Later I found some had over $600 monthly HOA compulsory payments. Isn’t it insane?
I highly recommend not to go for them as you won’t be able to control HOA cost later and it will be difficult to find future buyers for your property. I believe that’s why those homes were offered slightly lower than their market values. They were what we call – value traps. A sweet looking deal which is too good to be true.
Cost of Mortgage
This is possibly the most evil cost of all. I call it evil because if you just miss to make few mortgage payments on time; you might lose your home.
Look at the below chart showing same house bought at same price of $300,000 but financed at different mortgage rates. You might be paying much more for same house than your neighbor. This is something to keep in mind.
Going back to our discussion on; is your house an asset or liability? Well, in my opinion it can be either one of those depending upon how you deal with it. Let me explain it. You cannot get rid of property taxes that are owing to government every year but you can beat the banker easily by removing mortgage payments from your process of buying a house. In other words, buy a house with cash money rather than taking a loan to finance it through a bank.
I know it is easier said than done but remember there are two enemies in this game that you need to win over:
First one is; the banker who has right to foreclose your real estate property if mortgage payments are missed (even if its’ the last mortgage payment that was missed).
Second is; the government who has right to sell your property to anyone just for few years worth of property taxes due on your real estate.
By taking one of them out of the equation, will improve your chances of winning this game greatly. Remember lobby of bankers have worked with government very closely to set this game against you. So, you need to be very careful at each step while dealing with them.
If you haven’t checked below articles yet, then I suggest you to read following posts on increasing your savings and chances of being millionaire and accumulate enough savings to buy your home or real estate in cash.
- How to become a Millionaire when in your 20s – a must read for anyone in early twenties.
- How to become rich when you are in your 30s – great information on how to be rich when starting in 30s.
- How to Get Rich Doing Nothing – this post provide insight into getting rich process and proves how easy it is to get rich.
How much should you spend on a house?
If you have reached this point then you really want to buy a house and want to know how to protect yourself. Kudos to you !!!
In order to answer how much should you spend on a house, we will do an exercise of comparing a homeowner vs a home renter.
Lets say you are currently renting an apartment and would like to move to your own home. So, here are your expenses as a home renter:
So, as a home renter, your living expenses will be around = $ 1310 per month or $15,720 a year.
Now lets compare this to buying a house for $400,000 (net).
As a homeowner, your monthly living expenses will be $2794 or $33,528 a year.
This proves it again that mortgage payments are evil. You are paying $1,484 a month and a whopping $17,808 extra a year for living in your OWN home. Does it make sense to pay so much for our psychological emotional bias? I don’t think so and I think you also know by now that although you call yourself a homeowner for your real estate property but in fact you are just paying a rent to your banker or government or both for living in it instead of paying rent to a landlord.
What can be done
In process of buying a house, we discussed about replacement cost before. This is the time to use that knowledge to turn odds in our favor.
Apply Replacement Cost Knowledge
After you liked a property, find out its replacement cost (using formula discussed above).
Then if the real estate property for sale is below the replacement cost that you calculated, its great. If not, then you must negotiate to get it below the replacement cost or ready to skip. There’s no sense in over paying for anything.
In fact, if the seller is already asking for a price lower than your replacement cost for his real estate, even then a bit of negotiation is suggested. More discount that you can get; better it is, right? It’s no rocket science to understand.
Lets say, you managed to get a deal on your $400,000 property for $315,000 (which had replacement cost of $355,000 per your calculation). So, you are getting a discount of 11% to replacement cost.
This 11% discount will reduce your monthly mortgage payments by over $300 a month. If you invest that amount every month for next 30 years (tenure of your mortgage payments), then you would still make more than the price of home that you bought.
You would wonder why someone sell a real estate property for less than replacement cost? Well, many people across the world did during 2008-09 real estate market crash. I am not saying it will happen again, but there are still many sellers who keep switching homes for various reasons. If you look for, you will find good deals for sure. Even if you don’t today, then there’s no reason to over pay just to satisfy your emotional biases. Just hold onto your cash for right moment to get into the real estate market when odds are in your favor.
Keep your Ticket Size Small
Although the example here is intentionally kept under budget of a middle class family, but same calculations can be used for larger purchases.
Another thing that I want to suggest is to buy a decent home for far less amount than you can actually afford. For instance instead of buying $400,000 home, go for something under $200,000 or less and get a good deal over its replacement cost.
This will save you tons of money and still beat bank and government in their game to great extent.
Let me show you how much money you can save & make by buying a property well below your budget.
For illustration purposes, say you bought a decent house for $125,000 with 90% mortgage. Here’s how your monthly expenses will look like:
Now this is even less than your expenses while living as a renter ($1310). So, this is your threshold to maintain same expenses as homeowner as were when you are living on rent. Notice that you can also get to these living expenses by buying a house for $125,000 at first place without any discounts. But exchanging one dollar bill for $1 isn’t fun, right? So, always look for discounts to replacement cost in real estate property deals.
Although you moved to your own home now for $1200 per month but still this isn’t great.
Because your still have $112,500 mortgage on your head which you have to pay in next 30 years. After 30 years, you will end up paying $215,930 in total. Of course, you can say your home will be worth more than $215,930 in 30 years, but it’s not guaranteed, right? Remember 2008-09 housing market bubble?
Now lets consider another situation, suppose you have $125,000 of cash in hand today saved from techniques such as mentioned in How to Get Rich Doing Nothing.
What if you use this cash to buy real estate property for sale today? Lets do calculation in this case:
As you see your living expenses as a renter were $1310 a month which have reduced to $775 a month after buying a home in cash. It saves you $535 a month and $6,420 a year.
There’s a different way to look at this $6,420 savings. This is a tax-free return on your initial investment. Why tax-free? Because you are getting this saving out of your earlier expenses and going directly in your bank account. It comes out to be 5.1% a year rate of return on your initial investment of $125,000. If you are in US, this is far greater return than CDs are offering today.
You can further boost your return percentage by considering the areas where real estate property taxes are lower. As you can see we added $200 per month as property tax which is actually on higher side. You can get decent places to live in at half that price. But again, property taxes fluctuates too. Anyways, if you can get a decent place where taxes are around $100-150 a month, then you can add another $500 – 1000+ per year to your indirect savings, which will boost your tax-free return.
Can’t skip mortgage, then do this
If you have to take mortgage and can’t pay in full, then you would have to pay some interest over the tenure of your loan.
An important thing to note here is that from your first mortgage payment, bank will take up to 98-99% of that month’s amount as its interest payment. So only about 2% of first month amount goes against the principle of loan. In other words, on a 30 years mortgage plan, you would pay 90% of total interest cost within first 10-13 years. What this means is that after 13 years, if you ask bank to give you balance mortgage amount that is pending at the time, you would be surprised to see that over 90% of principle amount still pending.
This is because banks and government have worked over the years to set the rules of game in their favor. You are most certainly to lose if you go for 30 years payments. Here’s what you should do:
- Get 15 year loan – If you can get 15 years loan instead of 30 years. This will increase your monthly mortgage amount but you will save a lot on interest cost.
- One Extra payment – Make one extra payment towards your mortgage in middle of the year. Why middle of the year? Because there’s festive season in USA in november and december months and most people have little money saved after gifts and celebrations.
- Bi-weekly payments – Instead of paying one mortgage payment of say $1000 every month. Pay $500 every two weeks. Here’s a a quick calculation on savings:
On a $250,000 mortgage at 8% for 30 years, you will save about $115k in interest cost and pay off entire mortgage in 23 years instead of 30 years while still paying the same amount monthly. Banks know this is not in their favor, so they will make it very hard for you to get this setup. They will ask for additional fees to set up bi-weekly payments instead of monthly. I think it will still save you over $100k even after paying their fees. So, get list of charges from your bank and find out how much you would pay in fees.
Next let’s discuss about opportunity cost in case entire payment was made without a mortgage.
Someone might argue that instead of buying a house for with all your savings, would it not be better to keep living on rent and invest entire $125,000 to generate even higher returns. Again, we will look at numbers to answer it:
The safest option for you in this case will be investing in CDs which offer about 2.75% rate of return as of today. So, with $125,000, you would be able to generate $3,438 (pretax) every year. You can of course re-invest this amount after paying tax and grow your principal amount from $125k. But it will still be lower than 5.1% that you are getting tax-free in case of buying a house with $125,000 down.
You can also invest $125,000 in other high interest yielding investments such as mutual funds (index fund would be a better option) or direct equity investment. It can grow to really big gains if held for long-term. But again, any returns from this will be taxable.
Moreover, do not forget that you are still paying $1310 or more out of your pocket every month towards living cost. Buying a house all down will also lock in your living cost unlike living on rental which increase 5-10% yearly anyway. So, your living cost will keep increasing with rentals while your home will appreciate in value over time and keep your costs almost fixed for years.
In fact any money saved after buying real estate property should be invested. Here’s one example of making millions by saving just residual savings (indirect savings ) in an index fund.
Historically low-cost index funds have yielded 9% returns in last 20-30 years and outperformed market. Just by investing $535 (that you saved by moving from rental home to your own home bought with 100% down payment), in an index fund would yield over $1 million.
This looks Great, should I buy a house tomorrow?
Well No. A big NO. You can obviously buy a house today which is selling at $125,000 but that won’t be a sweet deal. You can still save on rent as explained above but the price you have paid for the house is very much bloated and the only direction it will head in future; is downwards. You need to consider replacement value of the asset before buying any. Remember buying dollar bills for 50 cents is what we are looking for.
You can buy a home during real estate downturn when homes are priced far below their replacement cost (around 40% mark down), then re-invest your residual savings into equity or secured deposits for next 30 years. Your final returns on initial investment will be far more than price of house that you paid.
I hope you like this post – the right process of buying a house followed by value investors. Have you bought a real estate property on sale? How much did you save? Let us know your story in comments below.
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