Primary homes, are a popular point of contention within the personal finance community. Should you buy your home as an investments (per the recommendation of Mrs. Frugalwoods), should you buy a home in a low cost area to avoid high rents (per the recommendation of Mr. Root Of Good), should you avoid home purchases except if you are rich (per the recommendation of JL Collins), should you only buy homes that enable a great lifestyles (per the recommendation of Mr. Money Mustache), or should you buy a junker and fix it up (per the recommendation of Mr. 1500)?
Having sold one house (condo), and bought two in the past three years, I feel like I have a tiny shred of wisdom to add to this much debated topic. These are the four rules that Rob and I went over when we bought our most recent house.
Pretend its a rental property
When you're buying a house, you should not just buy a house because it will eventually lead to wealth, or you feel like you're throwing away money by renting. Instead, you should buy with a keen eye towards immediate ROI. To be sure you're getting a reasonable ROI, you should shop for your primary house as if you are shopping for a rental property.
You should, generally speaking, only buy a house where you would prefer, from a financial perspective, to be the landlord than the renter. To make this judgement call, you need to understand two numbers: monthly cash flow and cash on cash ROI.
Monthly cash flow is the expected rent less known expenses. Expect ed rent is how much is a house like the one you're considering buying could be rented for in a similar neighborhood (check Zillow, Postlets, and Craigslist). Depending on the general rental/ownership landscape of the particular neighborhood you are considering, it might be tough to find decent numbers, but do your best to come up with a reasonable number.
Known expenses are mortgages, taxes, insurance, association dues, maintenance (estimate at about 5%-10% of rent), capital expenditures (estimate at about 5%-10% of rent) and vacancy (about 1/12 of rent).
After taking rent and subtracting your known expenses, are you still coming up with a positive number? If you're not, you probably want to pass on that house.
Cash on Cash ROI is your Annual Cash flow (multiply your monthly cash flow by 12) divided by how much cash you had to put down.
To better illustrate this, I'm going to show my current single family home, and our numbers:
Expected Rent: $950/month (this is what our house was rented for when we bought it)
Capital Investment: $100
Monthly Cashflow: $515
Down Payment $65,000 (no mortgage)
Cash on Cash ROI= (595*12)/65000= 9.5%
As a landlord, I would feel pretty happy with a 9.5% cash on cash return based on fairly conservative numbers, and I would be happy with a $515 cash flow. To be honest, since you're considering a primary house and not an actual rental property, I would be content with a positive cash flow (above zero dollars) even if the ROI is low.
Understand if your repairs will pay off
A lot of people will choose to buy rather junky houses and fix them to their liking because they believe that this will yield an excellent financial benefit when they sell (with the added benefit of a nicer house in the meantime). Some people (flippers) have a great deal of success with this strategy, but I would add a few cautions. Spending on home improvement won't tend to yield high returns in lower middle income neighborhoods- it is simply too easy to overbuild the neighborhood.
In order to figure out if your repairs are likely to pay off, its important to learn two numbers. The first is an estimate of the cost of the repairs, and the second is the market cap for your house.
Generally speaking, if you're buying with the intent to do extensive repairs (more than paint and flooring), you are likely to be taking your house from one of the nastiest houses on the block to one of the nicest. Do you have a good idea of how much those repairs are going to cost? If you're not an expert in that field (and even if you are) it's worth it to consider calling a contractor for an estimate. We plan to put in $15000 in maintenance and improvements over the next year or two (if we do our bathrooms), after putting in $10K already.
We like our house a lot more, but with the prices I've mentioned, we don't expect to see a huge financial payoff. We've seen "nicer" houses in our neighborhood sell for around $100K, so if our house is "nice" we can really only expect $90-$100K if we sell in the next two years.
Honestly, that's a pretty bad ROI (maybe even negative), which is why we are constantly back and forth about the bathrooms. Everything else will have a great ROI, but in our case, the bathrooms are bound to be a lot of work, so the juice might not be worth the squeeze. On the other hand, if we were going to stick around for 15 more years, we would have them done without hesitation.
Follow conservative rules of thumb
In general, you shouldn't buy a primary home unless you can put 20% down, and if the mortgage payment (principle+interest+taxes+insurance) is less than 30% of your take home pay. Don't buy a house that you will struggle to afford on a single income if you are a dual income couple who hopes to have kids, and don't buy a house before you've gotten a nice emergency fund and a reasonable start on retirement savings.
It takes a while to get used to home ownership, and there are usually several thousand dollars worth of expenses when you first move in, that's just how it goes. The first year of home ownership sees a lot of people sinking into debt as they try to suddenly get used to the American dream. If you follow all the conservative rules, even if you've completely ignored my advice you probably end up just fine in the long run.
Only buy in locations you love
I'm not going to tell you what you should or should not love in a neighborhood. Some suggest it should be close to work, some suggest excellent schools. Maybe you would like fun neighbors, or proximity to gym and favorite grocery store. Maybe you just want a quiet neighborhood with big trees, or maybe you want to live in a gated community. I'm not going to tell you what you should love, but I will tell you if you don't like your neighborhood, you shouldn't buy a house there. If you've got money to spend, you can always upgrade your house, but your pretty well stuck in the neighborhood unless you sell or decide to rent your place out.
Ideally, you would be able to design a reasonable life without venturing too far from your humble abode. I can't say that your location will be perfect through all stages of your life, but if your house is nearby most of your favorite haunts, then you have a very good thing going.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.