New to the Rockville, MD area, we found a groomer to cut our dog Rudy (Shih Tzu). We like to cut him as short as possible or “rat” style, so he looks alike once he’s done. After a great cut, the owner/stylist and I had an interesting conversation about his house. He bought it 15 years ago for about $250,000. It is now worth $750,000. wow! That is fantastic.

hanging by a thread

My hairdresser also talked about her neighbor (let’s call him Bob) who recently bought a similar townhome next to her for $750,000. Bob was telling her that they were going to kill him with her payments. It is not surprising! Assuming a fixed rate of 6%, you would have to pay $4,500 per month (at 6%, you pay about $600 per $100,000; at 7%, you pay about $700 per $100,000, etc.).

To shell out $4,500 per month at a 30% tax rate, you must earn $77,000 to be able to afford those payments. Don’t forget to add $500 per month in property taxes, at which point you’ll need $5000 per month or $85,714 to cover the payments. Now, if you want to eat or pay for a car to get to work, you’ll have to earn a lot more.

I’m pretty sure at the time Bob wasn’t really considering other expenses or the risk of losing his job, or worse, being married to work because he can’t afford to leave. Bob was probably thinking that he would have a nice retirement at his house, eventually getting enough raises or getting a better job to make up any shortfalls.

Some people buy a house just outside their price range, hoping to survive until they can afford it or until the real estate market turns around.

We are all programmed with the same assumptions:

* A house is a great investment because it forces you to save (this is true!)

* A house is the best place to put my money (oh boy, you’re in for a surprise)

* I can always do better than renting (not always, depends on the area)

* My house will be worth more tomorrow (I hope so!)

A different way of seeing it

Consideration #1: Overextending vs. Renting: Let’s start by talking about Bob, who is now stuck with house payments that he can barely afford. Let’s compare buying it to renting a large townhouse in my area, which is 5 miles down the road in an equivalent community. Renting a comparable 3-bedroom corporate townhouse will cost $1800, no tax, no HOA fee, no insurance.

My rented townhouse $1800

Bob’s house $5000 (mortgage, taxes, ins. and HOA)

Difference $3200 per month

Let’s say I’m willing to give up the benefits of owning my own home and invest that difference every month earning 6% per year (over time), which is the average appreciation of real estate over the last century. (The stock market in contrast is around 8%).

Using my 6% savings calculator, I will have accumulated $918,118 in 15 years. My hairdresser only appreciated $500,000 in 15 years of owning her own home in the city*, but she managed to pay off her mortgage early, bringing her a total of $750,000. Keep in mind that even though she can live rent free after that, she still has $500 in property taxes per month, $100/month in insurance, and ongoing maintenance/repair.

As you can see, buying a house will not necessarily result in a better investment. In addition, you also have an asset that may take time to sell at a price that you may not get.

*Taxes will affect the bottom line but not enough, plus the last 15 years of appreciation has been the largest percentage increase in the history of modern real estate.

Consideration #2: Future Growth: In this example, I was talking about a fairly prosperous area with a nice increase in appreciation over the last 15 years. But if we take a look at Altoona, Pennsylvania, where my wife is from, there’s no industry generating growth in the area, so home prices haven’t gone up in 30 years. By contrast, my brother, who lives in the SF area, will no doubt see price escalation every year. The future growth of the area has a lot to do with the success of choosing your next home.

Consideration #3: What Prices Are Really Based On – Household Income: What most people don’t realize is that the housing bubble didn’t just burst because of excessive speculation, exotic mortgages, easy lending practices, and excess inventory. When it gets down to business, home builders have a hard time charging more than a family can afford. So if the median income of most people hasn’t risen along with house prices, what do you think will happen to house prices in the long run (especially with higher food and fuel costs)?

If you buy a house for $750,000 (or insert your own figure) like Bob in the hope that the house will double, there have to be enough people in the future making enough money to pay double or triple that cost. In contrast, the median American household income has not doubled or tripled in the last 20 years, so why should home prices continue to double in the next 20?

Consideration #4: Environmental Factors: I grew up in Florida, which is a great place except for the occasional hurricane. Unfortunately, these hurricanes have actually increased insurance rates so much that many are considering leaving. Imagine paying $150/month in premiums one year and $600/month the next. It has happened to many friends I know. With earthquakes, wildfires, hurricanes, or floods, know the potential hazards of the area you’re moving to before you move.

Consideration #5: Insurance, Taxes, HOA Fees – As you can see, increasing insurance premiums can become an additional financial burden in certain areas of the country. Or, taxes or the HOA can also become that burden, like with my hairdresser. Think of it like she paid for the massive appreciation through higher property taxes. There is always a price. These other rising costs over time can make a home difficult to afford, which is another reason if you shop to buy within your price range.

Choose the house that’s right for you, then make it a home

Be realistic about your expectations when buying a home you can comfortably afford. Also, your home should not be your only investment. By overextending yourself financially, you not only squeeze yourself today, but you also risk that your home (your only investment) will not appreciate to a value you can afford to retire.

Pay only what you can comfortably afford in today’s dollars with your current income. A general rule of thumb is to pay no more than 1/3 of your monthly income toward your mortgage. You should also look for houses that are less than 3 times your annual income, unless you have saved a substantial down payment to cover any difference. Finally, choose the house that’s right for you, and then make it a home. Fall in love with your house only after it makes financial sense.