Making Your House Pay Off

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Making your House Pay Off

For Current Home Owners

For Sellers

For Buyers

Return on Remodeling Investments

A house is a tremendously important asset, but one that takes skill to manage. Whether you're a buyer, a current owner, or a prospective seller, we've got information to help you make smart decisions.

Owning a home has been a strong ingredient of the American dream for generations. Besides providing shelter, privacy, and the psychic rewards of ownership, housing is the most tax-favored and politically protected investment around. Homeowners receive tax deductions for interest on mortgage and property taxes. And, starting in 1997, sellers have been able to pocket huge gains tax-free without rolling them over in a new dwelling.

Housing isn't necessarily a high-yielding investment, even in the best of times. The Joint Center for Housing Studies, a Harvard University think-tank, in a study of thousands of home sales in four cities over an 18-year period starting in 1982, found that owners lost money on 41 percent to 56 percent of home sales, depending on the locality. That's after allowing for inflation and transaction costs. Homes whose prices hovered in the middle or top levels of their markets were more likely to lose money than lower-cost homes over the same period. That suggests that buying a modest house may be a safer long-term investment than buying a grand home in a posh neighborhood. Buyers of the least-expensive home on a posh block are more likely to come out ahead.

You can't sell a house instantly like a stock or a bond. And, however quickly you sell, you must pay heavy transaction costs, including state and local taxes, bank and legal fees, and commissions to real-estate agents, all of which may total as much as 20 percent of the house's value. When you put those facts together with current economic conditions, the outlook for housing doesn't warrant unalloyed optimism.

All that argues for more cautious management of your biggest asset.

FOR BUYERS

Owning your home, whether it's a house, condominium, or co-op, usually beats renting. Still, you have to make a careful appraisal of your own resources, the market, and what it will cost to carry a house.

Assess your circumstances. A key question: How long do you expect to keep your house? The longer you stay put, the more likely you will be to ride out any short-term dips in the real-estate market and to come out ahead of transaction costs. Buy when houses are overpriced, and you may wind up having to stay years before you come out ahead.

Match your money to your market. Your next step is to compare what you can spend with prices of homes where you plan to buy. If housing in your desired area is within reach, congratulations. If not, consider a lower-cost neighborhood. If you want to live where houses are selling fast and furious--and for thousands above asking price--then you have to decide whether to wait for prices to level off.

Finally, keep saving. You should maintain an emergency fund of three to six months' income to tide you over during a period of unemployment. Then try to put away 20 percent of your income for retirement. Just because your house is your biggest asset doesn't mean it should be your only asset.

FOR CURRENT HOMEOWNERS

If you've lived in your home for a few years, you face temptation. With interest rates at rock-bottom, you can use the equity you have built up to undertake major maintenance and remodeling projects. Before plunging in, however, you should know which improvements make sense and what your financing options are.

Improving. To hear contractors and remodelers talk, every dollar you spend on your house will pay off big-time.

But remodeling and upgrading are generally poor investments in the true sense of the word. Few projects pay for themselves. Even kitchens and bathrooms, long considered the most profitable improvements to undertake, return only 50 percent to 75 percent at sale--and only if you sell a year after the remodeling is complete. Five or 10 years later, your state-of-the-art kitchen could be a relic. (See The chart below in Remodeling: What pays most and least lists common improvements and their likely returns.)

Projects that should take priority are those that will protect your home from deterioration and damage: roof replacement, and plumbing and electrical upgrades. Although such improvements don't do much to beautify your home, they will help preserve its value.

Renovations that add square footage to your house are those most likely to add value--as long as they bring your house up to the standard of your area. Those that merely update styles may make the house sell more quickly, but only if you sell when the style is still, well, in style. Before you make changes to your home, take a hard look at houses in your neighborhood. You'll get the biggest bang for your buck by keeping up with the Joneses, not by going them one better. If houses have two baths and you have only one, adding a second will boost your home's value. The same goes for bedrooms.

Overimprovement yields diminishing returns. So don't add an in-ground swimming pool or a third story if you're the only one on the block to have one. Unless you plan to stay for many years, refrain from exotic decorating: Gold-plated faucets or a bathroom tiled in puce won't add to the value of your property. Don't undertake a big-ticket remodeling project if you plan to move within a year. You won't have time to enjoy it, and new owners will most likely want to do something different. Instead, go for maintenance and repairs, clear clutter, and paint.

Paying for improvements. Lenders allow homeowners to borrow against the cash they have in their house (the down payment and mortgage principal they have paid) as well as the presumed appreciation in value.

Three different financial instruments are available:

The second mortgage. You pay a fixed rate of interest for a set amount of money repaid over 5 to 15 years. It’s best for those who have a single project in mind.

The home-equity line of credit carries a variable interest rate and allows you to borrow up to a set amount. It’s suitable if you plan to undertake many projects over several years.

Cash-out refinancing allows you to replace your first mortgage with another, larger loan, and pocket the difference. Of course, by refinancing, you may be starting over with a new 30-year loan, which will ultimately boost your interest costs.

All forms of home-equity borrowing leach value from your house. Another drawback: more transaction costs. Second mortgages, home-equity lines of credit, and refinancing may carry fees, points, taxes, and other closing costs that total up to 10 percent of the loan.

Using your shelter as collateral is a risk you shouldn’t take lightly. Direct the money where it will do some good--value-enhancing home improvements, college tuition, and the like. Using equity to pay off credit cards lowers interest you’re paying on debts but can jeopardize your home if the spending doesn’t stop.

FOR SELLERS

If you're an empty-nester or plan to retire soon, there may never be a better time to unload that rambling three-story colonial and trade down to a smaller home. Baby boomers whose children have grown beyond school age may be able to beat the rush that real-estate experts believe will occur when their generation starts retiring en masse and moving to condos and other less labor-intensive dwellings.

Downsizing can reward you with a sizable nest egg. Thanks to a 1997 federal tax law, up to $500,000 of any gain on a house sale is tax-free for married couples ($250,000 for single filers). To pocket any part of that gain, however, you have to get the most you can out of your old house while buying one that's less expensive.

Setting the correct price is key to selling your house quickly and profitably. John Knight, associate professor of real estate at the University of the Pacific, in a study of several-thousand home sales over a two-year period in Stockton, Calif., found that houses whose prices are changed sell for less than homes with no price revisions. The longer a house sits on the market, the more it is stigmatized in the minds of buyers. Before setting a price, study newspaper and Internet listings, visit open houses, and consult several real-estate brokers for sales information on comparable properties.

Finding a lower-cost dwelling is more complicated. Even smaller houses in an area won't be a bargain if the market is strong. For savings, consider less fashionable suburbs or those whose school districts are of lower quality. Or consider moving farther from the city.

One option is to buy a vacation home that will eventually become a retirement haven. Doing so, however, may require you to carry two mortgages until you sell your primary residence; and, if you rent your second home to others, you can't deduct depreciation if you use the residence for more than two weeks a year. Properties in resort areas historically experience greater price fluctuations than do single-family houses in workaday communities. Buying such a home now, when prices are high, may be a costly mistake unless you are willing to hang onto the property for the next 10 to 20 years.

Gambling on pricey housing is daunting. Consumers who wind up spending an inordinate amount of their incomes on shelter run the risk of paying the rest of their expenses with credit cards, and sinking beneath their debts. With lenders offering ever easier terms, it's up to homeowners to protect themselves and to decide how much house they can afford, how much to spend on improvements, and how to cash out prudently.

RETURN ON REMODELING INVESTMENT

After three years, return is impossible to estimate, say our appraisers. They added other observations. On colors: stick with neutrals because they don’t date themselves. On swimming pools: in some areas, a pool can subtract from a house’s value because the homeowner is on the hook for liability insurance and maintenance. On all projects: Those that add square footage to bring a house up to--but not beyond--community norms pay off the most.

Click here for Remodeling Magazine's latest info on Cost to Value in the Austin area!

Below are Projects showing highest to lowest returns, as calculated by our appraisers.