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Making your house pay off ...
You can't lose betting on the house. That's the mantra prompting millions of Americans to spend whatever it takes to get into their first house, to move up to a better one, to buy a vacation home or rental property, or to pack the home they already own with lavish improvements--including $33,000 spa bathrooms, $15,000 multilevel decks, and $50,000 professional kitchens that would impress Emeril Lagasse. Real-estate investment clubs are even enjoying a kind of vogue.
And why not? While the Standard & Poor's 500 Index dropped 18 percent over the last year, housing prices have risen nearly 7 percent. In some areas, prices of existing homes have soared--up 14 percent in Fort Lauderdale, 21 percent in San Diego, and 30 percent in parts of New York's Long Island, rewarding sellers with windfalls that dwarf other assets.
For those who haven't sold, the sharp rise in home equity--up $80 billion in the first quarter of 2005 from about $7 trillion last year--has supported widespread use of home-equity lending to finance family expenses including college tuition, debt reduction, cars, and vacations.
Whether it's increased spending on homes or increased borrowing against them, the rationale is the same: With prices rising, there's no way you can lose.
But you can lose--and lose big. Many economists and real-estate analysts say that right now bubbles exist in dozens of housing markets across the country, which means if people's incomes can't keep up with the extravagant prices they are being asked to pay, then prices will begin to slacken. Sales of expensive houses are already starting to slow in parts of San Francisco and Westchester County, north of New York City. Ian Morris, chief U.S. economist for HSBC, a large international bank, points out that the price-income ratio, a barometer of value similar to the price-earnings ratio used by stock analysts, hasn't been this high since 1989, when house prices began to collapse. "In the short term, real estate is riskier than it has been in a decade," Morris adds.
The media, not to mention your neighbors, have exulted that real estate has remained strong even as the stock market has tanked. But, historical data from global economies, including Japan and the United Kingdom, show that housing prices usually don't decline until a year or two after a stock-market slide. If that's true, residential real estate in many U.S. cities could be on the verge.
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.
We'll identify areas of the country where real-estate bubbles have formed and explain how to figure out whether prices in your locality are poised to deflate. We'll help you decide whether you should buy now or wait; we'll also tell you how you can protect yourself if you choose to go ahead. While home improvements should be done to address your personal housing needs, certain projects do allow you to recoup some of your costs. In this report, we'll list common improvements and show how much of their cost can be recovered--and how to use home equity to finance them. We'll also explain how homeowners can reap the most when they sell. Finally, we'll explore the increasingly critical role of the appraiser in the housing market and explain why greater consumer protections may be needed.
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.
And, there have been plenty of profits to pocket. Since 1968, the single-family house has risen in value by 6.3 percent a year. But, in today's razzle-dazzle housing market, people forget that houses can also fall in value. In the late 1980s, for example, house prices throughout Texas and Oklahoma were devastated by the oil industry's collapse. Job losses in the downsizing aerospace industry and in the military led to a slump in California housing a few years later.
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. Unemployment nationally was 5.7 percent at press time, and a higher rate in your city could lower demand and prices. And, while interest rates are low, easy lending practices have extended mortgages to people who are already stretched. As a result, foreclosures leapt 8.1 percent to a record level this year, according to the Mortgage Bankers Association. More foreclosures could lead lenders to tighten the supply of mortgage money for all borrowers.
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.
You also have to calculate how much of your income you can afford to spend on housing. In recent years, lenders have allowed homeowners to pay as much as 40 percent of their total incomes on principal, interest, taxes, and insurance, or PITI, as the four are called. Because most mortgage lenders now off-load their loans into Wall Street mortgage-security pools, they will allow homeowners to carry much higher debt loads than they used to.
But stretching can be nerve-wracking. The only way Chrystle Fiedler, 44, a freelance writer with an unpredictable income, could afford the $123,000 two-bedroom cottage in Greenport, N.Y., she bought two years ago, was to take out an 8.65 percent variable-rate mortgage. Some months, her $1,000 house payment came to half her income. "It was scary, but I knew I could do it," she says. Fiedler is managing, but only because falling interest rates are allowing her to refinance with a 6.5 percent fixed-rate mortgage, a saving of about $200 a month.
You can't always count on interest rates going your way, however. That's why you should resist encouragement from real-estate agents and bank-loan officers to spend every penny, and instead hew to old-fashioned debt-to-income ratios, which allow only 28 percent to 31 percent of gross income for PITI. To find out how much you can afford, try the calculators on Fannie Mae's web site
www.fanniemae.com. Making a hefty down payment--the standard is 20 percent of the purchase price--will make your mortgage payment more affordable and allow you to avoid private mortgage insurance, which can add $50 to $80 a month to the mortgage for a $150,000 home. You should also total your other debts. To be safe, says John Henry Low, a Pine Plains, N.Y., financial planner, your total debt payments should not exceed 36 percent of your gross income. Until your debts fall within the guideline, you should not launch into a house purchase.
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.
Rapid price appreciation can't go on indefinitely. David Lereah, chief economist for the National Association of Realtors, expects price increases to return to normal next year--the rate of inflation, plus 1 percent to 2 percent.
There are signs to help you know when a market is ready to come down. Sales of pricier houses slow, a trend you can usually spot by closely tracking listings in your local newspaper. A growing unemployment rate in your area is another harbinger. Ingo Winzer, a real-estate analyst and president of Local Market Monitor, in Wellesley, Mass., identified cities where housing prices are overheated and due for a chill. (See "Where the bubbles are,"
in Consumer Reports magazine.) To determine which are overpriced, he compared median incomes to house prices, taking into account the portion of income that families in an area typically spend on housing. The same income buys much more in some areas than others.
You still may want to buy even if you are in an overheated market. If you do, insist on all customary legal protections, including contingencies in your contract for a title search, a mortgage commitment, and an inspection. An inspection generally costs $250 to $400 and will give you a reading on what needs repair. Look for inspectors who are registered with the American Society of Home Inspectors (www.ashi.com). They must have 250 home inspections under their belts before joining. Don't accept a recommendation from your real-estate agent, whose eagerness for a sale might compromise objectivity.
The bank will have your house appraised. In recent years, however, appraisers have come under pressure from lenders, developers, and real-estate brokers to inflate values, sometimes leaving homeowners with property that isn't worth as much as the mortgage. (See The appraisal
catch in Consumer Reports magazine.) To protect yourself, particularly if you're in a fast-moving market, hire an independent appraiser to determine whether the house is worth the price. Appraisers charge $225 to $500, depending on the complexity of the job. You can find one in your ZIP code by visiting the web site of the Appraisal Institute (www.appraisalinstitute.org).
Keeping spending in check. Credit counselors say that new homeowners often get into financial trouble by spending too much after they move in. The typical buyer of a new house lays out $9,000 for furnishings and improvements in the first year, according to Harvard’s Joint Center for Housing Studies.
Often the new spending goes on top of other debts. In 1998, Tammy Hitchcock, 33, an Atlanta hospital administrative assistant, bought a $50,000 condominium whose $473 monthly mortgage and carrying charges she could easily meet. She already had about $12,000 in credit-card debt and student loans, but she piled on another $5,000 for bedroom and dining room furniture. Now on a repayment plan with Consumer Credit Counseling Service of Atlanta, Hitchcock advises first-time buyers like herself to pay off debts before buying a house and to take on one project at a time. "I don't like walking into my dining room and not having wallpaper, but I'd rather take my time redoing it than have it on my credit card," she says.
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. Even sales clerks seem hip to that idea. Low, the financial planner, recalled a sales assistant at a local hardware store telling him that although $35 seemed high for a switchplate (usually a 59-cent item), he should consider it "an investment in your house!"
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.)
Nonetheless, many homeowners have bought into the belief that their improvements will pay off. "It will definitely make our house more valuable," says Bruce Bowman, a Carmel, Ind., lawyer, referring to the $60,000 new kitchen he and his wife Mindy, a homemaker, plan to install in their house, now worth about $285,000. The couple has borrowed about $50,000, removing all but 20 percent of their equity, but figure that remodeling is cheaper than moving to a new house. Even if they sell within a year, however, they're not likely to recover more than $30,000 to $45,000.
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, recently around 7 percent, 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, about 4.5 percent, 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. Partly as a result, homeowners had only about 55 percent equity in their houses in 2000 vs. 67 percent 30 years earlier. 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.
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