Although there are many ways to assess the impact of homeownership costs, one of the most intuitive approaches is to determine the homeowner's break-even rate. For the purposes of this article, the break-even rate will represent how much the purchase price of a new home will need to appreciate on an annual basis in order to cover the costs of owning the home. In this article, we'll show you how to use a practical methodology to assess the impact of your homeownership costs.
To illustrate this methodology, the following homeowner assumptions are made:
- The homeowner is single.
- The homeowner is in the 28% federal income tax bracket.
- The homeowner purchases a new home for $225,000.
- The homeowner makes a 5% down payment and obtains a fixed rate loan at 6.25%.
- The homeowner will live in the home for seven years.
The homeowner assumptions used in the illustration play a critical role in the valuation process. Therefore, if a homeowner chooses to use this methodology, he or she must adjust these assumptions in order to reflect his or her unique circumstances and expenditures. In any event, if this methodology is followed and the proper adjustments are made, homeowners should be able to determine the rate at which their homes will need to appreciate each year in order to cover the costs of owning their homes.
Costs of Homeownership
To begin this process, it is important to be aware of the primary expenditures that affect the value of a home. For the typical homeowner, these costs include:
- Home maintenance
- Natural disaster insurance
- Private mortgage insurance
- Brokerage fees
- Closing costs
- Property taxes
- Mortgage interest.
To determine how these costs affect the value of a home, we need to express each cost as a percentage of the home's purchase price. By evaluating the expenses in this manner, we can determine how much the home will need to appreciate each year in order to offset these expenditures. (To learn more, see Downsize Your Home To Downsize Expenses and Mortgages: How Much Can You Afford?)
Let's take a look at the end result (in Figure 1 below) and then work our way through each expense one by one.
|Source: Troy Adkins|
1. Home Maintenance Costs
Home maintenance expenditures include cash outlays for services such as appliance repair, pest control, house cleaning, chimney cleaning, gutter and downspout cleaning, landscaping, lawn maintenance and home security. (To save money on home expenses, see Fifteen Insurance Policies You Don't Need, Extended Warranties: Should You Take The Bait? and Five Money-Saving Shopping Tips.)
Tip: Although these costs can be minimized by purchasing a new home, many experts recommend budgeting 1% of the home purchase price every year in order to cover the costs of these expenditures.
2. Property Insurance
Insurance premiums for coverage against certain natural disasters such as fire, flood, tornadoes, earthquakes, or hurricanes may cost 0.55% of the home purchase price. Therefore, the home would need to appreciate in value by this amount each year in order to offset this expenditure. Now, clearly the costs for natural disaster insurance will vary significantly based on the geographic area in which the home is located. However, regardless of the locale, the mechanics of this concept can be tailored by the reader in order to determine his or her break-even rate. (Read more on this subject in Insurance Tips For Homeowners.)
3. Private Mortgage Insurance
Private mortgage insurance (PMI) is charged to homeowners that fail to put down at least 20% of their home purchase price as collateral for a loan. Homeowners are charged this amount each year to help protect the lender against default. In Figure 1, we have assumed that the homeowner will make a 5% down payment and that PMI insurance will cost 0.5% of the home purchase price. As such, PMI expense will directly increase the required annual home appreciation rate by this amount. (To learn more about PMI, see Six Reasons To Avoid Private Mortgage Insurance.)
4. Brokerage Costs
Brokerage costs are typically paid by the homeowner to a real estate agent for help with selling the home. In this analysis, we assumed that the homeowners will pay the real estate agent a 6% commission. However, because transaction costs are a one-time expenditure and we are trying to determine how much the home will need to appreciate each year in order to offset this cost, we need to spread the brokerage commission over the estimated length of time the home is expected to be owned. For this analysis, we use an industry accepted standard of seven years. By spreading the brokerage cost over this period of time, we determined that a home must appreciate in value each year by 0.86% in order to offset the cost of this expenditure.
5. Closing Costs
Closing costs are another expenditure that needs to be factored into our model. However, closing costs are more difficult to equate with the home purchase price, because these costs tend to be more closely tied to other factors. For this illustration, we assumed that the homeowner will pay a fee of $3,000 at the time the home is purchased. Therefore, assuming that the purchase price of the home is $225,000, closing costs would translate into an expenditure of 1.3%.
Closing costs are a one-time expenditure, but they should be allocated over the length of time the home is owned for the purposes of this exercise. As previously explained, we are making this adjustment because we are trying to determine how much the home will need to appreciate each year in order to cover this one-time cost. Following the seven-year home ownership assumption used in this analysis, closing costs would increase the annual break-even rate by 0.19%. We realize that closing costs depend on the institution that provides the loan. Therefore, the impact of this expenditure must be tailored by the homeowner in order to accurately determine its impact on his or her own break-even rate.
6. Property Taxes
In 2007, the median property tax rate in the U.S. was approximately 0.93% of the home purchase price. Therefore, a home would need to appreciate by 0.93% in order to offset this expenditure. However, the current provisions set forth in the U.S. income tax code allow property tax payments to be deductible for the purpose of calculating taxable income. Therefore, assuming that the homeowner is in the 28% federal income tax bracket, and that the purchase price of the home is $225,000, the tax deduction benefit associated with property tax payments would reduce the required home appreciation rate by 0.26%.
This property tax deduction factor is determined by multiplying the property tax rate and the amount paid for the home by the homeowner's federal income tax rate, and then dividing the result by the purchase price of the home. Again, to apply this methodology, the impact of the property tax factor will have to be adjusted in order to reflect the individual homeowner's federal income tax rate. (To learn more about property taxes, see Five Tricks For Lowering Your Property Tax.)
7. Interest Expense
We are assuming a fixed rate on a mortgage loan is 6.25% and that 95% of the home will be purchased with debt capital (with a 5% down payment). As a result, the impact of the equity made through the down payment will reduce the interest expense from 6.25% to 5.94%; as only 95% of the $225,000 home is being charged the 6.25% interest.
Like property taxes, mortgage loan interest is also a qualified tax deduction. The homeowner should pay around $13,359 in interest in the first year and, assuming the homeowner is in a 28% income-tax bracket, the interest tax shield would be $3,741. This amount is calculated by multiplying the amount of interest expense the homeowner will pay in the first year by the homeowner's income tax rate.
However, because non-homeowners are entitled to a standard deduction when completing federal income taxes, the benefit of owning a home should only include the portion of the income tax shield that is above the eligible federal deduction amounts granted to non-homeowners. For this illustration, we have assumed that the homeowner is single, and therefore is eligible for a $5,150 standard tax deduction. In comparison, if the homeowner were married, he or she would be entitled to a $10,300 deduction. By factoring the standard deduction into our equation, the interest tax expense would be reduced from $13,359 to $8,209. This amount is simply determined by subtracting the standard deduction amount from the amount of interest expense paid by the homeowner in the first year. Again, assuming that the homeowner is in the 28% income tax bracket, we determined that the interest tax shield would reduce the break-even rate by 1.02% ($8209 x 28%/$225,000).
Total Impact of Home Ownership Costs
Based on the methodology outlined in this article, the assumptions made about the homeowner and the estimated cost expenditures used in this analysis, we determined that a home will need to appreciate 8.69% during the first year after it is purchased in order for it to offset the costs associated with owning the home.
Now that we understand how to evaluate the break-even rate of a home, the question then becomes, "Is it likely that a home will appreciate on an annual basis at a rate that will exceed the costs of owning the home?"
To make this determination, the homeowner could visit the Office of Federal Housing Enterprise Oversight website to determine the strength of the home appreciation rates in his or her geographic locale. By looking at home appreciation rates in your area and following the methodology outlined in this article, you should be in a much better position to determine the likelihood of making a profitable home investment.