Posted in Personal finance, Spending

Good Buy or Good bye a house purchase

I had been thinking of upgrading to a bigger house for some time now. This is a difficult decision when you struggle to justify more debt, more wants and lifestyle creeps.

There are various factors to consider in deciding whether you buy that next dream house or say goodbye to your wants for a duration, till you are better prepared.

There are two aspects to this –

  • a numerical analysis
  • a behavioral analysis

Numerical Analysis

white graphing paper

What can you afford?

It is definitely not what the lender tells you in a pre-qualification or pre-approval letter.

You have to see the following numerical aspects in your finances.

  • Do you have cash for down payment? Usually 10-20% of the purchase price is a good thumb rule. 20% is better to avoid Private Mortgage Insurance, which will increase the monthly payment otherwise.
  • Add the mortgage payment to other costs like Property Taxes and Insurance.
  • Are there any up-front rehab costs? Can you get those repaired by the seller?
  • After adding up all costs, adjust your monthly budget to see where you will stand once you buy this house.
  • See the impact to your net worth and asset allocation once you spend the cash for down payment. Although it moves from cash to Home Equity, it can skew a previously well thought out asset allocation across stocks, bonds, real estate and cash.

What should you pay?

There are two main items where you have to shop around and get the best deals out there.

  • Purchase price. Since here we are dealing with numbers, the only thing that matters is whether you are paying too much.

    • List price offer or a multiple offer situation can quickly escalate the price and throw all deals out of the window.
    • Assess what all rehab needs to be done. It is better to get a contractor estimate during the inspection period, so that you can back out if found expensive.
    • Try to buy 10-20% below the price after subtracting any projected rehab expense.
  • Interest rates – This will depend on your credit score and the interest rates available in the market.

    • Getting estimates from various lenders will help compare the best rates.
    • Take into account closing costs and points as these can be significant and varies quite a lot across lenders.

What are the future costs?

A house purchase does not end with the closing. In fact, in terms of expenses it has just started.

Many people take on big house purchases only to realize later that the recurring costs or the holding costs of the property are too high and severely constraint their finances.

  • Holding costs

    • After you have accounted for the P.I.T.I (Principal, Interest, Taxes and Insurance), you need to make sure you still have enough slack in your budget to save for unforeseen expenses.
    • You need to have a cash cushion (preferably separate from your 3-6 months worth of emergency fund) for this property. The HVAC can go bust, the roof may get damaged in the next storm or there could be a disastrous water damage.
    • You also need to consider increase in Property Taxes and Insurance year after year.
    • To correctly account for the holding costs, you need to budget an amount every month and sock it away in the Home Maintenance Fund.
  • Future sale or rent value

    • No one stays in the house forever. You will also move at some point.
    • It is important to decide how you project the use of this house once you move out. Do you plan to convert it to a rental or sell it?
    • Decide on a tentative time frame when you may move out. Based on this and the neighborhood real estate projections, find out what the future sale value or rent will be.
    • Will the rent cover all the P.I.T.I expenses per month? Add a few more expenses like reserves for maintenance, capital expenditures (big expenses like roof),  property manager (whether you use or not, just budget for it). To effectively analyze this, learn about Cap rates, Gross rent value etc.
    • If you plan to sell it, will the appreciation rate be enough to justify your costs, with a sale commission of 6% and all the money you will spend on Property Taxes, Insurance and upkeep of the house over the years.

After you can define a good deal by satisfying most (if not all) of the above parameters, it is time to take stock of some behavior patterns.

Behavioral Analysis

woman wearing white dress standing near building

Do you really need to upgrade? What are you going to sacrifice?

Often it is our wants that itch us constantly to make that lifestyle upgrade. Whether it is keeping up with the Joneses or simply growing out of your current residence, it is a natural behavior trait for most people.

Answering the following questions may steer you to a better decision.

What is the motivation? A better neighborhood, schools or simply more space?

What exactly is the motivation? Is it due to moving to a better neighborhood, or moving to a better school zone? Or is it that the family grew and everyone needs more space?

This should be evaluated purely on basis of needs. For example, for more space can you rearrange or sell off unnecessary furniture and create more space in the process?

How will you clean and maintain the bigger house?

While buying a bigger house sounds exciting, think about maintenance. A bigger house brings in more maintenance headache. And we are not talking about money expenses here (we did that in the numbers section), but the overall energy you will need to keep it clean, mow the lawn and maintain the appliances, carpet etc.

Do you like more debt or want to manage debt?

For most people, buying a house with cash is not an option. So invariably you will take up a larger mortgage, whether you have one currently or not. Overall your debt increases. This has to be justified by the future stability of your job or the state of the industry or business you are dependent on. Or simply the peace of mind and how much debt will still keep you comfortable.

Is this going to be your long term buy?

If you buy a house (not an investor deal) and turn around to sell it, you will lose a bunch of money. Even after few years, it is difficult to break even. So if you are not staying in the house for longer, it will be another expensive switch few years down the line.

Thus it is better to justify all the needs and factors and make sure it will be a long term buy.

Can you rent first and then check out similar homes in the area?

Often the reason could be to just move to a better neighborhood for schools, or get more space. However instead of finalizing a buy, you can always rent a house in the desired area and then check out better deals as they hit the market.

This has the disadvantage of spending some money on rent, but in this section we are analyzing non-numerical aspects. Renting for a year or two will give better idea of the neighborhood, bigger house etc. and better justify the buy decision for a longer term.

Conclusion

All the above factors may seem daunting and may not be possible to satisfy to make a rational decision.

Some of the factors like rent to value ratio can be area specific. If your area is very expensive, then some of the numerical analysis will not give favorable results.

Hence it is important to consider other factors and take an overall informed decision.

This will also prevent the almost inevitable buyer remorse which is very common as you inch towards the closing date.

Once you take a decision, enjoy your mansion.

concrete building surrounded with flowers near roadway
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Posted in Personal finance

How to decide on a purchase – the P.V.T formula

I talked a lot about budgeting, saving and investing money in the earlier posts.

Budget – Grow the tree upside-down

One essential comfort zone

Investing in the High Five portfolio

However a fact of life is no matter how hard you try, there will be big purchases.

Some of them will be needs, while others may be simply wants.

These purchases are typically big ticket ones and can range from a thousand dollars to several hundred thousand dollars. For example, it can be an Apple iPhone/iPad to buying real estate for a primary home.

How do you decide when the purchase makes financial sense? After all, money will be spent and an opportunity to invest will be lost forever.

The P.V.T equation explained below helped me make the decision many times.

Although I have made bad decisions and recovered, but on hindsight sticking to a principle would have helped to be sensible 90% of the time.

What is the P.VT. equation?

The acronym stands for three important elements of a purchase decision.

  1. Price
  2. Value
  3. Time

To assign a score value to a purchase, it will have to be a combination of the relative success with above three parameters.

The main thing to guard against a purchase is whether it is a waste or not. So if we measure the waste factor, and try to keep it as low as possible, it is a sensible purchase.

The formula is as follows:

WF(Purchase) = WF(Price) x WF(Value) x WF(Time)

Where WF is the waste factor, in terms of how much of that parameter we are giving up during the purchase. Since it is a multiplication, a WF of zero will be approximated to 0.01 (1%).

Lets take 3 examples, an iPad, a car and a house.

iPad Pro: 

Price ~ $1000 and lets say it being Apple, we cannot manage a discount.

So WF(Purchase) = 1.0 [we consider the full price as 100% waste factor]

Value – How much value will it add to your daily life? Are you going to use it for work, or just recreation? It will also depend on whether you have other laptops or similar tablets at home. Lets say you are going to use it for personal work (like reading, keeping tab of investments etc.).  So you will use it 40% of your screen time.

Thus WF(Value) = 60% or 0.6

Time – How many years are you going to use it compared to the typical life of an iPad? Given that it is a technology product, the maximum life it can be used without needing replacement or becoming obsolete is probably 5 years. But you may be upgrading anyways after 3 years.

So WF(Time) = 2/5 or 0.4

Finally, WF(iPad) = 1.0 x 0.6 x 0.4 = 0.24

So 24% of the price is wasted. If you could have bought the iPad at 25% discount, then the purchase value will increase.

WF(discounted IPad) = (1.0 – 0.25) x 0.6 x 0.4 = 0.18, so now the purchase makes a little more sense.

Car: 

Typically it is a good practice to buy used cars at a discount. So lets say you buy at 40% discount, usually a 2-3 year old car.

Let us also say that this is your primary car and you don’t fancy owning 2-3 cars, so you will use it 90% of your commute time. And lets say you are going to upgrade after 5 years, even though a car can be kept for 10+ years.

WF(Price) = 0.6, WF(Value) = 0.1 (high value to you), WF(Time)=0.5

WF(Car) = 0.6 * 0.1 * 0.5 = 0.03

See this is much better usage than the iPad with a WF of 0.24. Now if you hold the car for 9 years, then 9/10 will give a better score.

WF(Car) = 0.6 * 0.1 * 0.1 = 0.006

House: 

This is the biggest purchase in most people’s lives and possibly can be better quantified as well.

We will make the following assumptions:

  1. Price – You will buy the house at 20% discount to the retail/asking price.
  2. Value – If this is your primary residence, the value may be very close to 100%, or the WF will be 1% (to avoid zero).
  3. Time – A house can be held for 20-30 years, but lets say you plan to upgrade after 10 years or so. So WF(Time) = 20/30 = 0.66

WF(House) = 0.8 * 0.01 * 0.66 = 0.005

So the house purchase makes even more sense than the car. Even though the house is used only 1/3 of its whole lifetime and the car is used 9/10 years, the house purchase makes more sense. It also had a lesser relative discount than that of the car.

The above P.V.T equation also reveals another hidden aspect. You can adjust one parameter vs. another. For example, if you are going to use the house or car for longer, you can afford to buy at a less discount. Your WF(Price) will increase but will be offset by the other two.

You can even use this formula when you are trying to compare paying a higher price for a high quality product or buying cheap for a not-so-durable product.

High Quality: WF(Price) = 0.8 or higher, WF(Value) = 0.6, WF(Time) = 0.1 (it will last long) , WF (Purchase) = 0.048

Low Quality: WF(Price) = 0.5 (less price), WF(Value) = 0.6, WF(Time) = 0.5 (last 1/2 as long), WF (Purchase) = 0.15

As you see, it makes sense to buy the high quality product if the value is same for both. At least in this case, however there are situations where if you can get a significant discount and know that the item will last longer, the lower quality product (non-branded) may outperform a branded one. 

Thus making purchases with such logic will keep your home clutter-free as below. You just have to choose a suitable threshold of the WF. For example, anything below 0.05 (5%) may be a good thumb rule to make the purchase.

Disclaimer: There will be many other factors in a purchase decision. The above formula acts as only a quick thumb rule and should not be the only criterion for decision making. 

cabinet ceiling clean comfort
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