How to Avoid a $20,000 Housing Error

money house on the hand...
ShutterstockDon't assume that all houses (including yours) are good investments -- because, frankly, many houses are not.
Tell me if one of these thoughts has ever crossed your mind:
  • "I'll live in this house for a few years, then rent it out, and then maybe sell it when it rises in value."
  • "I'm going to remodel big-time before I sell; I bet I'll get top-dollar."
  • "Renting is just throwing money away."
Not so fast. Before you start throwing a massive chunk of your income toward an untested assumption, read on. The following could save you tens of thousands in unnecessary costs.

Myth No. 1: There's No Difference Between Your Personal Home and a Great Investment Home. Let's start with that all-too-common statement: "I'll live in it, and later rent it out, and then sell it for a profit." This sentiment is based on the premise that the home you personally want to live in is also necessarily a great investment property. And, well, that's just not the case.

When you pick your own home, you judge based on personal and emotional factors: What school district is it in? How close it is to your office? How long is the commute? Does it have a yard? High ceilings? Modern appliances?

When you're choosing a rental property, on the other hand, you judge based on a metric called capitalization rate, or "cap rate." The cap rate is your net operating income (your net income, after expenses) divided by the acquisition cost. For example:

Purchase price: $200,000
Closing costs:$5,000
Initial repairs:$5,000
Total acquisition cost:$210,000

Rent:$15,000 per year
Operating Expenses:$7,000 per year (excludes debt servicing)
Net Operating Income:$8,000 per year

Cap Rate:$8,000 / $210,000 = 0.038, or 3.8 percent

In other words, your return-on-investment (if you were making an all-cash purchase) would be a measly 3.8 percent.

Why am I going into this level of detail? I'm illustrating that even if the rent is higher than the mortgage, that doesn't mean the house is a good investment.

There's a difference between the mentality that a homeowner uses versus the mentality that an investor uses. Don't assume that all houses (including yours) are good investments -- because, frankly, many houses are not.

Myth No. 2: All Remodels Are Profitable. Here's another common statement: "If I remodel before selling, I'll more-than-recoup the cost of the upgrades."

Not so fast. Certain minor upgrades or repairs might be necessary. You've gotten used to the fact that the toilet in the guest room is broken (nobody in your house uses that bathroom, anyway), but a new buyer needs an operable toilet. Fair enough. That's a necessary repair.

And if every house on your block has granite countertops -- and yours is the only one in the neighborhood with laminate -- that upgrade is sensible, as well.

But a major facelift might not pay for itself, and the more customized your choices, the less likely you'll see a return. Your new buyers won't care that you opted for granite with an ornate beveled edge rather than standard edging, or that you added custom cabinetry to the laundry nook. "Builder-grade" decisions may offer some return (or at least shorter time-on-market), but anything beyond that level is a losing proposition. Add upgrades for your own enjoyment, but don't do it right before you sell.

Myth No. 3: Buying is Always Better Than Renting. Let's close out with one of my pet peeves: the idea that renting is just "throwing your money away." This has always sounded like a strange phrase. Is toilet paper "throwing money away"? How about buying bananas and orange juice? No other good or service is seen as a financial throwaway -- what makes renting so special?

The standard argument is: Renting wastes money relative to buying, because you're not building equity. But what about the other necessary homeownership expenses that don't build equity? Here are many ways that people "throw away money" (don't build equity) as homeowners:

• Property taxes.
• Homeowners insurance.
• Interest on the loan (especially during the first 5 to 10 years, when most payments are applied to interest rather than principal).
• HOA fees.
• Loan origination fees, title insurance, escrow fees, attorney fees, real estate commissions and other closing costs.
• Maintenance (sprinkler systems, cleaning gutters, tuning the HVAC).
• Repairs (fixing broken appliances, replacing the water heater, re-roofing).
• Security systems.
• Housesitters.
• Termite and pest control.
• Missed opportunity. (What else could their money have been doing, if it wasn't tied up?)

To be clear, this doesn't mean that homeownership is bad. It simply means that the rent vs. buy decision isn't as simple as a one-size-fits-all cliche.

If you're grappling with the rent vs. buy decision, throw away all cliches and crunch some actual numbers. Whether you should rent or buy depends on the relative costs of houses and rent in your area, the amount of time you'll live at that location, closing costs, maintenance and HOA fees, whether or not you'll need to pay private mortgage insurance, and all sorts of other factors.

The bottom line? Keep these three myth-busters in mind, and you might save yourself from a housing error that costs you tens of thousands in additional interest, unnecessary upgrades, or missed opportunity.

Paula Pant owns five houses -- yes, five. No, she's not rich, but she's a real estate investor who built a portfolio of rental properties that cover her entire cost-of-living. She's 30 years old, and she invites you to check out all the details about her real estate purchases -- including the numbers -- on her blog, Afford Anything.
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