The Disasters I Survived the First Year I Owned a Home
Buying a house is a terrifying leap of faith. It will typically be your largest asset, but it will also be your largest debt. To acquire that asset, you borrow multiples of your annual income and enter into a 30-year agreement with a bank. You have to be confident about your future to make a three-decade commitment.
But it can also be incredibly rewarding. It isn't just a house: it is your home. You will raise your family, build your life and create amazing memories within those walls.
And it can also make a lot of financial sense: rather than just wasting rent, you are paying down a mortgage. Whereas rents rise with market prices, a fixed-rate mortgage can keep your payments constant (excluding insurance and property tax). And property prices only need to increase with inflation to make your house an excellent investment, because of the power of leverage.
The Power of Leverage
Why is leverage so powerful? Here is a simplified example: If you invest $100 in the stock market, and the market goes up by 3 percent, then you make $3. If you borrow $80 to buy a $100 home, and it goes up by 3 percent, then you still make $3. But you only put $20 of your own money into the investment, so you actually made 15 percent ($3 divided by $20). Even when you include the mortgage payment and maintenance costs, you can still generate good returns because of the power of leverage.
Despite all of the benefits, both emotional and financial, there are real risks, as the last five years have demonstrated to me. I started my career in banking as a risk manager. One of my first assignments (I was in my early 20s) was in the United Kingdom, where I joined a team that managed the risk of a subprime mortgage business. What I saw terrified me.
I witnessed case after case of people over-extending, buying homes they couldn't afford. I witnessed evictions and auctions of foreclosed properties. Some of these foreclosures were the result of loans that should never have been made. But others were the result of tragedies that were beyond the borrower's control, or that were not foreseen when the loan was taken. They included job loss, divorce, small-business bankruptcy or even theft. As I witnessed everything that could go wrong with a mortgage, I vowed never to take such a big risk unless I took every possible precaution. And, in my mind, that meant:
- Minimum of a 20 percent down payment.
- Six months of mortgage payments in the bank, in case something happened.
- A fixed-rate 30-year mortgage (I didn't want any interest rate risk).
- A monthly mortgage payment (including taxes and insurance) that was less than 20 percent of my monthly salary, regardless of how much the bank said I could afford.
In 2008, I decided to take the leap: I was prepared. (Yes, in 2008.) I had left my job at the bank and started work with an investment fund and felt secure in my future. I was able to cross off every item on the list. And I wanted to build a family with my wife.
And then a lot of bad things started happening.
In October, when it started getting cold, we heard a large explosion from the basement. It was the boiler. Or at least what used to be the boiler. I don't want to admit the total cost of replacement, but it was the equivalent to a couple of months worth of mortgage payments.
And then there were the repairs that we had planned. The home we purchased needed work, and I had budgeted for that work. Unfortunately, everything cost at least 25 percent more than planned. And many items cost much more. When we fixed the roof on the front porch, we found rot. That ended up costing twice as much. I made a big mistake: Confident in my future income, I decided to go full speed ahead with the repairs. To finance that, I started to dip into my emergency fund.
Here Come's Trouble
And then, a real emergency hit. Due to the financial crisis, I lost my job. At that moment, my home no longer felt like a good investment and a place to build a family. Rather, it felt like a threat to my financial independence. And remember how leverage can help amplify returns on the way up? Well, it makes pain on the way down even worse. If you make a 20 percent down payment, and your home value declines by 20 percent, then your investment loses 100 percent. It is all gone. And property prices in my neighborhood were declining rapidly.
So, in the first year, the dream had turned into a nightmare. Between the down payment, the boiler, the repairs and the cost overruns, my bank account was dangerously close to empty.
In the end, I found a job in London with Barclays (BCS), where I ultimately became the head of Barclaycard UK. I decided to keep the house and rent it out, and I still own it as a rental property today. Looking back, I realized that I had made some enormous mistakes. Had I not received the job offer with Barclays, I would have been in very difficult shape.
Here Is What I Did Wrong
- Emergency funds exist to help you deal with the unexpected. If you raid your emergency fund (like I did, to make non-critical repairs), you are just inviting disaster. And, unfortunately, disaster arrived at the worst possible time. (Not that there is ever a good time for disaster). When you create an emergency fund, open a separate account with the highest yield. Internet savings accounts are great: you can't raid them quickly, and they pay the highest interest rates.
- I underestimated the cost of normal repairs. In my day job at the bank, everything always cost more and took longer than planned. Why I thought dealing with contractors would somehow go according to plan, I don't know. For planning purposes, assume everything will cost at least 30 percent more than the quote. If it ends up costing less, great. But that will give you the discipline to wait before signing up for too many projects at once.
- I made a decent estimate for the average maintenance cost. However, we don't live with averages, or estimates. For many months, there are no costs. And then the boiler breaks, a tree falls in a storm or a pipe bursts. While there are some recurring expenses, the majority of these maintenance costs come in big, bulky packages. You have to be prepared for them, and I wasn't.
- I am so happy that I put 20 percent down. With that buffer, I always knew that I could walk away from my house completely, by selling the home. Negative equity places a huge limitation on future job mobility. You may bemoan the need for a big down payment, but I view it as a protection. And I am glad I waited to buy a home until I had that down payment.
- I am happy I signed up for a 30-year fixed rate mortgage. Technically I could have had a lower payment (with an adjustable rate mortgage), but I don't want to live with interest rate risk. I have since refinanced (into another 30-year fixed), and I feel good that the rental income I receive will increase over time, as my mortgage payment stays fixed.
- I am happy I bought the home. The story didn't end how we expected it. We thought our children would be running around the back yard for years. Instead, our tenants' dog is. But it is ours, we survived and we are stronger together as a result.
Nick Clements is the co-founder of MagnifyMoney.com, a website that makes it easy to compare and save money on banking products. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the United Kingdom.