Dear Readers: This article is the first in a three-part series, taking a closer look at the process of buying a house with the intention of protecting yourself from future financial losses. Since purchasing a house is typically the single largest financial transaction most people make in their lifetimes, I highly recommend taking the time to read this article in full, as well as any follow up articles, especially for those considering buying a house for the first time.
As part of my MBA studies, our class watched this video on the 2008 Financial Crisis, and then had a discussion on the various factors that created it. One classmate shared his personal experience during the downturn, and it certainly raised some questions. I have reproduced the story here, altering key details, but leaving the overall message intact:
“I’ve worked in real estate & development for over twenty years, including during the the financial crisis. I lost over $120,000 of real money on my home in Virginia, being forced to write a check at the closing table to “sell” my home when we moved. I had great credit when I contracted for the construction of the house, just before the crash. My income and assets supported the mortgage, and what we borrowed was less than what we qualified for. Based on lax lending standards and greed, the financial crisis was created around us. I’m one of millions of Americans who paid for it.“
I have a great deal of respect for my classmate, as I was nowhere near ready to purchase a house in 2008. I have no first hand experience what it was like looking at home values in 2004-2007 and thinking that I’d better buy in before prices went any higher and I couldn’t afford anything. And I have no idea what it’s like to see 50% of my home value disappear over the course of a year, even though nothing about the house or property has materially changed.
Out of curiosity, I asked my classmate what he learned, and what he might do differently in the future. It is a much easier way to go through life, learning from the mistakes of others, than it is to make those mistakes yourself. The answer I got, however, was one full of victimization, largely blaming his situation on circumstance. He said that going into the purchase, they calculated how much house they could afford, and purchased a house well below that, and thought that was enough. He thought he did everything “right”, and the system is what hurt him.
Mrs. SFD and I recently purchased our second house, and are about to buy our third. Throughout the process, we have both done a great deal of reading and research into the financial crisis as a way to figure out what went wrong, and how we could protect ourselves from adverse conditions in the future. We’ve done even more research into the mechanics of not just buying a house, but the experience of owning a house through all market conditions. And throughout all of our research, we think there are a few things that anyone buying a house, then or now, could do to protect themselves from a similar fate.
This is the first part in a three part series that will explore different ways to protect yourself from adverse market conditions when buying a house.
Remove Emotionality From Any Real Estate Purchase
Before even thinking about buying a house, the first step to avoiding a financial disaster is to be able to remove your emotions from the decision, and to objectively view any house you may buy. This is much easier said than done.
Think for a minute about some of your fondest childhood memories. There’s a pretty good chance at least a few of them are tied to the house you grew up in. For me, I remember when I was about five years old, the last night my family spent in my parent’s first starter house, eating pizza while burning one last fire in the fireplace. And I also remember the very next day, our first day at our new house, where everything was still new and bright. Even the carpet was still white*. And it’s memories like these, that make the impulse to buy a house even stronger once we achieve the first hallmarks of adulthood. Got your first real job? Time to start thinking about buying a house. Got married? Time to start thinking about buying a house. Having a child? Definitely time to start thinking about buying a house, so you can give them the same kinds of memories you have yourself.
I’m going to tell you right now, that these are traps. Buying a house is not just about making memories, it’s also about being prepared to make a large financial commitment.
In order to fight the the impulse to buy a house based on emotions, I highly recommend doing what Mrs. SFD and I did: go see as many houses as you can, before you’re ready to commit to buying. And the easiest way to do that is to go to open houses. I can pretty much guarantee you, you will find a house you fall in love with by doing this, and by going house hunting before you’re ready to buy, you’ll also be forced to come to terms with letting the house go.
It happened to both Mrs. SFD and I. For me, it was an all solid-log construction house, with two bedrooms, and a spacious living and dining area. The garage had a space for working underneath cars, and the back yard had a pond for fish. The house also happened to be just outside of an HOA, thus allowing the owner of this house all the benefits, and none of the costs – or headaches – that come from living in an HOA**. However, it would have required a large loan, and it would have been a difficult property to rent or sell in the future, given its unique construction. I went to two open houses for that house, just to take a look around.
For Mrs. SFD, her house was a three bedroom, two and a half bath, two story building (Mrs. SFD has a particular affinity for two-story houses.) She was in love with it. The house met every bullet point she had put in her head for a home we would want to live in. It had a large living space, a cute backyard, a nice kitchen – the whole nine yards. Unfortunately, it also came in at the very top of the bank-approved budget, and while it was technically affordable, it wouldn’t have brought in enough rental income should it ever need to be rented.
At the end of the day, neither home was being purchased with the intention to live in forever. This is something else to keep in mind. Even if you think the house you’re buying is one you’ll live in for a long time, remember, things change. People move, job offers are made, school districts get redrawn, and you never know what will happen next. When shopping for homes, Mrs. SFD and I made the decision never to approach a home as a “forever home” – a common term many realtors use to try and encourage the emotional aspect when home buying. Instead we view them as assets, and we have three simple questions we ask of every house we consider buying, either as a rental or as a primary residence. These are as follows:
- If, for whatever reason, we experience financial hardship, will we still be able to afford this house?
- If, for whatever reason, we need to move out of this house, will we be able to rent it for a profit?
- If we choose not to rent this property, will we be able to sell it, without taking a significant loss after selling expenses?
It’s really that simple. The first step in buying a house is to remove your emotions. That doesn’t mean you can’t enjoy the house you buy, or that you will necessarily be sacrificing future “memories” you hope to make, by making a financially rational purchasing decision. But it does mean, that as circumstances change, your house will be an asset to you, rather than a liability.
Your turn. How have you helped to separate your emotions from the buying decision when shopping for a house? What would you recommend to future homebuyers to avoid common mistakes?
*Bonus home buying tip: Light colored carpets show every stain. If you must have carpet, get a dark color or a textured carpet with dark elements.
** Is the free rider problem really a problem, if you’re the one who benefits?