Your home needs to fit into your total financial puzzle. It should be only one piece—and not the only piece—of that puzzle. You still need an emergency cash fund that can cover you for eight months. You still need to be saving for retirement. You also need to pay off student loans, get out of credit-card debt and make sure you have all the right insurance in place. And with that broad list of financial goals, you can't afford to let your housing expenses overwhelm your cash flow.
If I just struck a raw nerve, then it's time to reassess where you are financially. Maybe it's time to downsize to a more affordable home. That could mean moving to a less expensive neighborhood or part of the country or, perhaps, curbing your appetite for square footage. I find it interesting that the typical U.S. home has increased from about 1,500 square feet in the late 1970s to more than 2,400 square feet today. Also, the average number of people living in a home has shrunk. Bigger definitely isn't better when it comes with a price tag that makes you feel as if you were gasping for financial oxygen.
If you are in house hunting mode, another option could be to lower your price range so that you end up with a mortgage and a property tax that are manageable. This will require plenty of fortitude. Be prepared to stand firm with mortgage lenders and your real estate agent, who will no doubt egg you on to buy more home. Remember, they make more money when you spend more money. But your loan officer and your real-estate agent won't be any help when that mortgage makes a mess of your financial life.
Okay, I know you have home insurance—you can't get a mortgage without it. But very few people know much about their coverage, and that can end up costing them big-time. Pull out your policy—call your agent and ask for a new copy if you can't find it—and check the coverage.
On the first page, you should see a section labeled Dwelling Limit Coverage. This describes the upper limit of what your policy will pay out in the event you make a viable claim. Your specific type of coverage should be either Guaranteed Replacement Coverage or Extended Replacement Coverage. If your policy is for Replacement Coverage or Actual Cash Value, you are underinsured.
As its name implies, Guaranteed Replacement Coverage pays whatever it takes to rebuild. That's the gold standard, but it's hardly available anymore. So the next-best choice is Extended Replacement Coverage, which will give you up to 20 percent above the stated dollar limit on your policy. Let's say your home, which is insured for $250,000, is destroyed in a fire. When you go to rebuild, you find out it's going to cost $300,000. With an Extended Replacement Coverage plan, you'll be in luck—20 percent above your $250,000 in coverage works out to be $300,000.
Either option is far preferable to a simple Replacement Cost Coverage, which limits you to the face value of the policy—$250,000, in the example above—or Actual Cash Value Coverage (ACV). If you have ACV, I want you to upgrade your policy ASAP. Your payout with ACV will be based on the depreciated value of the damaged property, and that's bound to disappoint you and drain your bank account. For example, if your roof was 15 years old when it was damaged, your payout will be based on the depreciated value of a 15-year-old roof. That's not going to be nearly enough to cover the cost of replacing it.
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I appreciate that boosting your coverage ends up raising your premium cost, so let me try to ease that pain a bit with a couple of premium-cutting tips. If your current deductible is below $1,000, then I recommend raising it to at least that level. This will reduce your premium costs by about 10 percent or more and discourage you from making small claims, which can cause your insurer to raise your premium or refuse to offer you a renewal. Consider moving your auto and home policies to the same company, too. That can reduce your cost on each policy by about 10 percent.
The great real estate boom during the first half of this decade—when home prices jumped 20 percent or more a year in many parts of the country—did some serious damage to our perspective on housing. Based on those outsize gains and the expectation that the good times weren't going to fade away, many people jumped at the chance to buy investment property.
Too many people also took on a no-down-payment, interest-only loan on the assumption that they could use equity to sell the property or refinance the loan quickly. But that's not how things have played out. Since 2005, home prices in some of the once-hot markets have struggled to tread water or have actually sunk a bit.
Here's what you should keep in mind when you are crystal-balling future home values: Over decades—not short bubble periods—home values typically rise at an annual rate that slightly exceeds the rate of inflation. We're talking 4 or 5 percent—not 24 or 25 percent—a year.
Build your financial plan around that realistic real-estate outlook, and you won't overstretch to the point of jeopardizing your quality of life.