I love real estate. I really do. But I'm getting nervous. While I sincerely believe that buying a house is one of the smartest long-term financial decisions you'll ever make, notice that I said "long-term." There seems to be a growing sense that investing in real estate is also a short-term bonanza.
It doesn't take a PhD to see what's going on. The stock market looks iffy, the overall economy uncertain, but property values are climbing faster than a cat chased up a tree. In the past year, an average home rose about 11 percent in value; in hot markets along the coasts, appreciation rates have gone even higher. And that's been true since 2001.
Forget IRAs and 401(k)s. The topic everyone breathlessly asks me about is whether to get into the "flipping" game: buying a house or condo, renting it out for a few years, and selling at a big profit. Every time I hear that question, I'm amazed by the asker's can't-lose confidence. And I'm here to tell you that you can indeed lose, especially now with the housing market bound to cool down and interest rates finally starting to move up from their historic lows. It's all too easy to become a flipping fool.
The National Association of Realtors estimates that nearly one in four homes bought in 2004 was an investment, not a primary residence. That's got me concerned. If you're thinking of investing—with an eye on a flip—make sure you understand the risks.
Markets don't always go up. Having a short-term sell-by date makes it more likely that you'll be caught in a flat cycle. And buying into a market that's been on fire increases the risk of burnout. As everybody knows, the surest way to make money on any kind of investment is to buy low and sell high.
Rents aren't guaranteed. If you need to collect rent to pay the mortgage, what happens when your tenant flakes out on his check? What if the place is vacant between renters? If you don't have an eight-month emergency fund to cover your mortgage payments, you have no business getting into the real-estate investment game.
Being a landlord takes time and money. Whether you replace the roof tiles and fix the dishwasher yourself or hire someone to handle upkeep, property is never easy to maintain. If your life is already jam-packed with career and carpools, think twice before adding demands to your schedule.
Let's review what kind of real-estate investment makes complete sense: owning a home you intend to live in for at least five years. There is absolutely no guarantee that real estate will do well every single year. Nor is it unreasonable to assume that values could tread water or even fall. It's happened before, and it'll happen again. That's not bad news, just rational thinking. Long-term, you should be happy if your home appreciates at an average rate of 4 percent annually.
Also remember that, when you bought, there were transaction costs and, when you sell, you'll typically have to pay 6 percent to your broker. So if you flip a property that has appreciated less than those costs, you'll lose money on the deal. And don't tell me you're sure your house is going to appreciate 20 percent. There are absolutely no guarantees over the short term, my friend.
Now, if you do have a long-term horizon, buying real estate could be very smart. Stick to a mortgage you can afford, and you'll build valuable equity. Graduating from renter to owner also earns great emotional rewards—not to mention a major break on your federal tax return, because interest payments on your mortgage are deductible, as are local property taxes. Moreover, when you sell a place you've lived in for two of the past five years, you won't pay a penny of tax on the first $250,000 of gains. (That's the difference between what you paid and what you sold for, adjusted to reflect capital improvements such as a new bathroom.) If you're married and file a joint return, your capital-gains exclusion rises to $500,000.
Even if you're buying for yourself, you can make a colossal mistake by choosing the wrong mortgage. Given the sharp rise in home prices, creative lenders have started to push a type of loan called an interest-only mortgage. As the name implies, you pay just interest, no principal, for a set period, say, seven years. The allure is that your initial monthly payments are lower. For example, a $200,000 interest-only mortgage with a 6 percent rate will cost you $1,000 a month, whereas a "regular" mortgage, with which you pay both interest and principal, will run $1,200.
There's a catch, right? At some point, you must start paying back the principal. If you paid only interest for the first five years of a 30-year loan, you'll have to pay off the principal in the final 25 years. That translates into a sharp rise in monthly outlay. In California, 48 percent of new 2004 mortgages were interest-only, compared to 2 percent in 2001. If rates go up and/or property stagnates, this is a ticking time bomb.
I know that lenders tell you there's an easy solution: Well before your mortgage converts to the principal-paying phase, you either refinance with a standard 30-year mortgage, or you sell. Hello! There is absolutely no guarantee that you'll be able to do either. You could find yourself refinancing when rates are much higher. You could lose your job and no longer qualify as a refinance candidate. Or, if the market cools, you may not be able to sell at a big enough profit to recoup your broker's commission. Let me put it another way: If you can't afford to buy without an interest-only loan, you can't afford to buy.
And please don't be enticed by a one-year or even a three-year adjustable-rate mortgage. We're clearly in a period of rising interest rates, meaning that any adjustment is going to be up. That said, it can be smart to choose a "hybrid" loan that stays fixed for the first five, seven, or ten years. Your initial interest rate will be slightly lower than the rate on a standard 30-year loan—the key is to sell or refinance before the adjustable phase kicks in. If you're the average owner, who moves every seven years, that works out fine.
Given current interest rates, however, I still think your best option is a 30-year fixed mortgage, one with principal and interest payments that you can afford. These old-fashioned loans are hovering at a superlow 6 percent right now. Sure, that's higher than the 5.5 percent of 2003, but in 2000 the same loan carried a rate of 8 percent. If you plan to stay put, a 30-year fixed-rate promises the ultimate peace of mind.
When your home's value doubles, you need to be twice as smart. The tremendous rise in real-estate prices over the past few years has left a lot of people sitting on their own private gold mines. It can make sense to spend some of those home-equity gains to:
Finance major repairs. Or pay for upgrades that you absolutely need. That's a new roof or another bedroom for your expanding family—forget about the vacation in Bora-Bora and the fancy Mercedes you can't afford to buy outright. But keep in mind that even something that adds value to your house, say, a gorgeous gourmet kitchen, can put you at financial risk if the market tanks and your gold mine vanishes into thin air.
Take advantage of the tax code. If you've been thinking about selling the place where you've lived for two of the past five years, don't wait for prices to rise even more—greed is definitely not good. Right now, any profit up to $250,000 for single owners and $500,000 for couples is tax-free; then the rate rises to just 15 percent. If Congress doesn't vote to extend the capital-gains rules, the deal might not be as sweet after 2008.
Go down a size. If you're entering the empty-nest years, consider cashing in and moving somewhere smaller. You could potentially find a place to buy with cash or only a small mortgage. Then, safely invest the leftover money, and your house has just funded your retirement.
Unfortunately, the real-estate boom has tempted many owners to treat their house like a checking account, and that can be dangerous.
You should never turn to your home equity to:
Pay off credit cards. While I certainly hope you always live up to your financial responsibilities, it doesn't make sense to use a secured loan to pay off an unsecured one. Translation: If you fall behind on credit-card bills, there's usually no collateral that the card company can seize or require you to sell. Home-equity lenders could force you to do just that if you stop making payments.
Underwrite higher education. If you fall behind on a home loan used to pay for college, you could end up with a well-educated kid but no roof over your heads. What's smart about that? Student and parent loans are a better move.