Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

5 Ways Your Dream Home Can Become a Nightmare

Interest rates are at an all-time low. The housing market has finally begun to recover after hitting rock bottom late last year, according to a May 2012 report from research firm Fiserv. On paper, it looks like a great time to buy a house -- and owning a home has long been a key part of the so-called American Dream.

Yet, even in the best conditions to purchase a house, homeownership carries significant risks that can turn that dream into a nightmare. Buying a house can no longer be viewed as a fail-safe short-term investment. And if you're not planning on owning it for at least five years, you'd probably be better off renting. (It's less expensive in the short term.)

Here are five of the biggest risks of home ownership and how to minimize them.

1. You Could End Up Drowning in Debt.

For most homeowners, their homes are by far their largest investment, and the vast majority of the value of the home is borrowed. That means they owe a tremendous amount of money on an asset that isn't easily sold -- especially in today's improving-but-still-troubled housing market. Also, what equity they might have in the house can quickly disappear when prices drop. 

For example, if a homeowner owes $200,000 on a house that's valued at $220,000, she has $20,000 in equity in the house. Now, let's say the value drops to just $215,000. That’s about a 2% decrease in the house's value, but it causes a 25% drop (from $20,000 to $15,000) in your equity. 

Again, a home isn’t like a stock that you can sell in the same day; it is an asset that cannot be easily dumped if home prices start to fall.

The best way to shield yourself from owing so much on your home is to save enough money to provide a 20% cash down payment. That means you will have 20% equity in your home from the moment you close on the house, putting you at much less risk in case your property value falls.

2. You Could Be Left With Little or No Savings.

Putting a 20% down payment helps borrowers get the best interest rate and avoid private mortgage insurance (PMI) when purchasing a home. This investment can save a homeowner thousands of dollars over the course of the loan

PMI basically protects the lender against the possibility of a homebuyer defaulting -- or failing to pay -- on a mortgage. If you don't put at least 20% down on your new house, you'll likely be required to pay it. And it can really add up in the long run.

For example, making a 20% downpayment on a $200,000 home could result in a slightly lower interest rate (between 0.5% and 1% less), as well as helping the borrower avoid an additional 0.5% to 3% PMI payment. Over the course of a 30-year loan, that saves homeowners between $99,822.21 and $174,520.36.

The problem for many homeowners is that they pay the down payment with funds from their emergency savings account. That leaves them vulnerable should unexpected expenses arise. A safer method would be to retain this emergency fund, create another savings account for a down payment and wait until it can be fully funded from that account.

3. You Could Get Clobbered By Costs You Didn't Anticipate.

When deciding whether to buy or rent, Americans often compare only the monthly payments, but that vastly oversimplifies the costs associated with homeownership. 

Here are a few of the costs associated with a house that people often forget: 

  • Maintenance and repairs: Between 1% and 3% of the purchase price should be budgeted for maintenance and repairs per year.
  • Closing costs: These costs associated with purchasing a house typically amount to 2% to 3% of the total amount borrowed. They include origination and title fees, home inspections and many more varied fees. According to Bankrate.com, the average closing costs for a $200,000 home in 2011 were $4,070. Some people can negotiate so that sellers pay for these expenses or include closing costs as part of your home loan so you can pay them over the course of the loan.
  • Property taxes: These vary based on state and local rates, but can be a major expense.
  • Homeowners association (HOA) memberships: Not all neighborhoods feature HOAs, but the fees associated with them can be steep.
  • Insurance costs and much more. 

4. If Tough Times Hit, You May Not Be Able To Move.

Home ownership is a great feeling. To have a little slice of the country you can call your own carries psychological benefits. However, by purchasing this land and home, it does hurt your ability to move quickly. For example, if you were to suffer from a job loss, illness or other major life event that required you to sell the house and downsize or move to another part of the country, owning a home can be a major problem.

#-ad_banner_2-#In a worst-case scenario, you may need to pay two mortgages or housing payments at once. A way to curtail this risk is to purchase a house that takes up a relatively small percentage of your income. Lots of experts suggest your housing expenses should be around 25% to 30% of your monthly income, but by limiting your budget to closer to 20%, you won’t get stretched too thin and will have more flexibility in the event that you need to move.

5. The Value of Your House Could Drop Like a Rock.

Remember when people across the nation were swooping into places like Las Vegas and Phoenix, buying up houses and then selling them a few months later at a tidy profit? The collapse of the housing market makes that seem like a very long time ago. Meanwhile, houses are still being foreclosed on, and that can have an impact on housing prices. 

According to Corelogic, 10.9 million U.S. households are underwater -- 22.5% of all households in the country. That means the homeowner owes more on their mortgage than the home is worth. In places like Phoenix and Las Vegas, that percentage of underwater homeowners is closer to 50%. 

How do you minimize the risk of depreciation? Buy the house for a low price and live in it for a long time. If you never have to sell a house, depreciation won't mean much. Once the home is paid for and you plan to stay there for awhile, you won't have to worry about the market value and can enjoy your home with no payment at all.

The Investing Answer: Home ownership is fulfilling, exciting and can be a solid investment. Minimize the risks associated with homeownership by waiting to purchase until you are able to pay a 20% down payment, purchase a home below what you can afford after considering all the additional expenses and stay in the home for the long haul.