Home Finance 101
How large a down payment should I make?
Ideally, you should purchase a home and have enough accumulated for a down payment so that your down payment represents 20 percent of the purchase price of the property. Twenty percent down is the magic number because it's a big enough cushion to protect lenders from default.
If your down payment is less than 20 percent of the purchase price of the property, be aware that almost all lenders require you to obtain (and pay for) private mortgage insurance (PMI).
Although PMI typically adds several hundred dollars annually to the cost of your loan, it protects the lender financially if you default. You can also expect worse loan terms such as higher up-front fees and/or a higher ongoing interest rate on a mortgage when you make a down payment of less than 20 percent.
Suppose, for example, a buyer puts only 10 percent down, then property values drop 5 percent, and the buyer defaults on the loan. When the lender forecloses -- after paying a real estate commission, transfer tax, and other expenses of sale -- the lender will be in the hole. Lenders found they are far less likely to lose money on mortgages where the borrower has put up at least a down payment of 20 percent of the value of the property.
What should I expect to pay in closing costs?
On the day when a home becomes yours officially (known as closing day), you will have to pay fees for the services of several parties. In a typical real estate deal, closing costs total 2 to 5 percent of the purchase price of the property. You shouldn't ignore them in figuring the amount of money you need to close the deal. Exact fees vary by property cost and location. For more detailed costs read the section on Closing Costs below.
Why do I need homeowner's insurance?
Homeowner's insurance is mandatory. When you purchase a home, your mortgage lender won't allow you to close the purchase until you've demonstrated that you have proper homeowners insurance. Lenders usually insist that you pay the first year's premium on said insurance policy at the time of the closing.
What is PMI or Mortgage Insurance?
If you buy the home and make a down payment of, say, 20 percent of the purchase price, the lender is putting up the other 80 percent of the purchase price. So if the home burns to the ground and is a total loss, the lender may care more, at least financially, than you do. In most states, your home is the lender's security for the loan.
Almost all lenders today require you to purchase private mortgage insurance (PMI) if you put down less than 20 percent of the purchase price when you buy.
Do I pay PMI or Mortgage insurance for the life of the loan?
PMI is not a permanent cost. Your need for PMI vanishes when you can prove that you have at least 20 percent equity (home value minus loan balance outstanding) in the property. The 20 percent can come from loan paydown, appreciation, improvements that enhance the value of the property, or any combination thereof. Note also that, to remove PMI, most mortgage lenders require that an appraisal be done -- at your expense.
What are property taxes and how much should I expect to pay?
When you buy and own a home, your local government (typically through what is called a County Tax Collector's office) sends you an annual or semi-annual, lump-sum bill for property taxes. Receiving this bill and paying it are never much fun because most communities bill you just once or twice per year.
Property taxes are typically based on the value of a property. Although an average property tax rate is about 1.5 percent of the purchase price of the property per year, you should understand what the exact rate is in your area. You can call the Tax Collector's office in the town where you're contemplating buying a home and ask what the property tax rate is and what additional fees and assessments may apply.
The current owner's taxes may very well be based upon an outdated and much lower property valuation. Real estate listings may contain information as to what the current property owner is paying in taxes. Your property taxes (if you buy the home) will probably be recalculated based upon the price you paid for the property.
If you make a small down payment (typically defined as less than 20 percent of the purchase price), many lenders insist upon property tax and insurance impound accounts. These accounts require you to pay your property taxes and insurance to the lender each month along with your mortgage payment.
Are mortgage interest and property taxes allowable deductions on my income tax return?
One of the treasures of homeownership is that the IRS and most state governments allow you to deduct, within certain limits, mortgage interest and property taxes when you file your annual income tax return. When you file your Federal IRS Form 1040, the mortgage interest and property taxes on your home are itemized deductions.
On mortgage loans now taken out, you may deduct the interest on the first $1,000,000 of debt as well as all of the property taxes. The good folks at the IRS also allow you to deduct the interest costs on a home equity loan (second mortgage) to a maximum of $100,000 borrowed.
Just because mortgage interest and property taxes are allowable deductions on your income tax return does not mean that the government is literally paying for these items for you. Consider that, when you earn a dollar of income and must pay income tax on that dollar, you don't pay the entire dollar back to the government in taxes. The amount of taxes you pay on that dollar is determined by your tax bracket.
Are there tax benefits I should be aware of when selling my home?
When you go to sell your home someday, the IRS allows you to deduct home improvement costs from your profits before paying taxes on them. To take advantage of this, it is in your interest to track the amount that you spend on improvements. IRS home sale tax rules also enable qualifying taxpayers to exclude from federal taxation a large chunk of profit -- up to $250,000 for single taxpayers, $500,000 for married couples filing jointly.
For tax purposes, at the time of sale the IRS enables you to deduct the cost of improvements but not money spent on maintenance. What's the difference? Well there is a difference but, as with all matters on which the IRS has an opinion, that difference isn't always crystal clear.
Capital improvements are things that you do to your home that permanently increase its value and lengthen its life. Capital improvements include such things as landscaping your yard, adding a deck, purchasing new appliances (as long as you leave them when you sell), installing a new heating system or roof, remodeling and adding rooms, and so on.
Maintenance and repair expenses, in contrast, include those types of fix-up items that need to be done throughout your home from time to time. Maintenance and repairs include such things as fixing a leaky pipe or toilet, painting, paying someone to cut your lawn and pull weeds, and the like.
So, when you buy a home, keep handy a file folder into which you can dump receipts for your home improvement expenditures. If you're in doubt as to whether an expense is an improvement or a maintenance item, keep the receipt and figure it out when the time comes to sell your home.
How much should I expect to spend each year on the maintenance of my home?
As a rule of thumb, expect to spend about 1 percent of the purchase price of your home each year on maintenance. Although some years you may spend less, other years you may spend more. When your home's roof goes, for example, replacing it may cost you several years' worth of your budgeted maintenance expenses. With some types of housing, such as condominiums, you actually pay monthly dues into a homeowners association, which takes care of the maintenance for the complex. In that case, you're only responsible for maintaining the interior of your unit. Check with the association in buildings where you might buy a unit to see what the dues are running and whether any new assessments are planned for future repairs.
In addition to necessary maintenance, you should also be aware of what you may spend on nonessential home improvements.
