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Should You Buy a ‘Starter Home’ or Wait?


flickr.house.photo deanIn many parts of the country, the real estate market seems to be rebounding. “As buyers seek to take advantage of record-low mortgage rates, the supply and demand imbalance threatens to further limit deals as the key spring selling season approaches,” reads a recent Bloomberg article. For the first time in a long time, homebuyers may have to be competitive to snag a new house, which will drive real estate prices up.

If you’re a prospective first-time home buyer, you face the first of many tough decisions: Do you buy a starter home now or save up until you can afford your “forever” home?

Now, everyone will have different ideas of what constitutes a starter home. Indeed, one person’s starter home may be a house another family is happy to own indefinitely.

But in general, a starter home is something you’d be happy living for around five years even if you know you’ll outgrow it. A forever home, on the other hand, is one that you could potentially see yourself living in for the rest of your life, or at least the next 20 or 30 years. This means it meets most, if not all, the criteria of your dream home: the right location, the right size, and all of the extras.

What it comes down to, of course, is money.

The starter home

The term starter home always conjures up images in my mind of construction debris falling on Tom Hanks in “The Money Pit”. But starter home and “fixer-upper” don’t have to be synonymous. A starter home may simply be a small home or condo that you can afford now — with or without making some improvements.

There are benefits to buying a starter home now rather than waiting for years to buy a forever home. First of all, interest rates are at historic lows. Yes, they may be low next year or the year after that, but then again, they may not be low. A good mortgage rate isn’t everything, but your rate will impact your monthly payment and how much you’ll pay in interest over the life of the loan.

Another consideration is the inventory of houses on the market, which is low right now. Ideally you want to buy a property that will appreciate (or at least hold its value) so when you sell it a few years down the road you have equity to put into your forever home. We’ve seen that this isn’t always the case though, so you might also consider whether you can turn your starter home into a rental property in the future if it isn’t the right time to sell when you want to move. For starters, check the rents in the area and make sure they would be more than your mortgage payment.

Buying a smaller home that you can’t sell or rent out when you want to move is perhaps the biggest disadvantage of buying a starter home. Doing as much research as possible can help minimize this risk. Other downsides to starter homes include the costs and hassle associated with moving twice and the potential money you’ll spend making improvements to your starter home that you may or may not recoup when you sell.

The forever home

Of course, most of us won’t live in just one or even two homes our entire lives, but a forever home is something that you can see yourself living in for 20 years or more. Perhaps it’s big enough to accommodate a growing family and will be the kind of home that you envision making improvements to not just for resale value but to enjoy yourself over many years.

Here’s the problem: Not many 30-somethings — let alone 20-somethings — can afford their forever home in this day and age. As home prices and debt loans have risen, paychecks barely budged. In our grandparents’ day, one income bought a perfectly respectable home. Today, two professional incomes may not be enough to comfortably afford any home in some of the more expensive U.S. real estate markets.

So you may choose to rent something more reasonably-priced while you save up for a larger down payment on your forever home. The bigger the down payment, the smaller the loan. If you wait to buy, you also save yourself from the chance that you could be stuck with a smaller home in a bad time to sell, unable to move up.

One disadvantage of waiting for your forever home is that something that’s not affordable now may be even less affordable in the future. Sure, you hope to earn more in the next few years, plus you can save a little bit of money every month, but they aren’t making more land. And if you want to see something frightening, just take a look at the projected population growth in your area.

Though real estate is cyclical and will always have its ups and downs, in the long run it may be harder to get that dream home of yours if you don’t get your foot in the real estate door, so to speak.

A middle ground

Consider how much of a price difference there is between your starter home and your forever home. If the difference can be saved up in a year, you may want to consider waiting. But if the difference between your $150,000 starter condo and your $500,000 single-family forever home seems like it would take more than five years, you may want to aim for a middle ground.

So you may not be able to afford a huge house in the best neighborhood right now, but what about a fairly large house in an area that’s 15 or 20 minutes further from your work? You could look into a townhouse instead of a single family home, or make a few sacrifices like going for that great home with a smaller yard. Instead of having the all or nothing mentality, you may be able to find something that suits your needs for the foreseeable future until you can afford that forever home.

Personally, I’ve chosen the starter home routine. I bought a starter home (which is now a rental property) then three years later bought a “middle ground” home. The home I’m in now will probably suit my family’s needs for around five years. Then I’ll work towards that forever home.

What about you? Did you choose to buy the starter home or wait for the forever home? What are your plans for the future?

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About Sarah Davis

Sarah Davis is a real estate broker in San Diego, Calif. She enjoys helping both buyers and sellers and was voted one of the top 10 best real estate agents in San Diego in 2013 by Union Tribune readers. In her spare time she talks about real estate on a local radio show and manages her website RealtorSD.com.

Comments

  1. Thanks for the article Sarah. I’d be curious how you have calculated the return on your home investments vs. the opportunity cost. I have not purchased a home yet so I don’t have real-world experience with it, but the research I’ve done makes it seem like owning a home for less than 7-10 years is likely a poor investment (unless you get lucky with your home price increasing). But on average, home prices have increased at a much smaller rate than a portfolio of stocks and bonds, which would be the opportunity cost, and you have all of the associated closing costs on both ends. I’d love to hear how you’ve viewed your move from a starter home to a “middle ground” home from a financial standpoint, and how you are expecting it to go when you move again to your forever home.

    Thanks again for the info!

    • Denise D. says:

      I think you’re taking more of a risk if you buy a home that you intend to sell in five or seven years, as opposed to one you hope to live in until retirement–or even longer–because you risk your home value going down and losing money when you sell. Or you risk not being able to sell when you want/need to. But I’ve always thought that simply comparing home appreciation to the stock market was a bit of an oversimplification. A house is a place to live after all, and you can’t live in your stock portfolio. Wouldn’t it be wiser to first calculate how much your mortgage payment (including insurance, HOA dues, and property taxes) would be and compare that to your rent? If it’s a lot more than your rent, that money might be better invested in the stock market, where you could get a better return. On the other hand, if your rent is more than the mortgage payment and extra maintenance/utilities costs associated with owning, the stock market vs. housing appreciation argument doesn’t really apply–unless you move to a cheaper rental, you can’t invest that money anyway.

      If renting is saving you hundreds of dollars every month and you’re investing that money in the stock market, I can see the argument for renting. But if you’re ready to be a homeowner and you want to buy and can afford it, why worry about comparing home appreciation to the stock market? I’m not an anti-renter person; my husband and I are long-term renters, and it’s served us well. I believe we’ve made the responsible decision by renting this long, though we hope to become home owners in a few years. I do think that there are benefits to home ownership if it’s done properly and for the right reasons. And I think people who bought a home simply because they thought it would appreciate rapidly weren’t looking at the long-term trends that you’re speaking of–that housing generally appreciates at or slightly above the rate of inflation.

      That aside, I do agree with your line of questioning regarding closing costs. Sarah, how do you reasonably estimate the “break even” point on a home purchase? And I enjoyed reading the article. My husband and I have been debating about whether we should buy a starter home or just save more and buy the place we really want. We don’t want a huge forever home, but we’d like a small house with a yard, as opposed to a condo or townhouse. I’ll share your take on the subject with him. Thanks!

      • Denise, I think you make really good points. My intention was not to compare long-term home ownership to investing in the stock market. I completely agree that there are many positive reasons to own a home long-term, both in terms of finances and lifestyle. My intention was more to understand how the author had figured the return based on her shorter-term use of these first two homes. In my research, it seems like the short-term costs of purchasing and then selling a home can be punishing on your finances, so I was interested to hear if her experience was different.

        Like you, my wife and I have been renting for years, even with a 1 year old son. With near-term uncertainty as to place of employment and even where in the country we want to live, we have felt much more comfortable financially renting right now than buying and facing selling in a few years time. We share your desire to eventually buy, but we’d like to buy a place we could at least see ourselves living for the long-term, as opposed to buying just for the sake of buying.

        • Denise D. says:

          Sounds like you and I are on the same page. I agree that buying a home that you intend to sell in the short term is a risky maneuver, especially with the way the housing market has been the last few years. The author seems to be suggesting keeping the first home to use as a rental property, thus avoiding the selling/closing process and associated costs. I guess it would depend on your financial situation and how comfortable you are with being responsible for your primary resident and a rental property.

        • When making the comparison between buying a house and investing in the stock market, you also have to consider that your rent goes into a black hole. So, unless your investments can earn more than your rent each month, then it is not the better investment. With buying a home, you are building equity and will get most, if not all, of that money back when you sell. If you are renting, all of that rent is a loss. Yes, you have closing costs, typically 3% of the home value, but 1 year of rent probably outweighs those closing costs.

          I’m looking for my first house right now. My rent is about $13,000 a year, but the closing costs on a $350k house is about $7,500. So, in my case, as long as I live in a house for over a year, then I come out ahead. Yes, my mortgage will be $2,000 a month, doubling what I pay in rent, but most of that $2,000 is buying me equity in my house, which I will get back if/when I sell it. If I took that same $2,000 a month and paid $1,000 in rent and invested the other $1,000, there is no way that $1,000 in the market could make up for the fact that I am throwing away the other $1,000 a month in rent.

          In the end, a house is part investment and part lifestyle. You need a place to live, so why not put your money into a home where you are building equity instead of guaranteeing the total loss with rent. Of course, you need to be financially ready to purchase a house and not over-extend yourself and become house-poor.

          • Before I start, this is not meant to discourage you. I hope you do your own research and come to whatever conclusion you’re most comfortable with. But I would like to clarify some things for you that, based on your comment here, you have not fully understood.

            At the start of paying your mortgage, it is completely incorrect that most of your payment is building equity. In fact it’s the exact opposite. Most of your payment is going towards interest, which is money you will never see again. You mentioned that your mortgage payment on a 350k house would be $2000 per month. Making the assumptions that you’re putting 20% down and taking out a 30 year mortgage, that means you’d have a $280,000 mortgage at about a 7.8% interest rate. If that’s indeed the case, of your first $2000 mortgage payment, only $195 is going towards your home equity. In fact, after the first 5 years, using bankrate.com’s calculator, you will have paid $127k in interest and only built up $18k of equity. (If instead you’re talking about a 15 year mortgage, then after 5 years you will have paid $49k in interest and built up $95k of equity. A much better equation for you.)

            If instead you paid your current $1100 rent (approximated based on your $13k per year number) and invested the other $900 each month, with a relatively conservative 4% return you’d have about $60k after 5 years. Much better than you $18k equity in the first scenario above.

            Again, not trying to discourage you from anything. And these numbers will look different if you stay in your home for a long time. Also, my guess is that you’re upgrading your home/location if you’re going from your current rent to a $350k home, which may be a big factor for you. But to just assume that renting is throwing money away and that buying a home is good because you’re building equity is a vast oversimplification.

  2. David E. Weliver says:

    This post hits home for me right now too. After about 2.5 years in our starter home, we’re buying a “forever” home a few miles down the street. We often thought we’d be here more like 5 or 6 years, but the combination of finding the right house and good mortgage rates caused us to move sooner.

    As an investment, our current house was a terrible one: we’re selling for a couple thousand less than we paid in 2010, never mind updates we made and the realtor’s commission. But we didn’t buy it as an investment.

    It was a nice place to live. It was a home.

    Could we have found a nice rental instead? Sure. But in the town we wanted to live, there aren’t many rentals. And when I add up the interest and taxes we paid, the upgrades we made, and the net loss we’ll take when we sell (after closing costs and realtor’s commission), we paid an equivalent of $1,600 a month in “rent”. That’s almost exactly what it costs to rent a comprable home in this area.

    If you’re savvy, I think that the financial difference between renting and owning (at least in the short term) will be small. The non-financial differences, however, are significant. Renters enjoy less maintenance, less risk, and the flexibility to move without worrying about a house to sell. Buyers, instead, get that intangible “pride of ownership”. Either way, your home will be one of your biggest expenses. Pick your poison!

    • Thanks for the info David. Glad to hear that your experience was so positive. I definitely think there are ways to purchase a home responsibly, as you clearly seem to have done. I also think that there are many people who’s only mindset is “I need to buy a house”, because that’s what they’ve heard their whole life, and you can really get in trouble that way. But again, glad to hear that you were able to make it work, even in the short term. Gives me some encouragement that we could do something similar.

  3. “In our grandparents’ day, one income bought a perfectly respectable home.”

    Lifestyle inflation has been changing things a lot, in our grandparents’ day 800-1000 sq feet was a respectable home, today you will have a hard time finding someone that considers 800 sq feet a “respectable home.”

    • I agree completely Mark, while certain housing markets have gone absolutely bonkers, a lot of the supposed ‘difficulty’ in finding an affordable home in your 20s is people wanting to move back into the house they left when they went to college (i.e. their parent’s ‘forever’ home). 5 bed/2.5+ bath, 2500 sq ft, etc.

      We bought a house last year, built in the early 60s, just under 1000 sq ft, 2 car garage. We plan on adding a half bath in the basement and this house could easily be a forever home. Plus having it paid off in a few years will be much more comfort to me and my wife than an extra thousand sq ft of living space to fill with stuff we don’t need. Still if we need the option, we can keep it and rent it or even sell it and move the equity into a ‘normal’ house in the ‘burbs.

  4. I’ll share my experiences here. This article caught my eye because it’s something I’ve definitely put a lot of thought to over the past few years. I really believe every situation is different. I bought a starter home when I was 21 — I am now 23. It is a 4 bedroom condo about 2 miles away from a pretty large public university, which I was planning on attending. I was going to move out from my parents’ anyway, and this condo just kind of picked me – I wasn’t even seriously looking at the time. But it happened, and I wouldn’t go back. It spoke to me because of its long-term cash flow potential. After I finish school and I move out, I’ll still keep it because the rents generated more than cover my mortgage and other expenses. Even now, with me staying in one room, the mortgage is covered. So it was a pretty ideal move. However, my first year was definitely in the negative, as I bought it when I was a senior in college and had it managed by a property manager — no bueno. It was returned to me after a year as a DISASTER. I had to re-do the carpeting, paint, etc. not to mention that many times rents were late and one tenant even was evicted. I’ve definitely learned from that experience and won’t be using an outside property manager again.

    The seller covered closing costs — so when it comes to that, there is always some wiggle room. Don’t know what the real estate market is going to do over the next few years, but either way — whether I hold it or sell (if the market surges), I’m in a pretty good place. My situation is pretty unique, but I’m sure there are others out there who’ve made a similar move. Which means… you can too! If you don’t mind taking a little risk and putting in some effort…

  5. I bought a starter home when I was 26 years old. I knew I was only going to own the home for five years or so but thought that it would be better than “wasting” my money renting. I met my future wife and I bought the home in 2009 when I took advantage of the $8k first time homebuyer credit. We moved in together got married and in two years our job situation changed and we ended up putting the house up for sale. I purchased the house (in upstate NY) for $128k in June 2009 (realtor never explained to me what seller concessions were) and closing costs/down payment was $15k. We put the house on the market in July of 2011 and made a move to an apartment a few hours away spending the same amount on rent as we did on the mortgage. It was hard for me to swallow that we’d be “wasting” our money not building equity into something or being able to take advantage of “writing the interest off.” Mind you this starter home needed TLC and that’s what we gave it. We spent a few thousand on paint, trim, etc. to spruce it up so I figured when selling time came we would be ok. I was wrong. We rented while paying on the mortgage for seven months until we closed in March 2012 for $118k and me cutting a check for another $11k. in two and a half years we paid over $30k in real estate fees, house upgrades, appliances, etc. On top of this we were required to pay back the $8k on this years return. Luckily we found out from our accountant that on IRS form 5405, if you can prove you took a loss on the house you do NOT have to repay the credit. Skip ahead a few months, I am now 29, my wife 32, and our learning experience has led us to purchase our “forever” home. Sure it was much bigger and more expensive than the first but we are lucky to have great jobs. My point to this is WAIT and rent and save up. A starter home isn’t just about writing the interest off. It is repairs, property care, upgrades, etc. The only positive thing that came out of the first house was a huge learning experience. I understand everyone has a different situation but the amount of money spent in closing costs/down payment when purchasing and the closing costs when selling a starter home in a few years can be the money spent for a 20% down payment on a “forever” home thereby eliminating that pesky PMI payment. Good luck and my best to all!

  6. My husband and I just bought our first home and we wrestled with the question a lot, primarily when we were setting our house-hunting budget. We ended up buying in between our idea of a starter home and a forever home. We got the house we could see ourselves living in for 10-15 years. In the market we’re in, we were able to purchase the home with a total (mortgate, insurance, taxes, PMI) monthly payment $7 higher than the house we were renting. So far, our utilities have also been cheaper in the new home. Once we looked at the numbers, buying wasn’t a stretch. When it comes time to sell, even if we sell at a loss, we figure we are no worse off since we would have been spending at least that much in rent monthly. Also, where we were renting, other houses on our street with the same specs as ours were renting for 50-75% more per month than we were paying. We didn’t like the odds of our landlord wanting to raise rent at the end of our lease. If people are willing to pay that much more, of course the landlord would want to make it! Staying in the rental market seemed much, MUCH riskier than purchasing.