Can you make a killing buying fixer-uppers?
Many people are enticed by the prospect of making money by repeatedly buying rundown homes, moving into them, fixing them up and reselling them for a profit. The strategy has become even more popular in recent years, thanks to homeowner-friendly changes in the capital gains portion of the federal income tax code. Given all the right circumstances, fixer-uppers can be a lucrative investment, but they're by no means a sure bet or a license to print money.
Is the fixer-upper life right for you? Here are some questions to consider:
1. Do you have the expertise required to meet with contractors or make major improvements yourself? Most homeowners know how to paint a bedroom or install a new light fixture, but those routine chores are a far cry from adding a second bathroom, remodeling an out-dated kitchen, landscaping an entire front yard and the like. Tackling these improvements without the necessary experience and expertise can lead to costly mistakes. And if the home really only needs easy, inexpensive or purely cosmetic repairs, your efforts probably won't add enough value to be profitable.
2. Do you have a working knowledge of which improvements are likely to add value? As a general rule of thumb, improvements that are invisible to home buyers or merely bring the home in line with expected minimum standards don't add much resale value. If you make the wrong improvements, you won't see much, if any, return on your investment. Another potential pitfall is over-improving the home compared to other homes in the neighborhood.
3. Are market conditions in your favor? There's nothing worse than buying a fixer-upper with the intention of making a profit in a couple of years only to discover the real estate market has turned sour. If home values are depreciating, your fixer-upper might be worth less than you paid for it even if you make wise investments in improvements.
4. Are you prepared to pack all your belongings, put your home on the market and move every few years? Moving is time-consuming and stressful, even when it's anticipated and welcome. Will your spouse cooperate with repeated packing and unpacking? How will your children cope with switching to a new school every few years? Will you be able to bond with your neighbors? How much will it cost to move your furniture and household goods?
5. Will transaction costs wipe out your profit? A convincing argument can be made that even the considerable advantages of homeownership aren't always worth the transaction costs associated with buying a home for a short-term residency. The same advice should be taken to heart before you buy a fixer-upper with the goal of making a profit. Will the higher resale value of the home exceed your purchase price, plus your investments and your transaction costs? If so, will the profit-even tax-free--be adequate compensation for your time and effort?
Do You Know What You Want?
Whether you are a first-time homebuyer or entering the marketplace as a repeat buyer, you need to ask why you want to buy. Are you planning to move to a new community due to a lifestyle change or is buying an option and not a requirement? What would you like in terms of real estate that you do not now have? Do you have a purchasing timeframe? Whatever your answers, the more you know about the real estate marketplace, the more likely you are to effectively define your goals. As an interesting exercise, it can be worthwhile to look at the questions above and to then discuss them in detail when meeting with local REALTORS®.
Do You Have The Money?
Homes and financing are closely intertwined. (Financing is the difference between the purchase price and the down payment, commonly referred to as debt or the mortgage.) The good news is that over the years new and innovative loan programs have evolved which require a 5 percent down payment or less..
In addition to a down payment, purchasers also need cash for closing costs (the final costs associated with closing the loan). Not everyone, however, elects to purchase with little or no money down. Less money down means higher monthly mortgage payments, so most homebuyers choose to buy with some cash up front.
As to closing costs, in markets where buyers have leverage, it may be possible to negotiate an offer for a home that requires the owner to pay some or all of your settlement expenses. Speak with local REALTORS® for details.
Is Your Financial House in Order?
Those great loans with little or nothing down are not available to everyone: You need good credit. For at least one year prior to purchasing a home, you should assure that every credit card bill, rent check, car payment and other debt is paid in full and on time.
How Much Can I Afford?
Look at your income to get a guesstimate. As you think about applying for a home loan, you need to consider your personal finances. How much you earn versus how much you owe will likely determine how much a lender will allow you to borrow.
First, determine your gross monthly income. This will include any regular and recurring income that you can document. Unfortunately, if you can't document the income or it doesn't show up on your tax return, then you can't use it to qualify for a loan. However, you can use unearned sources of income such as alimony or lottery payoffs. And if you own income-producing assets such as real estate or stocks, the income from those can be estimated and used in this calculation. If you have questions about your specific situation, any good loan officer can review the rules.
Next, calculate your monthly debt load. This includes all monthly debt obligations like credit cards, installment loans, car loans, personal debts or any other ongoing monthly obligation like alimony or child support. If it is revolving debt like a credit card, use the minimum monthly payment for this calculation. If it is installment debt, use the current monthly payment to calculate your debt load. And you don't have to consider a debt at all if it is scheduled to be paid off in less than six months. Add all this up and it is a figure we'll call your monthly debt service.
In a nutshell, most lenders don't want you to take out a loan that will overload your ability to repay everybody you owe. Although every lender has slightly different formulas, here is a rough idea of how they look at the numbers.
Typically, your monthly housing expense, including monthly payments for taxes and insurance, should not exceed about 28 percent of your gross monthly income. If you don't know what your tax and insurance expense will be, you can estimate that about 15 percent of your payment will go toward this expense. The remainder can be used for principal and interest repayment.
In addition, your proposed monthly housing expense and your total monthly debt service combined cannot exceed about 36 percent of your gross monthly income. If it does, your application may exceed the lender's underwriting guidelines and your loan may not be approved.
Depending on your individual situation, there may be more or less flexibility in the 28 percent and 36 percent guidelines. For example, if you are able to buy the home while borrowing less than 80 percent of the home's value by making a large cash down payment, the qualifying ratios become less critical. Likewise, if Bill Gates or a rich uncle is willing to cosign on the loan with you, lenders will be much less focused on the guidelines discussed here.
Remember that there are hundreds of loan programs available in today's lending market and every one of them has different guidelines. So don't be discouraged if your dream home seems out of reach.
In addition, there are a number of factors within your control which affect your monthly payment. For example, you might choose to apply for an adjustable rate loan which has a lower initial payment than a fixed rate program. Likewise, a larger down payment has the effect of lowering your projected monthly payment.
View the Home Buyer's Handbook brought to you by the Attorney General of Minnesota.