Primary Residence: Determining What You Can Afford

Primary Residence: Determining What You Can Afford

Typically, people buy the nicest house that they can afford. Sometime the thought process is that increasing income over one’s lifetime will ease the burden of a large house payment. There is some merit to this thought process, but I would also urge you to analyze this purchase as a banker would.

This first most important thing to understand is that a primary residence may be considered a financial asset, but it is also a liability because you always need a place to live. Unless you want to be homeless after you sell it, you will always need to purchase another home or rent another apartment. Now, if you purchase a secondary residence for the strict purpose of being rented out, this is purely a financial asset. Either way, I suggest you analyze the purchase like a banker.

Bankers understand that there are 11 major properties that can be used to judge a financial asset. Even though your primary residence is not a financial asset, these tools can be useful for analyzing any large purchase that you make. A home as an asset has advantages and disadvantages to it’s properties, much like any investment.

  • Moneyness: Ability to buy stuff. For example, cash and checks can be used to purchase food or clothes. A house or car cannot do this. You cannot go to a grocery store and buy food by trading your house. Moneyness is an attractive feature for a short term investor.
  • Divisibility and Denomination: Cash and checks can be divided down to the penny. This is smallest denomination in the United States. Other assets cannot be divided like this. For example, often bonds are sold in units of $500 or $1000. Houses are sold in complete, while condos are sold by the unit. While you could take parts off your car or house and sell them for their individual value, most people can clearly see that the value of the lumber in your house is not worth tearing your house apart to eat for a week. Divisibility is an attractive feature for an investor, but not for a borrower. A borrower does not want to get twenty $5000 loans to purchase a $100,000 home.
  • Reversibility: This is the cost to purchase an asset. Generally, a house bought in cash has no major cost, but there is also no market maker. This is a barrier to buying/selling a home. If you decide you want to sell your home, you most likely have to hold it until you can find a buyer. This makes you the market maker and slows down the process. You can hire a Realtor to assist you in selling the house, but this adds to your market making costs. Reversibility is an attractive feature to an investor, and homes require significant cost when transacting and do not have very good reversibility.
  • Cash Flow: Cash flow is the amount of money that is received from a financial asset. A home, which is lived in (without renters), will always generate negative cash flow. Taxes, insurance, and home repairs all contribute to this negative cash flow on a primary residence. Cash flow is attractive for an investor. A primary residence provides no cash flow, but a rental unit provides cash flow each month.
  • Term to Maturity: Term to maturity is the amount of time before a profit or dividend will be paid to an investor. For a home there is no specific term to maturity. The maturity date is the date that you can sell it. This requires you to become a market maker as stated above. With a thirty year loan, a house will typically not provide any maturity until several years into a loan, preventing sale at any sort of profit.
  • Convertibility: It’s common for corporate bonds to have a convertibility clause which allows them to be converted into normal shares. This is attractive to an investor for negotiating market fluctuations. A home does not provide any sort of convertibility. If the home market crashes, it can not be changed into a car and driven to a different neighborhood.
  • Currency: Because of currency fluctuations between countries, it can be attractive for an investor to have an asset which can be sold in multiple currencies. For example, there are bonds which can pay interest in either yen or dollars. Obviously, homes in the US can only be bought and sold in US dollars.
  • Liquidity: Checking and savings accounts are completely liquid. Assets (dollars) can be removed at any time. With a house, one can sell it faster by lowering the asking price, sometimes greatly loosing money. Therefore, homes do not have a good liquidity property. Home liquidity is further limited by the lack of a market maker to buy the home at any time and the lack of divisibility. Liquidity is an attractive feature for an investor.
  • Return Predictability: Return predictability can be somewhat tracked using the Case/Shiller Home Price Index. Prior to 2008, the predictability of home prices was fairly steady and attractive. Since the housing bubble burst, it has been more difficult to predict home prices. Predictability is attractive for an investor.
  • Complexity: Complex assets are made up of other assets. Derivatives may be considered more complex because they are composed of multiple financial assets with complex conditions on buying and selling. Complexity, well complexity can be attractive for market makers, but often risk is difficult to judge for investors.Homes, are simple assets composed of only one investment which makes it fairly easy to analyze.
  • Tax Status: Tax paid on an asset can vary wildly. Homes typically require payment of tax once or twice per year. The rate of tax paid varies by state, county, and city which can make it difficult to judge. Even within similar houses in similar neighborhoods in the same city, taxes can vary wildly. When purchasing a home, one must consider the tax. The tax can sometimes be negotiated with the state, county or city after purchase, but this is risky. Some states, counties, and cities can lock in tax at a certain rate after a certain age (e.x. San Francisco) – this is very attractive for retirees in volatile markets.

Akron, OH

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