For First-Time Homebuyers, Consider This

by Louis

Does it make more sense to rent or buy?

This age old question is asked by many people considering buying a house. Recent studies indicate that the cost of renting now exceeds the cost of buying in many markets.

In an effort to curb the decline in real estate value, slow foreclosures, and encourage home ownership, the Obama administration has expanded on two policies started in 2008: the Federal Reserve Mortgage Backed Security Purchase Program and the First-Time Homebuyer Credit. Taken together, these two programs currently create a short window that greatly effects the question “To rent or to buy?” for first-time homebuyers.

Federal Reserve Mortgage Backed Security Purchase Program

In November 2008, the average rate on a 30-year fixed mortgage was 6.09% per a monthly survey published by Freddie Mac. However, on November 25, 2008, the Federal Reserve changed the mortgage rate landscape in the near term by announcing that it would initiate a program to purchase $500 million in mortgage-backed securities (“MBS”) backed by Fannie Mae and Freddie Mac.

In March 2009, the Federal Reserve decided to increase its MBS purchases by $750 million, bringing the total purchases to $1.25 trillion. The goal of the Fed’s program is “to reduce the cost and increase the availability of credit for the purchase of houses…”

After the program was announced, mortgage rates immediately fell. In fact, per the same Freddie Mac survey cited above, the average rate on a 30-year fixed mortgage during April 2009 was 4.81%, the lowest recorded rate in the 38 year history of the survey.

While arguably not the only factor affecting the sharp decline in mortgage rates, there is no denying that the MBS purchases have a strong effect. The MBS program is scheduled to last at least until the end of the year. Where mortgage rates will go after the Federal Reserve is finally done purchasing MBS is anyone’s guess, however, many commentators suggest the only way for rates to go is up.

Reverse mortgage rates may also rise, so if you are considering one, first read over the reverse mortgage pros and cons. The first obvious benefit you will notice is that you do not have to make monthly payments to your lender. However, a major problem you could encounter is that the remaining balance will be due all at once if you move out of your home or pass away.

First-Time Homebuyer Credit

In addition to additional MBS purchases, the Obama administration revised the First-Time Homebuyer Credit in the recent economic stimulus package. Prior to the revision, the credit was $7,500 for principal residences purchased on or before December 31, 2008.

The credit previously needed to be repaid to the government over a 15-year period. However, for purchases of a principal residence after December 31, 2008 and before December 1, 2009, the credit is increased to $8,000 and does not need to be repaid to the government if the homebuyer does not sell their house within three years after the purchase.

For purposes of this credit, the IRS defines a “first-time homebuyer” as a person that has not had an ownership interest in a principal residence within three years before the date the home is purchased.

It should be noted that not all “first-time homebuyers” qualify for the credit. For example, the credit begins to phase-out for individual taxpayers earning more than $75,000 and married filing jointly taxpayers earning more than $150,000. There are no plans at the current time to extend this credit for purchases past December 1, 2009.

Impact on Home Purchases

These two unprecedented programs currently in place for most of 2009 create unique factors that prospective homebuyers, with the means for a sizable down-payment and savings for an emergency fund, should consider in making their decision about whether to rent or buy a house.

Consider the below example:

Jack and Kate earn $100,000 a year, file a joint tax return, and do not currently itemize their deductions. They have never owned a house and are currently paying $1,500 in non-deductible rent for a two bedroom apartment. Jack and Kate want to buy a house which is currently selling for $400,000. Real estate taxes are $4,000 and homeowners insurance is $800/year.

Jack and Kate have enough cash for a 20% down payment and an ample emergency fund. Jack and Kate are considering taking out a $320,000 mortgage.

If MBS Purchases and Tax Credit Did Not Exist
Let’s assume Jack and Kate obtained at a $320,000 mortgage at the 6% interest rate, a relatively low historical standard. Their monthly payment would be $2,318. (The first payment will break out as follows: $1,600 of tax-deductible interest, $333 of tax-deductible property taxes, $67 of non-deductible homeowners insurance and $318 of principal. The amount of interest and principal will change a couple of dollars with each subsequent payment).

With the MBS Purchases and Tax Credit
Currently, Jack and Kate may be able to get a $320,000 mortgage with as low as a 4.75% interest rate. Their monthly payment would now be $2,069 (The first payment will break out as follows: $333 of tax-deductible property taxes, of $1,267 tax-deductible mortgage interest, $67 of non-deductible homeowner’s insurance and $402 of principal).

In addition, Jack and Kate should be able to obtain a $8,000 credit on their 2009 tax return (they can actually get the credit sooner if they extended the filing of 2008 tax return or file an amended 2008 tax return).

To put into monthly terms, the $8,000 spread over 36 months is approximately $222. Therefore, if we hypothetically apply the $8,000 to their mortgage payments for the next three years, Jack and Kate’s payment is effectively $1847 over the next three years, with the same tax benefits for the interest and property taxes.

Whereas Jack and Kate may have been taking the standard deduction before their home purchase, Jack and Kate should be able to itemize. Therefore, they may obtain other deductions they would not have been entitled to before (e.g. charitable contributions, unreimbursed employee expenses, etc.).

As seen from this example, a first-time homebuyer may obtain significant benefits from the two programs. Over the next three years, instead of paying $2,318 for their mortgage, Jack and Kate will effectively be paying $1,847, a savings of $471/month.

Weighing Benefits vs. Risk

While the benefits of the two programs are clear, the current data indicates that the housing market is still in decline. For instance, national home prices dropped 19.1% in the 1st quarter of 2009 compared to the first quarter of 2008.

However, the data also indicates that the decline in slowing from month to month, indicating that the housing bottom may be near in some housing markets. In fact, many commentators are suggesting that now is a great time to buy since prospective homebuyers can find great deals on foreclosures and short sales.

The decision to buy house may be the biggest financial decision a person makes. Many factors should be taken into account. However, at least for 2009, two more factors should be taken into account by prospective first-time homebuyers.

This post is not responsible for providing readers with specific tax advice and encourages readers to consult with their own tax advisors to confirm their specific tax consequences, including any state, local, or foreign tax considerations. This post was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, or local tax penalties.

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