Ownership cost calculations for family homes
The OC Housing News provides detailed ownership cost calculations for every family home for sale on the local MLS.
A point-in-time analysis
Today is reality; tomorrow is a fantasy. The ownership cost calculation is a snapshot of the cost of ownership at the time of first payment. It makes no projections for future changes such as home price appreciation. This analysis purposely does not project future changes for two reasons: First, the costs at the time of first payment are concrete and knowable. It requires fewer assumptions and no crystal ball. Second, most people who estimate future appreciation wildly overestimate. Very small changes in rates of appreciation make very large differences over 10 or more years. Overestimating appreciation always makes owning a property look very desirable financially. It’s a mistake many people made who bought at the peak of the housing bubble.
Concise Description of Ownership Cost Terms
Below is a concise description of each line item displayed on the MLS property details, why the item is important, and how it’s calculated. For more detailed descriptions, links to posts on these topics is provided at the bottom of this post.
This is the current asking price on the MLS.
A conventional loan requires a down payment that is 20% of the purchase price. Down payments will less than 20% down require private mortgage insurance, a policy paid by the borrower that protects the lender from loss. FHA down payments are generally 3.5% of the purchase price. The down payment is calculated by multiplying the asking price by 20% for a conventional loan and 3.5% for an FHA loan.
Mortgage Interest Rate
Mortgage Interest rates are set by lenders competing to offer loans to borrowers who are buying or refinancing real estate. Mortgage Interest Rates are quoted on many websites, such as Bankrate.com. If the loan is over the conforming limit, a jumbo premium of 0.35% is added to the market rate. The OC Housing News calculations uses the interest rate prevailing when the listing first came on the market. The interest rate is periodically updated. The mortgage interest rate shown is not a quote. It is provided for estimating payments and cost of ownership.
Number of Years
The terms of a loan generally require repayment over time. A mortgage with a fixed repayment schedule is called an amortizing mortgage, and the period of time over which the mortgage amortizes is called its term. The term of mortgages is generally 30 years, but 15 year terms are also common, and lenders offer other schedules. The OCHN calculations assume a 30-year fixed-rate amortizing mortgage because it is a stable balance between low payments and reasonable repayment period, and it’s the most common form of home financing.
The mortgage balance for a conventional mortgage is the asking price minus the down payment. The mortgage is 80% of the purchase price in these calculations, but buyers executing a move-up sale may have larger down payments and smaller mortgage balances.
The FHA mortgage is not as simple to calculate as a conventional mortgage because the FHA charges a 1.75% up front fee that gets rolled into the mortgage. The amount borrowed is 96.5% of the purchase price (100% – 3.5%) plus the 1.75% charge, for a total mortgage balance of 98.25% of the purchase price (96.5% + 1.75%). This is why the FHA mortgage plus the down payment does not equal the asking price.
The income requirement is based on standards set by Fannie Mae, Freddie Mac, and the Federal Housing Administration (GSEs and FHA). The monthly cash outlays (described later) multiplied by 12 gives a yearly payment burden. The yearly payment burden must not exceed 31% of a borrowers income under most circumstances (FHA often makes exceptions). The formula is as follows: Income Requirement = Monthly Cash Outlays X 12 / 0.31
Monthly Mortgage Payment
The monthly mortgage payment is determined by lenders using a formula outlined below. It’s based on the mortgage amount, mortgage interest rate, and loan term (number of years) as described above.
The following formula is used to calculate the fixed monthly payment (P) required to fully amortize a loan of L dollars over a term of n months at a monthly interest rate of c. [If the quoted rate is 6%, for example, c is .06/12 or .005].
P = L[c(1 + c)n]/[(1 + c)n – 1]
Proposition 13 sets property taxes in California are set at 1% of purchase price (assumed asking price).
Mello Roos & Special Taxes
Mello Roos are an example of a special tax levy put on the property by the developer in California. The local Assessor’s office has this information online, but it is not organized in a way permitting easy download, so it must be estimated. Not every developer creates a Mello Roos district, so some properties developed since 1985 may have no Mello Roos. For those properties, the cost of ownership calculations will overstate the true cost.
The calculations on the OCHN estimate as follows:
If the year of construction is 2002 or later, Mello Roos = Property Cost Basis × 0.04.
If the year of construction is 1994 or later but earlier than 2002, Mello Roos = Property Cost Basis × 0.02.
If the year of construction is 1985 or later but earlier than 1994, Mello Roos = Property Cost Basis × 0.01.
Homeowners insurance rates vary widely, but the standard estimation is $25 for each $100,000 in home value.
The HOA dues is taken straight from the MLS. Sometimes agents input this information incorrectly, but for the most part, the numbers are accurate.
FHA Mortgage Insurance
Conventional mortgages with 20% down pay no private mortgage insurance. FHA insures mortgages with as little as 3.5% down, and the cost of this insurance is 1.3% percentage of the loan balance — it’s higher than property taxes in California.
Monthly Cash Outlays
The monthly cash outlays — also known as PITI — is a standard lender calculation of housing costs. It is the sum of the costs listed above: payment, property tax, Mello Roos, Insurance, HOAs, and mortgage insurance.
The tax savings is the most complicated of the calculations. Based on the income requirement, the borrowers income is compared to both Federal and California tax tables to determine the marginal tax rates for both entities. To determine the maximum potential tax savings, the marginal tax rate (both Federal and State) is multiplied by the sum of mortgage interest, property taxes, and mortgage insurance (those are deductible expenses). However, to calculate the actual tax savings the marginal tax rate must be multiplied by the standard deduction, and this number must be subtracted from the maximum potential tax savings. This adjustment is necessary because in order to claim the deduction, a tax filer must itemize, and this requires surrendering the standard deduction. This calculation is so complex because it must be repeated for both State and Federal taxes, and both have different tax rates, different income thresholds, and different standard deductions.
Since part of the mortgage payment is principal, and since this is effectively a forced savings account, the amount of principal amortization must be backed out because it is not a true cost of ownership.
The payment is calculated by the formula detailed above. The interest on the debt is the outstanding loan balance multiplied by the interest rate and divided by 12. The interest is subtracted from the payment to ascertain principal amortization. Over time, principal amortization grows and mortgage interest declines. However, since this is a point-in-time analysis, only the amortization of the first payment is counted.
Opportunity cost is perhaps the least understood of the adjustments to ownership cost. When a down payment is applied to a home purchase, that money came from somewhere. If the buyer would have chosen to rent, that money could have been invested in any number of safe investment alternatives. The loss of this investment income is the opportunity cost.
The calculation herein takes the mortgage interest rate, divides it by 3, then adds 1% to it. This generally approximates the yield on medium-term CDs, money-market accounts, or Treasuries. For example, at 4.5% interest rates, the opportunity cost would be 2.5% (4.5% / 3 + 1%).
Maintenance and Reserves
Real property requires routine maintenance. Further, over time, more expensive items such as roofs or exterior paint need replacement. Budgeting for the irregular expenses of routine maintenance and the slow depletion of wear and tear requires establishing a monthly allowance for maintenance and replacement reserves.
The formula used here is asking price times three-tenths of one percent divided by twelve (0.003/12).
Monthly Ownership Cost
The monthly ownership cost is the monthly cash outlays adjusted for tax savings, principal amortization, opportunity cost, and maintenance reserves.
Comparable rental rates are determined by an advanced algorithm for selecting comparable properties. When I was actively flipping properties in Las Vegas, I evaluated both resale and rental comps on over 1,500 properties. I developed a series of steps to gradually loosen the various parameters until I obtained a sufficient number of comparable properties to make a reasonable estimate of value. These algorithms are proprietary. As this is an automated analysis, there is a degree of error in these estimates, and the actual comparable rental rate may be significantly higher or lower than the rate shown.
(Savings) or Loss
The savings or loss is the monthly ownership cost minus the cost of a comparable rental. If this number is negative (in parenthesis), then the property costs less to own that to rent, which is a good sign. If the number is positive, it costs more to own than to rent.
Furnishing and Move In
Furnishing and move in costs vary considerably depending on the tastes of the buyer. There are generally fixed costs for movers and other service providers, and variable costs for furnishings. In general, people will furnish a house in proportion to its cost. The following formula is a low-cost estimate; most people when moving in to a family home will spend much more.
The formula used here to estimate is 1% of the asking price plus $3,500.
The buyer and seller often split certain costs at closing, and some costs are entirely the responsibility of the buyer. What’s paid by the buyer and what is a split cost varies by local custom. For financed purchases, the buyer must pay closing costs including loan origination fees and other lender costs.
The formula used here to estimate is 1% of the asking price plus $3,500.
The down payment is calculated above. It’s repeated here because it’s part of the calculation of total cash costs.
Total Cash Costs
The total cash costs is the amount of money a buyer must have available to complete the sale including furnishing and move in, closing costs, and the down payment. People often forget about closing costs and furnishing cost and go into debt shortly after the sale to cover these costs.
Emergency Cash Reserves
Though not an actual cost of acquiring the property, financial advisors always recommend having sufficient cash reserves to cover expenses in case of an emergency. Further, lenders often require liquid cash reserves in addition to the down payment as a condition to funding. Most borrowers do not reserve much if anything when buying a home. Almost none have an additional six-month’s income like most financial advisors recommend.
The calculation herein only estimates three month’s of income based on the income requirement generated above.
Total Savings Needed
The total amount of savings necessary to have a stress-free purchase is the total cash costs plus sufficient emergency reserves.