Should I Upgrade My Existing Home or Buy A New One? Here Are Some Key Considerations

Read the next post in this series: Thinking of a Second Home? Here Are Some Key Considerations.
If you are considering purchasing your first home, read: Tips for First-Time Home-Buyers.

A common scenario I hear, especially for those in the hot housing markets of California, goes something like this: “We don’t really fit into our house anymore. Should we buy a new home or remodel our existing home?”

Oftentimes, the folks in this situation live in a home built decades ago that is not up-to-date. Remodeling or rebuildling is expensive in California. But, then again, so is buying a new home.

What’s smarter…remodeling/rebuilding or buying a new home?

The process of transforming an existing home or buying a new one weaves together many threads. From cut-and-dry financial calculations to questions of personal and family well-being, I find that the best outcomes in purchasing a home come from a holistic approach where the particular considerations of each option are well understood.

So, what are some key considerations in deciding whether to trade up to a larger and/or newer home?

Exciting developments in our personal lives–a new child or a big promotion, for example–can prompt us to consider purchasing a new primary residence. Perhaps a bigger house is desired or a home in a new school district. To best prepare yourself for such a transition, I recommend beginning by evaluating your current home.

• What would you net in proceeds if you were to sell at an acceptable price, a good price or the ideal price? Work to determine how much of those proceeds would go to pay off any mortgages, realtors, closing costs and, for some, capital gains taxes. What’s left over?
  
• Are you eligible for a capital gains tax break given the IRS home sale exclusion rule? If you lived in the home as your primary residence for two of the last five years, you likely qualify for a $250,000 home sale exclusion per person. A domestic couple, for example, would be eligible for $500,000, which means the first half million dollars of capital gain is excluded from capital gains calculations.
  
• What is your current cash flow situation? Take into account costs like property taxes, mortgage payments, homeowners insurance, utilities and any other recurring bills related to your current home.

Next, turn your attention to the house you want to purchase.

• How far do the net proceeds from the sale of your current home cover the up-front costs of purchasing your next home? Where is the down payment coming from? Do you need to sell assets to make the down payment? If so, what are the tax implications of selling those assets? Remember, if you sell appreciated assets, you likely will have an additional tax liability.
  
• If you need financing, will you qualify for it? Generally speaking, lenders will not approve you if the total housing payments, plus any other debt payments, exceed 40% of gross income. For example, if your mortgage payments, home insurance, property tax plus, let’s say, student loan payments exceed 50% of gross income, you will likely not qualify.
  
• If you qualify for financing, can you actually afford it? What is the difference between your recurring home expenses at present and those anticipated with the new home? For example, are the property taxes higher? Is the insurance more expensive? Look beyond just “getting in” and examine what will likely be higher monthly expenses. And don’t forget to think through other recurring expenses, such as child care. Will your income suffice to cover it all?

If this analysis suggests that the home you want to purchase is affordable, consider the actual transition. If you are in a financing position, do you need to sell your home first before you buy or can you buy before you sell? In a very competitive market, it is hard to buy a second home on the contingency of selling a first home. Some, who have enough equity or other assets, may qualify to own both homes at the same time, although this path is generally not ideal or sustainable from a long-term cash flow perspective.

If you have enough equity in your existing home, some people choose to take cash out through a home equity line or a cash-out refinance to make funds available for the next purchase without having to sell assets. Some may use a margin loan or pledged asset line to borrow against the value of investments, but please first understand the risks thoroughly, should those investments decline in value. Remember, though, that this liability has to be serviced by debt payments, and as such, will impact how much a lender might qualify for you on the second home.

I recommend taking a step back and thinking about the bigger emotional picture when contemplating a new or larger home. You’ve likely built memories in your first home; what will it feel like to leave those behind? Is a different house going to make a major difference in your quality of life? Will that offset the financial trade-offs, having to go through the process of moving and/or changing your children’s school districts? Is the home you wish to purchase truly ideal or is this next potential purchase also a compromise of sorts?

There are no right or wrong answers to these questions. It’s the exercise of asking them and being truthful with yourself that helps build clarity on the right path forward.

What are some key considerations in deciding whether to remodel or rebuild one’s existing home?

While modifying your existing home may seem like a simpler and less risky endeavor, it’s important to keep in mind that renovating or rebuilding a home is usually a large and complex undertaking. Let’s break it down into a few key areas that warrant review.

• Financially, the cost of construction, labor and materials is volatile and currently increasing for a variety of reasons, particularly since the pandemic began. Recently, for example, the price of lumber has been skyrocketing. Who saw that coming?
  
• If you will need to vacate the premises for the construction, how long must you leave? For those three, six or even 12 months (or more!), where will you live and what is the cost associated with that? If you decide to reside in the home during construction, how will that impact your quality of life?
  
• California tends to have strict guidelines on permitting, occupancy, approvals and more, which adds risk to timeline and cost. You will likely be required to submit plans and get permits. If the scope of work is large enough, your project may be labeled a “new construction,” which can bring to the fore all current codes and requirements such as set-back minimums, mandatory solar installation, new sprinkler systems or needing to bury utilities. For many properties, especially those multi-decades old, this can create significant extra work and cost.
  
• Your construction project may be subject to public review and/or public hearings. If so, you’ll likely need to spend time engaging your neighbors and being responsive to their input on your plans. Your relationship (or your contractor’s) to your local municipality will be important here. This additional hurdle in the process further illustrates how remodeling or rebuilding your home is not entirely within your control.

This is not to suggest that rebuilding or remodeling a home is a bad idea. These projects simply involve more moving parts and risks, typically, than people usually assume–especially in California.

To get a sense of the affordability of upgrading your home, it’s important to take into consideration all potential costs. These include obvious line items like the costs of construction management, labor and materials. But they also include expenses like rent on a storage unit or another dwelling during the project. Don’t forget that it’s extremely common for projects to go over budget and it’s advisable to add room for that in your projections.

It is also vital to think through financing. Do you have cash or investments that can help you pay for it? Or do you plan to use some of the existing equity in the property, such as through a cash-out refinance, home equity line of credit, or a combination of the two? It’s important to bear in mind that it’s next to impossible to get this kind of financing once construction is underway; secure it in advance–before demolition!–when your home will appraise. There are additional options for financing available, such as construction loans, depending on each individual’s situation.

While expensive and often cumbersome, renovation sometimes comes with a tax benefit that is not available if moving into a new home altogether. Counties will typically complete a supplemental assessment of the property value which can increase property taxes, but this increase is often less than the differential in property tax from moving to a new property. This is because property tax increase in California is generally limited by Prop 13 while you live in the home. Moving can reset the whole equation to a much higher rate, however, especially if the new home you are purchasing is significantly more expensive. We suggest you learn more from your county’s assessor. Here, for example, are links to information about San Mateo and Santa Clara county.

Finally, it’s advisable to consider the emotional and life-balance aspects of a major construction project on your home. If occupancy is allowed by your municipality, you may be living in a construction zone, which can be stressful and upend domestic tranquility. If you aren’t allowed to live there, or don’t wish to, you will be spending significant time away from your home.

In the day to day, most homeowners undergoing construction are faced with endless decisions about details like cabinet knobs and paint color. Do you thrive on this kind of engagement or do you bristle at it? If you are in the latter camp, can you afford a design-build company that will do a lot of that legwork for you?

There is certainly a lot at play here. What is the take away?

Having a place to call home is central in most of our lives. It’s a place where we can take refuge, recharge and nurture ourselves and our families. But sometimes we make decisions that lead to overextending ourselves and, therefore, take away from that sense of calm and centeredness a home can bring. Don’t get me wrong, buying or upgrading a home can be an exciting and life-changing experience. The key is preparation and setting yourself up for success. Putting in the work to make these large expenditures of time and money align with your overall ambitions and life plan is worth the effort.

The information provided in this commentary is intended to be educational in nature and not advice relative to any investment or portfolio offered through Wealth Architects. The views expressed in this commentary reflect the opinion of the author based on data available as of the date this commentary was written and is subject to change without notice. The information provided in this blog is not a solicitation for the investment management services of Wealth Architects.