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The Complete Guide to Disability Insurance

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

Quick quiz: What’s the most valuable financial asset you own as a young professional and a provider for your family?Here are some hints: It’s not your home. It’s not your 401(k). And it’s definitely not your car.

The answer? It’s your future income. The money you earn in the years to come will allow you to pay your bills, save for the future, and create a secure financial foundation for you and your family.

Really, all the plans you’re making both for today and the future rely on the assumption that you’ll continue earning money. Which is exactly why it’s so important to protect that income and make sure you receive it no matter what.

That’s where disability insurance comes in.

Disability insurance ensures that you’re able to continue paying your bills and putting food on the table even if your health prevents you from working for an extended period of time. By sending you a monthly check that replaces some or all of your income, it protects your biggest financial asset from those worst-case scenarios.

It’s something that just about every working parent should have, but it’s a complicated product that can be difficult to understand and get right.

So in this post you’ll learn all about how disability insurance works and what kind of policy you should be looking for.

Why You Need Disability Insurance

Disability insurance is often ignored both because the prospect of becoming disabled seems remote and because the premiums can be hard to swallow, especially for young families who are already struggling to pay for child care and all the other expenses that come with having young kids.

But extended disability is a lot more common than most people think.

According to WebMD, your odds of becoming disabled before you retire are about 1 in 3.

The leading causes of disability include:

  • Arthritis
  • Back pain
  • Heart disease
  • Cancer
  • Depression
  • Diabetes

For the most part it’s chronic illness that causes disability, not the kind of major accident that typically comes to mind. And the odds of it happening before you’re financially independent are fairly high, though there are some situations in which your personal odds may be lower.

So the big question is this: If you’re one of the 33% of people who faces an extended disability, where would the money come from to pay your bills and put food on the table? How long would your savings be able to support you, and what would you do if you needed help past that point?

Most people would struggle to make it more than a few months, which is exactly why disability insurance is so valuable. By replacing your income for potentially years at a time, it ensures that you’ll be able to continue taking care of your family no matter what.

Short-term disability insurance vs. long-term disability insurance

There are two main types of disability insurance: short-term and long-term.

Both can be helpful, but they play very different roles in your financial plan. Here’s an overview of each.

Short-Term Disability Insurance

Short-term disability insurance only offers benefits for a relatively limited amount of time. Most short-term disability insurance policies cover you for 3-6 months, though they can provide coverage for up to two years.

There is typically a waiting period of up to 14 days before the insurance kicks in to prevent it from covering minor illness and injury. After that waiting period, it will typically start to pay 50%-100% of your regular income until you either return to work or your coverage period ends.

One of the most common uses of short-term disability insurance is during maternity leave. Many, though not all, short-term disability policies cover the latter parts of pregnancy and the period after childbirth, which can help replace your income while staying home with your newborn.

Most short-term disability insurance policies are offered as an employer benefit, and in some cases that coverage may even be free. Private coverage is also an option if you aren’t able to get coverage through work, though those policies can be expensive. For example, a healthy 38-year-old male might pay a $2,300 annual premium for a $5,000 monthly benefit and 12 months of coverage.

One alternative to short-term disability insurance is building an emergency fund. A 3-6 month emergency fund would provide the same protection as a 3-6 month short-term disability insurance policy, with the added benefit of not having a monthly premium.

Long-Term Disability Insurance

Long-term disability insurance is where you typically find the most value. Because while a short-term disability could be covered by a healthy emergency fund, an extended disability is much more likely to deplete your family’s savings and put you in a difficult position unless you have some way of replacing your lost income.

Long-term disability insurance picks up where your emergency fund or short-term disability insurance leaves off. There’s typically a 3-6 month waiting period during which you would have to replace your income by other means.

But once you’re past that waiting period, your long-term disability insurance would start replacing your monthly income and would continue to do so for years at a time, as long as you remain disabled.

This is a big potential benefit. A long-term disability policy that replaces $5,000 per month in income will potentially pay you $60,000 per year for as long as you’re disable. That would go a long way toward keeping your family on the right track.

Given that potential value, it’s usually more important for families to secure long-term disability insurance than short-term disability insurance. For that reason, the rest of this guide will focus primarily on long-term disability insurance.

10 Questions To Ask When Shopping for a Long-Term Disability Insurance Policy

Long-term disability insurance is a complicated product with a lot of terms and conditions that vary policy to policy. Finding a good, independent disability insurance agent who isn’t beholden to any particular insurance company can help you secure the right policy at the right price for your specific situation.

But whether you’re looking on your own or with the help of an agent, there are 10 key features you’ll want to evaluate.

1. Your Monthly Benefit

Your monthly benefit is the amount of money your long-term disability insurance policy would pay you each month in the event of disability. And there are a few key factors that go into deciding how big a benefit you need:

  1. What are the monthly expenses you would have to cover if you lost your income? Consider the fact that you may be able to cut back on certain discretionary expenses, but also that you may have additional medical expenses in order to treat the disability.
  2. What other income sources do you have? You can factor in your spouse or partner’s income, your savings, and possibly even help from family.
  3. Would your benefit be taxable or tax-free? The benefit from an individual policy you purchase on your own would almost certainly be tax-free. The benefit you get from an employer policy would likely be taxable. The difference affects how much money you would actually have available to spend.

2. How They Define ‘Disability’

Believe it or not, there is no one way of defining disability. There are a lot of variations, but most policies fall into one of three main groups:

  • Any occupation – This is the most restrictive of the three definitions. It defines disability as the inability to perform any job, no matter what it is or how much it pays. It’s hard to qualify for benefits under this definition.
  • Own occupation – This is the broadest of the three definitions. It defines disability as the inability to perform the main duties of your current job. It’s easiest to qualify for benefits under this definition.
  • Modified own occupation – This is a middle ground that defines disability as the inability to perform a job for which you are reasonably suited based on education, training, and experience. In other words, not just any job will do. You have to be able to work in a job that fits your level of experience and expertise before benefits stop.

Understanding your policy’s definition of disability is key to understanding the protection you’re actually receiving. A big benefit with a strict definition of disability may be less valuable than a smaller benefit with a definition that’s easier to meet.

3. The Elimination Period

The elimination period is that amount of time you have to be disabled before you can start to collect your benefit.

Typical elimination periods range from 60 to 180 days, with longer elimination periods leading to a smaller premium. You should consider how long your savings and/or short-term disability insurance would cover you when deciding how long an elimination period to choose.

4. The Benefit Period

This is the maximum amount of time you would be able to collect benefits as long as you continue to meet the policy’s definition of disability.

Many long-term disability insurance policies pay out until age 65 or 67 to coincide with the standard Social Security retirement age. Other policies will only pay benefits for 5-10 years.

Longer benefit periods are more valuable, but also more expensive. You should consider the likelihood of being able to replace your income in other ways, such as transitioning to a different job, when deciding how long you’d like your benefit period to last.

5. What isn’t Covered

Most long-term disability insurance policies will exclude certain types of conditions from coverage. For example, mental health conditions are often not covered or are subject to a shorter benefit period.

Sometimes the exclusions will only last for a period of time, such as the first two years of the policy being in place. Sometimes they last for the life of the policy. You should evaluate these exclusions in relation to your personal and family health history to understand how likely you might be to run into them.

6. Premium Guarantee

Some long-term disability insurance policies are non-cancelable, which means that you are guaranteed a fixed premium until your coverage period ends. The insurance company cannot cancel your coverage and cannot raise your premium.

Other policies are guaranteed renewable, which means that the insurance company can’t cancel your policy, but they can increase the premium as long as they increase the premium for all policies across an entire class of policyholders (such as all policyholders in a given state or all policyholders in a given occupation category).

If you don’t have either of those guarantees, it means that your premium could increase each and every year and that those changes are at the discretion of the insurance company.

7. Residual Benefit

A residual benefit feature means that you could receive partial benefits if you return to work at a reduced salary.

This feature can help you build your workload over time, making for an easier and smoother transition.

8. Cost-of-Living Adjustment (COLA)

Policies that come with a cost-of-living adjustment will increase your benefit each year based on the rate of inflation. This is meant to ensure that you are able to pay for the same amount of goods and services each year, even as the cost of those things increase over time.

Some COLA riders have a maximum annual increase and/or a limited amount of time for which they are applied. For example, a policy might cap the annual increase at 3%, and it may only increase the benefit for a certain number of years before leveling off.

9. Future Purchase Option

Many long-term disability insurance policies guarantee you the right to increase your coverage in the future if your income increases, without any medical underwriting. This is a valuable benefit because it eliminates the risk that a decline in health could prevent you from getting more coverage when you need it.

10. Insurer’s Financial Rating

Finally, you should make sure that the insurer is in good financial condition. The last thing you want is to have the insurance company flake out on you when it’s time to collect.

You can look up an insurer’s rating through any of the following companies: A.M. Best, Fitch Ratings, Moody’s, and Standard & Poor’s.

The Pros and Cons of Group Disability Insurance

There are two ways you can get long-term disability insurance:

  1. Through your employer as an employee benefit (referred to as group disability insurance)
  2. On your own through an insurer of your choice

Both have their pros and cons. Here’s a breakdown.

The Pros of Group Coverage

1. Cost

Group disability insurance is often less expensive, and the premiums are typically tax-deductible. Many employers even offer a base level of long-term disability insurance coverage for free.

The lower premium can come with some negative trade-offs, as you’ll see below, but in the best cases it simply makes the insurance easier to afford.

2. No Medical Underwriting

Your ability to get group coverage is in no way affected by your current health. Eligibility is solely dependent on your employment status with the company.

This can be an especially big benefit if you have significant health issues that would make individual coverage either prohibitively expensive or impossible to get.

3. Simplicity

Group coverage is easy to get in place. All you have to do is sign up during open enrollment, choose the level of coverage you’d like, and you’re done.

The Cons of Group Coverage

1. Benefits Are Taxed

In most cases, your group disability insurance premiums are tax-deductible, and the benefits you receive are taxed. Which means that you won’t actually receive the full benefit.

So while group long-term disability insurance can be affordable on the front end, sometimes that comes at the cost of smaller benefits on the back end.

2. May Not Cover You Completely

In addition to the benefits being taxable, your employer may not offer enough coverage to meet your full need to begin with. You may need to get an additional policy if you want to be fully insured.

3. Lack of Control

Your group disability insurance policy is what it is, and you don’t have much, if any, say in the features it offers.

Sometimes this won’t matter, since the policy will have everything you want. But sometimes it will be lacking in certain areas, which could leave you with weaker coverage than you’d like.

4. Can’t Take It with You

You typically can’t take your group disability insurance coverage with you when you leave the company, and your employer could also choose to stop offering it at any time.

All of which means that you could find yourself without coverage somewhere down the line. And if your health status has declined or your next employer doesn’t offer group coverage, you may find it hard to get affordable disability insurance elsewhere.

The Pros and Cons of Individual Disability Insurance

The Pros of Individual Coverage

1. Portability

Individual long-term disability insurance policies are portable, meaning that they’re yours as long as you continue to pay the premiums, even if you change jobs. This is crucial to making sure that you always have coverage when you need it.

2. Definition of Disability

With an individual disability insurance policy, you have the opportunity to choose a broader definition of disability that increases your chances of receiving benefits. This can be particularly helpful if you work in a highly specialized field where having an own occupation definition would be beneficial.

3. Tax-Free Benefits

Individual disability insurance premiums are not tax-deductible, but the upside is that any benefits you receive are tax-free. This ensures that you get as much money as possible when you really need it.

4. Control over Other Features

You have a lot more control over all the policy features when you buy individual coverage. You can often pick and choose whether you want residual benefits, cost-of-living adjustments, and the like, allowing you to customize your coverage to your specific needs.

The Cons of Individual Coverage

1. Cost

Individual disability insurance is typically more expensive than group coverage, particularly if you have pre-existing medical conditions or you work in a high-risk occupation.

While it can vary greatly depending on the specifics of your circumstances, a reasonable rule of thumb is to expect $2-$2.50 in monthly benefits for every $1 in annual premium.

2. Complexity

Long-term disability insurance is a complicated product, and unfortunately, it’s hard to shop around and get a true apples-to-apples comparison of policies.

Your best bet is to look for a truly independent disability insurance agent who isn’t tied to any particular insurance company, and who can guide you through the process and help you understand the pros and cons of the various policies offered by different companies.

3. Medical Underwriting

Applying for individual long-term disability insurance includes a medical exam and a review of your medical history, after which the insurance company may ask more questions to get a better understanding of your current medical condition.

This can be time-consuming, can feel invasive, and in some cases can lead to a more expensive policy or even a denial of coverage altogether. It can also lead to an attractive offer if you’re in good health, but regardless, it’s a cumbersome process you have to go through.

A Quick Note on Social Security Disability Coverage

While Social Security does offer long-term disability coverage, it’s generally not a good idea to rely on it.

The main reason is that it has a strict definition of disability, requiring you to be unable to work in any job for at least one year. It only pays out under the most extreme of circumstances.

You also need to have worked long enough to qualify for any coverage at all, and even if you do qualify, it often won’t meet your full benefit need.

All of which is to say that if you truly want financial protection from disability, getting some combination of group and individual coverage is likely the way to go.

Are You Protected?

No one likes to think about the possibility of being sick or disabled, but protecting your income is a crucial part of building true financial security.

Disability insurance can be an effective way to get that protection. When it’s done right, it ensures that you’ll have money coming in no matter what, allowing you to continue providing for your family even in the most difficult of circumstances.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt here

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Life Events

Places Where You Can Earn Six Figures and Still Be Broke in 2019

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

expensive metros to live in
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A household bringing in $100,000 each year should be on firm financial footing. But depending on where you live, that amount might be barely enough to scrape by — or might not even be enough to cover the basics. Taxes, housing, transportation and other typical expenses can easily eat up six figures a year in certain cities, leaving families strapped for cash, according to a recent analysis by MagnifyMoney.

For this study, we looked at data from the U.S. Department of Housing and Urban Development (HUD)’s Location Affordability Index (updated in March 2019), which also uses data from the 2012-2016 American Community Survey, to see which cities would leave a dual-professional households earning $100,000 with little to no disposable income. We considered the average cost of housing (e.g. insurance and taxes), transportation (e.g. car payments, parking, tolls, bus fare, etc.), childcare, food, retirement contributions, utilities and other line items in a typical family’s budget.

After tallying up all of the expenses, we were able to calculate the disposable income of families living a typical six-figure lifestyle in various metro areas around the United States. Then, we ranked the top cities where families earning $100,000 a year would have the least (and most) amount of money leftover at the end of the month. Here’s what we learned.

Key takeaways

  • In San Jose, Calif., considered the capital of Silicon Valley, a joint income of $100,000 with a preschool-aged child means a couple may have to run up their credit cards $1,046 a month just to cover what the typical two-earner household spends on the basics (not including compounded interest on that credit card debt).
  • In seven of the 100 metro areas we reviewed, the average professional couple spends more than $100,000 on the basics.
  • In McAllen, Texas, a couple earning $100,000 can expect to have around $1,795 left over every month after paying the typical bills for a local dual professional household.
  • Seven of the 10 places where couples can expect the most disposable income are in Texas, Florida and Tennessee, where there’s no state income tax.
  • More than half of married couples have six-figure incomes in 19 of the 100 metros we reviewed.

Worst places in the U.S. to make six figures

Although rising incomes are outpacing housing cost increases, according to one of our previous studies, families in certain metros are continuing to struggle to make ends meet — even after pulling six figures. In seven of the 10 worst cities in the U.S. to make six figures, a household income of $100,000 isn’t enough to cover basic expenses.

For example, in Oxnard, Calif., a coastal city in Southern California, families need to scrounge up another $195 to break even each month. Meanwhile, those in the northern California city of San Jose have a whopping total of $1,046 in unmet expenses each month.

Things get slightly better as families head east. Those in the Big Apple have about $65 in disposable income each month (not even enough for the average Broadway show ticket). But families making $100,000 a year in Minneapolis have an extra $149 to play with after expenses, so at least not all Minnesota families are doomed after making six figures.

Breaking down the expenses by line item can give you a sense of what’s costing families the most in these metros.

The majority of household budgets is devoted to housing, transportation and childcare. Housing was the single largest expense in the top 10 places where you can earn six figures and still be broke, with families in San Jose, Calif., paying the most ($2,760 each month) and families in Worcester, Mass., paying the least ($1,779). Transportation ate up the second largest portion of the budget, ranging from $1,082 to $1,532 depending on the city, with childcare costing slightly less.

Best places in our rankings to make six figures

Everything’s bigger in Texas — including the amount of disposable monthly income for families making $100,000 a year. In McAllen, a city along the state’s southern border, households have $1,795 left in their bank accounts after covering basic expenses; meanwhile, families in the western city of El Paso have just slightly less ($1,679) to spend at the end of the month.

Cities in Florida took third and fourth place, followed by Tennessee metros in fifth, sixth and eighth place. No city in our list of the top 10 places where you can earn six figures and still be flush left families with a surplus of less than $1,400.

A relatively low cost of housing helps families keep more money in their pockets in the best places to make six figures; none of the average households in the top 10 metros spent more than $1,299 to keep a roof over their heads. Families in McAllen, Texas, barely pay more than four figures for housing, which costs $1,004 a month on average.

Seven of the top cities are in places with no state income tax, giving families another roughly $200 to $400 to play with each month, compared with those in the worst cities for families earning $100,000. Childcare was also significantly less in these cities, ranging from $514 to $694 a month, roughly half (or less) of what families making $100,000 pay in the most expensive city, San Jose, Calif.

Our full rankings

Check out the full rankings of the 100 places where you can earn six figures and still be broke (or flush).

For the most part, the percentage of the population that makes over $100,000 in these cities inversely correlates with the average amount of disposable income those families have. None of the average families making $100,000 in these 100 cities saw housing or transportation fall below four figures, making those categories the most significant line items in everyone’s budgets.

Overall, families on the East Coast and West Coast tended to have less disposable income than households in other parts of the country.

Understanding the metrics

There are a few changes to the methodology in our 2019 study. We focused on the largest 100 metros this time around as opposed to some 381 metros last year. We also took a more detailed approach to calculating variables that impact a family’s disposable income.

We based our case study on a family earning a gross income of $8,333 per month. Then we subtracted their monthly expenses, debt obligations and savings to come up with an estimate of how much cash they’d have left over at the end of the month.

These are the assumptions we made for this study:

Savings. We assumed the family contributed $500 monthly to their 401(k). In previous years, we assumed the family set aside 5% of their savings in a regular savings account. This year, we changed the savings to 401(k) contributions because it’s something of a bastion of corporate middle-class personal finance, and it offers a tax benefit.

Tax assumptions. Our study assumes the couple will file jointly for 2019. They took the standard federal deduction and received a federal $2,000 credit for their one child. They also took the standard deductions and credits offered by their state, and took advantage of the pretax Dependent Care FSA child savings plan to deduct the $5,000 maximum from their taxable income by their employer. The couple had insurance premiums paid from their pretax income by their employer and their 401(k) contributions paid from their pretax income by their employer.

Debt. We assume the family had a monthly student loan payment of $393 — the median student loan payment according to the Federal Reserve — in order to be consistent with the other metrics (which also look at the mean). Housing and auto debt are bundled in with the housing and transportation cost budget line items in monthly expenses.

Monthly expenses. We based monthly expenses — housing, transportation, food, utilities, household operations, child care and entertainment — for each location on data taken from the Bureau of Labor Statistics, the Department of Housing and Urban Development, Care.com, Kaiser Family Foundation and the Federal Reserve. We calculated an average for these expenses taking into account the lifestyle costs of a six-figure earner. We also removed entertainment and combined household expenses with housekeeping supplies and apparel. The cost of apparel is the average amount for a woman, man and child under the age of 2 in each metro.

Compared with last year, we beefed up the monthly necessity expenses — although by no means hit them all — by adding costs like household operations costs and utilities to get a more realistic sense of how much people would have left over after paying their basic bills.

Unfortunately, we haven’t located updated childcare costs compared to last year, so that remains the same in our numbers, but is likely to have increased. We’ve also added the average (mean) income for married couples in each metro, as well as the percentage of married couples in each metro with incomes over $100K.

Further, while the median cost of each expense would have painted a more accurate picture of what half the population experiences, this data only included the average, or mean, of the metrics, so the results may overstate what typical people earn and pay, especially for housing and transportation. With that being said, we recognize we may be lowballing some expenses a typical family faces. For example, our data on health insurance includes monthly premiums, but not copays for visits to the doctor and the cost of prescription drugs.

Methodology

The hypothetical family we created is a typical one that earns a combined income of $100,000 (the average income for a married-couple family in 2017 was $110,786 (the median was $85,031), and 41% of such couples earned at least $100,000 that same year).

We were conservative about the couple’s financial and debt obligations by making the following assumptions:

  • Both have corporate-style employers who offer typical benefits.
  • They have one child currently in day care.
  • Between them, they contribute 6% of their income to their 401(k)’s to maximize typical matching, which is considerably less than the median rate of 10% from an employee in a matching plan (page 7).
  • Only one of them has student loans and is making the average payment of $393 a month. (Student Loan Hero and MagnifyMoney are both owned by LendingTree.)
  • The entire household is on one person’s group insurance plan.
  • The family has average spending habits and expenses for where they live.

To calculate federal and state taxes, we assumed the following:

  • The couple will file jointly for 2019;
  • Took the standard federal deduction;
  • Received a federal $2,000 credit for their one child
  • Took the standard deductions and credits offered by their state;
  • Took advantage of the pre-tax DCFSA child savings plan to deduct the $5,000 maximum from their taxable income by their employer;
  • Had insurance premiums paid from their pre-tax income by their employer;
  • Had their 401(k) contributions paid from their pre-tax income by their employer.

The following variables were used to create their hypothetical expenses (each is the average cost for the geography indicated in parentheses):

  • Federal tax contribution (national, but adjusted for state average health care premiums)
  • State tax contribution (state)
  • FICA contribution (national)
  • 401(k) contribution (national; see notes on assumptions)
  • Insurance premiums for family coverage (state)
  • Housing costs for dual professional families (MSA)
  • Transportation costs for dual professional families (MSA)
  • Food costs (regional)
  • Utilities cost (regional)
  • Household operations, housekeeping supply, and apparel costs (regional)
  • Child care costs (MSAs where available (half of the MSAs), and state averages where not)
  • Student loan payments (national)

Sources include the Bureau of Labor Statistics; the Department of Housing and Urban Development; the Tax Foundation; Care.com; the Kaiser Family Foundation; the U.S. Federal Reserve; and the U.S. Census Bureau.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Joni Sweet
Joni Sweet |

Joni Sweet is a writer at MagnifyMoney. You can email Joni here

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Life Events, Mortgage

How to Buy a House With a Friend — The Right Way

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

Not everyone can afford to buy a home on their own, especially if they’re managing student loan debt or don’t have a high salary. Fortunately, if you and a friend share the common goal of owning a home, there may be a path forward.

For good friends or cohabiting couples, buying a home together can help both parties boost their net worth or simply achieve homeownership.

However, purchasing a home together isn’t as simple as signing some paperwork and splitting the bills. The key to a successful co-homeownership arrangement is to set yourselves up for success from the get-go.

The content below is your guide to buying a house with a friend — the right way.

Is it a good idea to buy a house with a friend?

Before you get too excited about buying a home with your BFF, take the time to determine whether the decision makes sense for the both of you.

If either of you can’t afford or qualify to buy a house on your own, then it might make sense to buy with a friend, said Michael Becker, a branch manager with Sierra Pacific Mortgage in Lutherville, Md.

Getting started buying a home with a friend

First, you need to be clear on where you both stand financially. Do you each have a proven track record of paying your bills on time? Are you keeping balances low on your credit cards? Do you have steady employment and income?

You’re entitled to pull your credit report from each of the three credit reporting bureaus — Equifax, Experian and TransUnion — once every year at no cost to you. You’ll also need to have an idea of where your credit scores stand, preferably by taking advantage of a service that offers a free credit score.

Before you start house shopping, you’ll want to know how much house you and your friend can afford based on your combined creditworthiness and income. That’s where a mortgage preapproval comes in.

A preapproval is a letter from a mortgage lender that says you’re conditionally eligible to borrow money to purchase a home. You’re given an estimated loan amount and interest rate. Having this information not only helps you better understand what types of homes might fit in your price range, but also helps home sellers take you more seriously as prospective buyers.

Creating a co-ownership agreement

You’ll want to settle on a co-ownership agreement before you start the homebuying process. Make it plain and get in writing how you’ll split equity in the home, who will be responsible for maintenance costs and what will happen if there’s a major life event such as death, marriage or having children.

“It’s important to talk about it and what your plans are if the relationship breaks down,” Becker said. “If somebody dies, what do you want to do with the house?”

A real estate attorney can help you set up an official co-ownership agreement.

Questions every co-ownership agreement should answer

The co-ownership agreement you draft and sign will need to address the issues surrounding your joint homeownership. Here are the main questions the agreement should answer:

Q What happens if one of you wants out?

Your agreement should outline an exit plan in case one or both of you want out of the property. This can get extremely complicated. For example, what if one of the co-owners wants to be bought out by the other co-owners?

Let’s say you’ve got three people on a mortgage and on the title to a property. If the other two can come up with the money for the equity, you’ve solved that problem.

If you wanted to sell your interest in the property, however, the co-borrower would need to refinance the mortgage to remove your name from the paperwork. If they don’t refinance the loan and start missing mortgage payments, you’ll still be on the hook and your credit profile will be affected, even if you’ve moved on from that home.

Keep in mind that whomever refinances needs to qualify again for the mortgage. If you decided to buy a home together because you couldn’t originally qualify for or afford a mortgage on your own, you still might not qualify to own after a refinance, unless your financial circumstances have improved dramatically.

If you can’t refinance, you all may decide to arrange for the departing owner to rent out their living space in the household — then you’d need to take time to find a tenant.

Q What happens if one of you suffers a job loss?

You’ll want to be prepared to fulfill your financial obligations if someone loses their income. That’s why it’s recommended to create a shared emergency fund, which you can draw from if one of you runs into financial issues (or, of course, to handle any maintenance needs). You can establish the contributions and rules surrounding a shared emergency fund in your co-ownership agreement.

A good rule of thumb is to stash away three-to-six months’ worth of living expenses. If you each save that much individually, you can pool up to a year’s worth of expenses for a rainy day.

Q How will you split the bills?

The co-ownership agreement also needs to address how you all will split up housing costs. Should you put some of the bills in one person’s name and some in the other’s name? What about opening a joint account and contributing a set amount to it for monthly bill payments?

Don’t forget about maintenance, repairs and escrow payments. You’ll want to be prepared for increases in your property taxes and homeowners insurance, should they come.

Applying jointly for a mortgage

Once you’ve decided that you and your friend will apply for a mortgage together, there are several things to keep in mind about the mortgage application process.

Although you’ll be co-borrowers on the same loan, you’ll each fill out your own mortgage application, Becker said. All of your information will be listed separately, including information about your income and existing debts. Once your applications go through underwriting, your and your friend’s information will be merged.

Based on this information, your lender will make adjustments to the mortgage rate you’re quoted. The more money you and your friend can contribute as a down payment, the better your mortgage rate tends to be. Similarly, higher credit scores will put you in a better position to get a competitive rate.

Whose credit scores do lenders use?

A lender will consider both of your credit scores during the underwriting process, which means a person with a lower credit score could drag down your collective credit score, leading to a lower mortgage rate.

When you apply for a mortgage individually, your credit scores are pulled from the three credit reporting bureaus and the lender uses the middle credit score — the second highest score — to help determine your estimated mortgage rate. In the case of a joint mortgage application, the lender will pull all three scores for each applicant, take the two middle scores and use the lowest of the two.

Choosing the right homeownership structure

When you buy a home, you’ll get a title, which proves the property is yours. The paper the title is printed on is called a deed, and it explains how you, the co-owners, have agreed to share the title. The way the title is structured is important because it details what happens when one of the co-owners needs to part with the property.

The two most common ways to approach joint homeownership are tenants in common and joint tenants with rights of survivorship.

Tenants in common

Tenants in common (TIC), also referred to as tenancy in common, is the title structure most unrelated people use when buying a home. TIC outlines who owns what percentage of the property and allows each owner to control what happens if they pass away. For example, a co-owner can pass their share onto any beneficiaries in a will and their wishes will be honored.

The TIC allows co-owners to own unequal shares of the property (60/40, 75/25, etc.), which can come in handy if one owner will occupy a significant majority or minority of the shared home. For example, if two friends decide to buy a multifamily home, but one friend pays more because one friend’s space has much more square footage than the other friend’s space, they can split their shares of the home accordingly.

Pros of a TIC structure

  • Ownership can be unevenly split. You can own as much or as little as you want of the property as long as the combined ownership adds up to 100%. So, if you’re putting up 60% of the down payment, you can work it out with the other co-owner(s) to own 60% of the property on the title.
  • You don’t have to live there. You can own part of the property without living there. This is relevant for someone who simply wants to be a partial owner, but doesn’t want to live at the property.
  • You get to decide what happens to your share after you pass away. The TIC allows you the flexibility to decide what happens to your interest in the property in the event you pass away. You can decide if it will go to the other co-owners or to an heir. Regardless, the decision is yours.

Cons of a TIC structure

  • You could pay more housing costs compared to your friend if you have a larger ownership share. Because a TIC doesn’t require a 50/50 split, if you use more of the home’s square footage than your friend, you could shoulder a larger portion of the monthly mortgage payment and other bills.
  • Co-owners can sell their interest without telling you. Co-owners in a TIC can sell their interest in the property at any time, without the permission of others in the agreement. However, if they are also on the mortgage loan, they are still on the hook to make payments.

Joint tenants with rights of survivorship

In a joint tenants with rights of survivorship (JTWROS) structure, you and your friend would have equal shares in the property — a 50/50 split. This title structure differs from the TIC in that in the case of one co-owner’s death, the deceased party’s shares will be automatically absorbed by the living co-owner. For this reason, this type of structure is more common among family members or unmarried couples looking to purchase a home together.

If you were buying a home with a family member instead of your friend and would like your relative to automatically absorb your share of the property in the event of your untimely death, you’d go with this option. Even if you have it written in your will to pass your interest to another beneficiary, that likely wouldn’t be honored.

A joint tenants agreement requires these four components:

  1. Unity of interest: Co-owners must all have equal ownership interest.
  2. Unity of time: Co-owners must all acquire the property at the same time.
  3. Unity of title: Co-owners must all have the same title on the home.
  4. Unity of possession: Co-owners must all have the same right to possess the entirety of the home.

Pros of a joint tenants structure

  • Everyone owns an equal share in the property. There’s no arguing over shares if you go with a joint tenants’ arrangement, since it requires all co-owners to have an equal interest. So each co-owner has the same right to use, take loans out against or sell the property.
  • No decisions to make if someone dies. There’s nothing for co-owners or family members to fight over after you pass away. Your ownership shares are automatically inherited by the other co-owners when you pass away, regardless of what might be written in a will.

Cons of a joint tenants structure

  • Equal ownership. Equal ownership can be a con as much as it’s a pro. If you’re going to occupy more than 50% of the space, or put up more of the mortgage or down payment, you may want to own more than your equal share of the property. If that’s a concern, a TIC agreement is best.
  • No outside beneficiaries. In the event of your death, your co-owning friend would receive your share of ownership in the home, which means you can’t grant your ownership share to an heir in your will.

Pros and cons of buying a house with a friend

Still not sure if you and your friend should buy a home together? Consider the following pros and cons before making your decision.

Pros of joint homeownershipCons of joint homeownership
  • Gives you the chance to enter the housing market sooner than if you’d waited until you could buy on your own.
  • Lenders consider the lowest middle credit score between you and your co-borrower, which might impact how good of a mortgage rate you’ll get.
  • Potentially increases your buying power, as two separate incomes are being considered for the mortgage.
  • You’re both on the hook for the mortgage payments every month — a half payment won’t satisfy your lender.
  • Provides you with a choice in how you’ll structure homeownership.
  • If one of you wants out, the other has to refinance. If they can’t qualify for a mortgage alone, this could create problems for you both.

The bottom line

It sounds like a fun idea to own a home with a friend, but there are several considerations to work through before you get entangled in a contract that will impact you both financially and personally.

The biggest mistake you can make is letting feelings take over, Becker said. This applies to pre- and post-homeownership decisions.

“It should be very calm, cool, planned out, thought out,” he said. “Sometimes when those relationships end, people let their emotions get the best of them.”
Know (and get it in writing) where you each stand on taking title, paying bills, filing taxes and establishing a way out — should life change for either of you.

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Crissinda Ponder
Crissinda Ponder |

Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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