With the housing market slowly crawling back, I thought it would be beneficial to share some insight on buying a home and trying to decide how much home you can afford. Here are some of the important things to think about before buying a house (particularly for first-time home buyers).
1) Should I Rent Or Buy?
I know that so many people want the “American Dream” to own their home as soon as they possibly can. However, first it would be beneficial to take a real hard look at IF you should buy in the first place. If I’m being honest with myself, I think that when we jumped into our first home, we may have moved too soon. Our 1 bedroom apartment was getting cramped and I wanted a place that I could put a stake in the ground and call my own. We did buy as the market was going down so I thought it was a great deal (we got it for less than the previous owners bought it for when it was brand new 3 years prior – so I was happy with that), but we got in just in time to ride the plunge even further down and watch quite a few of our neighbors go into foreclosure and become forced to sell. It’s important to run the numbers on a rent vs. buy analysis, similar to this one on Yahoo. However, if you’re really excited, it may be easy to be optimistic and play with the numbers to “prove” your case to buy, so be honest with yourself.
2) How Much Can I Get Pre-Approved For?
Before you go out and look, it is very helpful to get pre-approved for a certain amount. That way, the person financing your mortgage has looked at your financial situation and can give you a pretty good idea on a limit of what you can get approved for when you find the home of your dreams. Who should you use to finance your mortgage? That depends. Big banks have a more “cookie cutter” process, so if your financial situation doesn’t fall in the norm, it may be more difficult to get through the hoops. Smaller banks or lenders may be willing to work with you a little more, but since they are smaller, they may not be as able to take on a riskier situation. It’s good to shop around and ask others for recommendations. Yes, lenders are bound by similar guidelines, but different lenders have different niche’s, so ask around to find the best fit for you.
3) How Much Home Can I Actually Afford?
Wait, doesn’t that sound the same as #2? No, oftentimes there is a big difference between question #2 and #3. The number your lending institution gives you is how much THEY are comfortable lending you for a house, but you need to decide how much YOU are comfortable borrowing to be able to make the payments. The lender is not your financial planner. It’s their job to lend money and make money off the interest they charge you. You should run your own numbers and see what makes sense in your budget.
4) How Much Should I Put On A Down Payment?
The quick answer, in my humble opinion, is “as much as possible,” especially if you plan on being in the home for quite some time. As I mentioned, the lending institution is going to make money off of what they lend you. The more they lend, the more they make. You may say, “yeah, but a few thousand isn’t going to make a big difference.” Did you know that on a 30-year mortgage at a 3.5% interest rate, you stand to pay $616 interest on every $1,000 you borrow? That means you’re paying 62% more to borrow every $1,000. If your interest rate is 4.5%, you’re paying $824 interest to borrow each $1,000. If your interest rate is 6%, the total rises to $1,158 which means you’re paying back 116% on every $1,000 borrowed. So don’t look at every $1,000 as what it currently is (and what you could purchase with it today), but what you can save on payments if you put that money down now (and free up more cash down the road).
You may say, “Yeah, but I need to furnish the place and buy all new _____ for our new house.” While it may be nice to have all new _____ in your new house, I would suggest making those additional purchases for the house over time and get as much of a down payment as you possibly can. Remember, still leave some emergency fund cushion in your account to have just in case. In addition to a down payment, you also need to consider closing costs on the home. These are fees charged by your lender, title company, etc as well as prepaid insurance and other expenses. This money is due at closing. In many cases, you can try and negotiate to have the seller pay a portion of these costs.
5) What If I Can't Get At Least A 20% Down Payment?
The reality is that you will have to pay PMI, or private mortgage insurance. In laymen’s terms, if you don’t put at least 20% down initially, the lending institution deems it too risky to take on your mortgage without some sort of insurance. With PMI, you’re taking out an insurance policy on yourself (and you are paying the premiums) to help offset the risk of them lending money to you. So because I’m more risky, they are making me pay more to show that I can pay what they are lending me? Correct. At that point, really ask yourself if that additional money paid out is really worth it, or if you can be patient and save up some more so that you can get to that magical 20% threshold. This tool will help you estimate what you may expect to pay in PMI.
When I was on the small side of 20% down on a house (our first house we put 0% down. I’ve learned a lot since then and the laws have changed a lot since then), I rationalized it by saying how happy I was going to be in a home instead of cramped in a smaller living situation. I tried to use logic to convince my feelings of excitement to own a home. However, now that I’m on the good side of more than 20% equity on a house, I can tell you that you’d have to do A LOT of convincing for me to take on a payment where I have to pay PMI again. Better to not be leveraged and put that money towards something else.
6) What Other Expenses Do I Need To Consider In Owning A Home?
After you’ve taken care of your mortgage payment and potentially PMI, you also have to pay taxes. The nice thing is that MLS listings show how much the taxes have been in the past on each particular property (or you can look it up in the county records), so you can get that number pretty easily. Taxes will add a substantial amount to your house payment each month, so you need to plan accordingly for it. After all of those, you need to factor in homeowners insurance. Using a mortgage calculator, like this one on the FHA website, can help you add up all of these expenses to show you what you can expect to pay in an inclusive mortgage payment. Once that is calculated, things like utilities (which hopefully the previous homeowner can give you an estimate) and other homeowner expenses like lawnmowers, snow blowers, garden/yard tools, etc., need to be accounted for. Also, regular maintenance on the house pops up more often than you’d guess, so this shows that home-ownership can be quite expensive when all is said and done. Add up all of these numbers to give yourself an accurate picture.
7) Plan In Some Cushion So That You Don’t Become “House Poor”
The “American Dream” may be nice in your mind, but it’s no fun to live in a house that was a little more than you could afford, has rising taxes each year, increased utility costs each year, and more unexpected expenses than you planned for. The bottom line – leave plenty of cushion in your budget. Fannie Mae recommends that no more than 28% of your budget go towards home expenses. You could be in this house for the next 30 years or more. You can’t predict the future, your future income, future market conditions, and future tax implications, so leave yourself some room to enjoy the house you’re going to take so much time paying for.
Personally, I’d rather live in a house that’s not quite as fancy and have money to take vacations with the family and enjoy life a little more than to have the nicest house on the block and try to figure out how I’m going to make my mortgage payment each month. Some people can have the nicest house on the block and still easily pay their mortgage, and that’s great. However, for many of us, that’s not the reality.
Blessings to you all as you go through your home-buying process. If you have additional insight, feel free to post in the comments below or contact me.