Your decision to become a homeowner can be one of the most pivotal decisions in your financial life. Undertaken responsibly, home ownership can form the foundation to your financial well-being. However, buying before you’re ready, buying “too much house”, or buying for the wrong reasons can severely derail things.
In part one, we explored what the true monthly costs of home ownership look like. If you can’t afford the monthly costs of maintaining your home, then it doesn’t matter if you’ve saved enough for a down payment or figured that owning may be more efficient than renting.
Assuming you’ve taken my advice and determined that you can handle the on-going costs of home ownership, then let’s figure out what’s next.
The age-old rule of thumb for a down payment is 20%. Going back to our pleasant Virginia townhome in part one, which we were buying for $400,000, would mean we need to come up with $80,000 for a down payment. That’s a lot, especially for a first-time homebuyer. Fortunately, the idea that you have to have 20% is a bit outdated. If you have 20% available, that’s great. But, there are still reasonable options available to those that do not.
Assuming you have minimal to zero debt and have maintained a good credit history, conventional lenders will be happy to offer you a mortgage with only 10% or 15% down. Before you jump at the idea, examine how the terms of a loan might be affected. How is my interest rate changing under different down payment amounts? How much will private mortgage insurance (PMI) be? Generally, if you put less than 20% down, a lender will typically raise the interest rate at which they loan you money. If you qualified for 3.75% with 20% down, that rate may rise to 4.00% with 15% down or 4.25% with 10% down. Over the long term, this can make a big impact on the total interest you pay on the loan.
In similar articles to this, an author might go on to talk about options available beyond conventional loans for those with less than ideal credit, large amounts of debt, or those that haven’t even saved enough for a 10% down payment. While there are situations where an FHA, USDA, or state-sponsored loan can be worthwhile tools, more often than not it simply enables buyers to get themselves into a bit of financial trouble.
I’m going to make a blanket statement and say that if you have a lot of other debt, have poor credit, or can’t save up to at least 10%, you’re probably not in a good position to buy a home right now. There’s nothing wrong with that. If you practice good financial habits and save some money, you may be in a great position to buy a few years from now.
So, you’ve got your 10% for a down payment, you can handle the monthly costs, the money side is set, right? Not quite. You still need to address closing costs. These costs differ significantly for the buyer and seller, but for the moment we’re only going to focus on what the buyer needs to do. In order to buy a house, a multitude of things need to be done to satisfy the lender, the state, and the county.
Your lender is going to require a home inspection, termite check, home appraisal, survey, and sometimes a few other items to make sure the house is in good order before granting you a loan. The expenses for all of these items come out of your pocket. The lender may also assess a fee for originating the loan, they have to get paid for their services after all. Beyond that, there is a host of other costs such as title fees, transfer taxes, and recording expenses.
In total, this typically costs the buyer between 2% and 3% of the price of the home. The expectation is that the buyer provides this cash at closing in addition to the down payment. So, if you intend to put 10% down on a house, you’re actually going to need 12% or 13% in cash at settlement. It is possible to negotiate a seller into covering a portion of your closing costs, typically for the trade-off of an increase in the purchase price of the home. However, you cannot just assume a seller will agree to this.
If you’re buying your first home, the cost of renting versus buying is very important. The assumption for the uninformed consumer is: “I’m throwing money away spending $X on rent, if I buy a house, that $X I’m spending on rent will go to equity in a home that I can sell one day.” As we discussed in part one, this could not be further from the truth. The overwhelming majority of your expenses, especially in the first several years, will not ever go towards equity. A very small portion of your monthly payment is paying off the principal on your mortgage, everything else is a sunk cost the same way rent is.
Furthermore, that 2-3% we paid in closing costs to buy the home is also gone. Also, the approximately 6% we’ll pay in closing costs to sell the home (closing expenses to the seller are outside the scope of this article, but they check in at around 6% of the sale price in most cases). This causes us to not require that our non-equity building expenses of home ownership are cheaper than renting, but we also need to make up 8-9% of the home value beyond that to cover closing costs.
A lot of variables go in to calculating a true break-even on the time to own a house. The rate of home appreciation, opportunity cost of money spent on a down payment, and most importantly, the location where you’re buying all play significant factors in adjusting the number of years it well take to beat renting. Unfortunately, these variables are so specific to a property, that I can’t give you a hard number. Calculators you find online differ in methodology quite a bit as well. One calculator may tell you four years, while another might say ten for seemingly the same inputs. I use a rule of thumb of 5-8 years. If you are buying property in a place where renting is expensive relative to buying, then think five or six years. If things are reversed, think seven or more.
While there are more things that can influence a decision to buy a home, we could spend days discussing fringe situations. Overall, we’ve covered most of the things you need to sit down and consider before you jump in to a home. Everyone’s situation is a little different, so your unique circumstances may require adjustment of some assumptions. Use this as a guide to make sure there isn’t anything you’re over looking.
Once you determine that it might be time to work with a financial advisor, it’s important to find the right advisor for you and your family. We’ve put together a guide of questions that are essential to ask an advisor before you hire them.
Don’t make a mistake by working with the wrong financial advisor. Ask the right questions the first time to determine if a financial advisor is right for you.