Deciding to purchase a home is an important, and usually beneficial, step on the road to financial well-being. However, if your reason for home ownership is “I just want to stop wasting money on rent,” then I think it’s important to point out a couple of the aspects of home ownership that you may be overlooking.
Before figuring out how much house to buy, or how much of a down payment you need, your real starting point should be: How will the monthly costs of owning a home fit in to my budget?
This discussion isn’t meant to calculate your ratios or your qualifications to acquire a loan. Realistically, even post-recession, a lender is going to let you buy more house than you really can afford. Instead, you should look at your own spending and see how the costs of home ownership fit in to your lifestyle.
For a practical example of what these costs look like, let’s pretend we live in a two-bedroom apartment in a multi-unit apartment building and we’re buying a $400,000 townhouse in Northern Virginia with a 10% down payment. As we go through each separate expense of home ownership, I’ll provide a sample figure of what a real number for that expense would be for our example home.
If you’re contemplating a home purchase, you hopefully understand the basics of a mortgage – a bank loans you money to buy the home, you pay the bank back over time with interest. You can Google a mortgage calculator online that will tell you what your monthly principal and interest payment will be. It’s not uncommon to see a figure that’s just as much (or less!) than what you might be paying now in rent. Unfortunately, your costs don’t stop at principal and interest.
At the time of this writing, a qualified borrower with good credit should be able to secure a 30-year fixed loan at about 3.75%. For our example home, the monthly principal and interest would be $1,667.
Based on its value, you will owe property taxes on your home. Rates will vary from area to area, but a decent starting point is usually around 1% of your home’s value per year. As your home (hopefully) appreciates in value, so will the amount you’ll owe in taxes. You typically pay these taxes monthly alongside your mortgage payment.
Our example home will cost us $333 per month in taxes.
You’re going to want to protect your home so that a fire or falling tree limb doesn’t destroy what we just bought, and assuming you’re not paying all cash for the house, a lender is going to require that you have insurance.
Insurance rates will vary based on a variety of factors, such as whether it’s a free-standing house or townhouse, what type of roof it has, what type of foundation it has, where it’s located, etc. However, for simplicity we can start at 0.25% of the home’s value per year.
To insure our example home, it’s going to cost us $83 per month.
Pretty much all townhome communities, and some neighborhoods with free-standing houses, will assess a monthly fee paid to the homeowners’ association (HOA). What those HOA fees are and what they pay for will vary from community to community, so it’s important to read the specific neighborhood agreements for any property you might be considering.
If you’re buying a condo, you can usually expect a pretty significant condo fee to be attached to the property. However, these fees aren’t necessarily a big negative. Quite a bit of maintenance, amenities, or even utilities may be included in this fee. As with an HOA agreement, it’s important to have a complete understanding of what the fees are and what it’s being used for when evaluating a property.
For our example townhome, our HOA fee is going to pay for mostly communal expenses, but it’s also going to pay for our trash collection service. It will be $100 per month.
As a renter, when your drains clog or the roof springs a leak, it’s your landlord’s responsibility to pony up the money to fix it. If you’re the homeowner, that responsibility falls on you. A thorough home inspection prior to purchase may give you an idea of items that may need addressing over the next few years, but ultimately it’s hard to predict what’s going to require you to shell out cash and when. In some years maintenance may cost you thousands of dollars while in other years it may be almost nothing.
Furthermore, a several decade old home is more prone to requiring maintenance than a brand new construction. It’s important to take into account the specifics of what you’re buying when budgeting for these costs.
While maintenance expenses will never consistently be a specific amount per month, we’re going to assume that maintenance will average $150 per month over the long term for our example home.
Common wisdom says you really shouldn’t be buying a home unless you can afford a 20% down payment. While it’s certainly a goal I’d recommend pursuing, it’s becoming more and more uncommon for first-time homebuyers to be in a position to afford 20%.
When borrowing more than 80% of the property value, lenders are going to require you pay for PMI alongside your mortgage until you’ve built enough equity in the home to get you over 20% equity.
Since we’re only putting 10% down on our example property, we’re going to have to pay PMI for several years until we can build some equity in the house. This will cost us $125 per month.
One thing that many homebuyers don’t consider is how their utilities might change when purchasing a new property. Moving from a smaller apartment unit, where some of your utilities may be bundled into your rent, to a larger home can sometimes significantly increase your electric, gas, water, and trash collection bills. Once again, a good home inspection can go a long way to giving you an idea of how much heat or cold is passing through old windows or poorly sealed doors and walls.
Since we’re moving from a modest two-bedroom apartment to a larger townhome we’re going to assume that we’ll see a pretty dramatic increase in our electric and gas bills. Fortunately, trash collection is included in our HOA fee. The additional cost of utilities above what we’re paying now will be $75.
At the end of the day our sleepy townhome is going to cost us about $2,458 per month and then an additional $75 in utilities over what we’re paying now. Only a few hundred dollars of that is actually going towards building equity at first. The rest is a sunk cost the same way our monthly rent is now (yes, you may qualify for a deduction for interest and property taxes on your federal and state tax returns, but that is a discussion for another day). As we slowly pay down principal on the mortgage, more and more of that payment will go towards building equity, but the other costs are expenses that won’t leave us with anything when we go to sell the house.
Many of these costs are going to vary significantly depending on what type of home you buy and where. What’s important is that you consider each of these expenses and get an idea what they will be for the home you want. Once you add everything together, and see the full picture of your homeownership costs, you can determine whether or not it actually makes sense to buy your first home.
Today we only addressed the monthly costs of owning a home, which again, should be your first step. Once you have calculated what these costs will be for the property you’re considering purchasing and have determined that those costs are manageable and in harmony with your current budget, then we can figure out the next piece of the puzzle.
In Part 2 we will look at what goes into a down payment, closing costs, and where exactly we might expect to break even when buying vs. renting.
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.