Buying your first house is a financial as well as personal long-term commitment.
Crunching the numbers on mortgage, down payment and ongoing costs is essential before you even begin to look.
You can't time the real estate market any more than you can predict the future of the stock market.
I want to buy my first house, but with prices escalating at such a crazy pace, I’m feeling unsure. Is this an okay time to buy, and if so, can you help me figure out what I can afford?
There's no question that this is a challenging time for first-time homebuyers. With demand for homes soaring and supply at record lows, prices—as you point out—are skyrocketing across the country. Another important trend is mortgage rates, which remain at historic lows. Low rates can make your new home more affordable—but at the same time they can increase market demand, driving prices up even further.
As you prepare to purchase your first home, understand that there are always competing forces impacting real estate prices—all beyond your control. For starters, it’s extremely difficult to predict where prices will go. Historically, home prices have outpaced inflation, helping many people build wealth over long periods of time, but that doesn’t come with a guarantee for the future, especially over the short term.
In addition, the transaction costs of buying a home can be steep, which is why many experts recommend not buying a home unless you’re confident you’ll be able to stay put for at least five to seven years. On the other side of the coin, a ‘starter’ home can be your entry into the real estate market. If you delay and prices continue to rise, it can be that much more difficult to take this first step.
Bottom line, I believe that it’s best not to think of your home as you would an investment, but as your chosen place to live. There isn’t one ‘right’ time to buy—you simply have to weigh all the variables and determine the best time for you.
If you've thought about all this and still feel that the time is now, let's talk about cost.
Guidelines to help you get started
There are several general guidelines for determining how much house you can afford—or how much you can borrow. The CFPB has some great resources for new homebuyers. Some lenders say you can afford a mortgage that's roughly two to two and a half times your annual income. Others may go up as high as five or more times your income, depending on your other assets, future earnings potential, credit score and other debts.
It's good to know how much someone might be willing to lend you, but even more important is how much you can afford to pay. So the rule I go back to—and many lenders do as well—is the 28/36 rule. This rule suggests total housing costs shouldn’t exceed 28 percent of your gross monthly income. All your debt combined shouldn’t exceed 36 percent of gross monthly income.
So do the math. If you make $100,000 a year, your total housing cost shouldn't be more than $28,000, or $2,333 a month. On the other hand, if you have no other debt, you might consider pushing this a bit higher, but avoid exceeding 36 percent total. (Tip: try using an online Mortgage Affordability Calculator to help you run the numbers.)
What you should aim for in a down payment
While how much you can handle in monthly mortgage payments is important, the other key cost consideration is the down payment. Ideally, you want to aim for at least 20 percent down. And that can be a big chunk of money.
While it’s possible to put down 10 percent (or even 3.5 percent with certain mortgages), that will likely require you to purchase private mortgage insurance (PMI). PMI protects the lender—not you—if you stop making payments on your loan, and it can be expensive (more than 1 percent of your loan balance depending on how much you borrow and your credit score). VA loans have no down payment or PMI requirement and also have limitations on who is eligible to apply.
You also need money on hand for things like brokerage and appraisal fees, housing inspection and closing costs.
If you have the down payment taken care of, great. If not, you may want to explore other options. This can include living with family, renting longer or rethinking the kind of home you’re looking to purchase or its location.
Also, look at your current housing costs. If they're lower than a potential house payment, put the difference in savings each month. That way you'll not only build your down payment, you'll get used to budgeting for the mortgage.
Ongoing costs to plan for
Upfront costs are only part of the picture. Homeownership is an ongoing financial responsibility that includes insurance, property taxes, periodic maintenance and repair, and possibly homeowners association fees. Lenders may require proof of homeowners or flood insurance and may also require that property taxes, insurance and other fees be escrowed. Be sure to factor these costs into your monthly budget—and don't let these costs crowd out other important goals like saving for retirement.
On the plus side—potential tax advantages
We've been talking about costs but there can be some tax advantages that can help ease the financial burden. Currently, you can deduct the interest expense on up to $750,000 of home-secured debt used to purchase or make capital improvements on your principal residence. Mortgage points may also be deductible on an original mortgage the year you pay them. Plus, up to $10,000 of property taxes may be tax deductible.
That said, don’t be seduced by salespeople touting tax deductibility. In order to itemize and deduct these expenses, they must be higher than the standard deduction. And keep in mind that nearly 90 percent of people take the standard deduction these days.
Starting the process
If you're ready to get going, I strongly advise you to first check your credit report. Then get pre-approved by a lender. It's also a good idea to check with a financial advisor so you can be realistic about your budget and understand how the purchase may impact other parts of your financial plan like insurance, estate planning and retirement. The more prepared you are, the better the deal you can make—hopefully for a house you'll love for years.
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