Thinking about becoming a homeowner? Buying a home is a major financial decision. It is one that evokes many positive emotions, such as security, the transition to adulthood, and the pride of ownership. On the negative side, a recent survey reported that buying a home ranks as one of the most stressful financial events. For new families, a home and its corresponding mortgage will likely be the largest asset and liability on your balance sheet. Figuring out how much home you can afford, deciding on the down payment amount, the type of mortgage, and the necessary insurances needed can be overwhelming. In this week’s article, we are going to look at 5 strategies to prepare you for your first home.
The Right Mindset
The very first step of homeownership is adjusting your mindset. Owning a residential home is a large asset, requires ongoing maintenance, and is not always an investment. The median home price in the US is nearly $230,000 according to Zillow, but that varies greatly by city and state. For example, the median home price in Seattle, WA is $670,000. Purchasing an asset this large leveraged with debt without a full and complete understanding can be detrimental to your financial well-being.
And contrary to what you may have heard, buying a home is rarely an investment. It is also no replacement for a diversified portfolio. The 100-year inflation-adjusted housing price growth was less than 1% per year. And if you do happen to think of your home as an investment, think of it as a $230,000 investment in a single stock that you purchased by borrowing around $50,000 that will likely barely keep pace with inflation. It is best to view your home as a lifestyle decision. Any appreciation on the value is the icing on top of the cake. While you might be saying, “Doesn’t it depend on where I live? Yes, but that turns into a game of market timing based on demand economics consisting of factors beyond your control e.g. job market, climate, natural disasters, local government, taxes, etc. As I’ve written about before, financial planning is about focusing on what you can control.
Before you even begin searching for homes, your financial planning foundation should be set. This refers to your risk management strategy i.e. the plan for worst-case scenarios. While we tend to avoid this line of thinking due to behavioral biases, it is necessary in planning. How will you pay your mortgage if you get laid off, disabled, or if a spouse dies? So make sure you double-check that you have adequate disability and term life insurance to protect against these real risks. Do not just rely on the coverage your company provides. Your employer may offer some group disability and life insurance, but odds are, it is not sufficient and certain fine print may limit its overall benefit. Lastly, make sure you have an emergency fund of at least 3-6 months of essential living expenses saved up (with future home expenses factored in). Just as you wouldn’t build a house without a solid foundation, the same principle applies here.
Know Your Breakeven
At the crux of the rent versus buy decision is the breakeven. The breakeven is the point in time where buying equals the cost of renting. The average breakeven time in the US is 5 to 7 years. However, in some cities, this can be as high as 15 years. This means in order to make sure your purchase is worthwhile, you need to commit to living in a home for a set number of years. A lower down payment with private mortgage insurance can even extend the breakeven beyond those averages. With this in mind, if you’re moving to a new city, it can be a smart decision to rent for at least 6 months before buying. This is a helpful tactic to eliminate buyer’s remorse and it will give you time to explore your favorite areas. Nearly 66% of millennials homeowners said they had regrets about buying according to Bankrate.com
Factor In Total Housing Costs
When looking at how much home you can afford, it’s important to factor in all of your home costs. These include not only PITI (Principal, Interest, Taxes, Insurance), but the cost of initial furnishings, ongoing maintenance, homeowner association fees, and utilities. For the PITI portion of home costs, these should not exceed 28% of your gross income. If they do, you may find yourself “house poor.” For example, if your house payments equate to 35% of your gross income, it will be difficult to save for other goals e.g. travel, retirement, education, business opportunities, etc.
For initial furnishing, you may spend anywhere from 5% to 25% of your home’s purchase price, depending on how much furniture and belongings you already own. Another estimate suggests furnishings may cost $50-$100 dollars per square foot. Make sure you get estimates of furniture and other items, such as appliances, before you purchase your home. On average, for ongoing maintenance, expect to spend around 1% of your home’s value per year. However, this does not mean that you may incur this expense every year. Some years you may spend more on maintenance costs than others. Another factor to consider is how you value your free time. Are you ready to commit to mowing grass, raking leaves, or shoveling snow? Yes, you can outsource those tasks but that increases your ongoing maintenance costs.
In earthquake-prone areas like Seattle and most of California, you’ll need to consider earthquake insurance. Movements of the ground are not covered under any homeowner's insurance policy. Investigating your need and the cost of this insurance is a prudent move. Going through an independent broker is a good starting place to learn more.
Be Financially Savvy: Down Payment & Mortgage Term
For your home down payment, consider at least a 10-20% down payment. Most lenders will require private mortgage insurance (PMI) for down payments less than 20%. PMI is a non-deductible cost that ranges from 0.5% to 1% of your total mortgage. You can drop PMI after five years if your home equity is 20% or more. Think of PMI as a sunk cost; you don’t get those dollars back and there are no tax advantages. Therefore, in most cases, it’s a smart money move to put 20% down or as close to 20% as you can.
For your mortgage term, consider taking a 15-year fixed term. 15-year mortgages have a lower interest rate and over the duration of the loan, you will save money on the interest payments. However, before committing to a 15-year term, make sure your PITI costs are lower than 28% of your gross income. If the payments are too high, you can always start on a 20 to 30-year term and refinance later if interest rates fall. For refinancing, always run the numbers and make sure the new closing costs don’t break the bank.
The Bottom Line
Purchasing a new home is an important decision and it’s often a stressful one. However, with a solid plan, it doesn’t have to be. Know your numbers, have your risk management strategy in place, and understand your why for owning. Do not buy a home because you feel like you need to or because your friends or family are encouraging you. It’s your money and your life. Base the decision on your core values and your lifestyle.
If you would like personal guidance on planning for a home purchase from a Seattle-based Certified Financial Planner, reach out to schedule a free consultation.
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