So You Want to Buy a House?
“Contact your bank for pre-approval.”
“Determine your budget.”
“Location, location, location!”
“Make a wish list of features you want or need.”
“Start browsing online to get an idea of what you like.”
All of this advice and more is cited as step one for prospective homebuyers. But before you start shopping for a home in earnest, there is one thing you absolutely must do: have an annual budget.
I’m not talking about a stab in the dark at what you think you spend in a year. I mean cold, hard, well-crunched numbers based data, i.e. your spending from the previous year or more.
If you’re working toward home ownership, I’m assuming you’ve already started saving a 20% down payment. More here on why that’s critical and you’re foolish to buy a house without one. Plus, practicing the discipline required to save up that big of a chunk of change is a good sign that you’re financially responsible enough to take a death pledge (the literal translation of mortgage.)
A fortunate few receive all or part of a down payment as a gift or from an inheritance. If this is the case—congrats! What a wonderful gift. But this makes it all the more important that you carefully inspect your budget and confidently know what you can afford. I’ve seen people buy too much house this way and it’s not a pretty sight.
Why am I so dull as to peel you away from your Zillow search so you can stare at bank statements and spreadsheets? Because I love you.
- How the heck can you set a home price budget without knowing what type of monthly payment you can afford?
- How can you determine what you can afford without knowing how much you spend now?
I realize that people compare mortgage payments to their current rent prices, and that makes sense to some extent, but you also must account for the hidden costs like closing fees, property taxes, homeowners’ insurance, utilities, repairs and maintenance, furnishing, and moving. Check out Millennial Firecracker’s excellent calculations on the true cost of home ownership. This stuff definitely adds up over time, making home appreciation less profitable than you might think. Plus, you can’t walk away from a 15- or 30-year commitment easily as you can at the end of a lease.
And don’t even consider your monthly budget, not until you account for all those annual or biannual expenses like vacations, Christmas, gifts, other holidays, and the like. Once you’ve determined those expenses, either spread them out evenly over your monthly expenses (total ‘em up & divide by 12), or subtract them from your take-home pay and pretend that money isn’t even yours. Then put it in a separate savings account.
Let me also highly recommend that you set your budget based on one income, even if you are a dual income house, if you ever conceivably might have kids. Even if you both plan to keep working. Even if you don’t think you’ll want kids. You simply do not know what the future may hold, and how having a child could change your plans.
Aside from having kids, you also never know when one partner could become unemployed. So pretty please do yourself a huge favor and buy a place you can afford on one person’s income. If you both keep killing it at work, you can pay that sucker off fast and be done with the death pledge.
How Much House?
The age of the starter home seems to be over. According to Zillow’s research on Millennial homebuyers, “millennials tend to buy larger homes with more square footage and a higher price tag. The median millennial home purchase is $217,000, which is just 11 percent less than Generation X home purchases and slightly costlier compared to Baby Boomer homes.” I don’t assign moral values to home size or price, but it’s curious that the generation with sometimes mortgage-sized student debt are also biting off big home loans. Certainly knowing your monthly budget will help you avoid getting in over your head.
With your budget in mind, determine how much you’d like to spend on a mortgage, including principle, interest, taxes, and insurance (PITI). Don’t forget to estimate 1-3% annually of the home’s value for maintenance—believe me, you’ll need it. Houses are made of wood, drywall, paint, and lots of other materials that wear out over time. They are also full of expensive appliances which are ticking time bombs for a financial emergency, if you’re not prepared.
Now that you’ve got a real monthly number that’s based on data (i.e. your past spending), go play with some online mortgage calculators. Zillow reports that two-thirds of millennials use mortgage and affordability calculators while considering home ownership. Friends, let’s make that number 100%.
And don’t be fooled by incomplete calculations. Watch out for those real estate web site calculators that report the monthly price for that gorgeous turnkey house is less than you’re paying in rent. They’re often assuming a 30 year term with 20% down, and may not be counting hundreds of dollars per month for property taxes.
While you’re playing with those calculators, select a 15 year term, which will NOT be the default. I know there’s a raging debate over whether or not to take a 30 year and invest the difference, earning a higher interest rate than you’re paying. But let’s just be real. Most normal people are NOT going to be putting the difference into the stock market. If you are really going to invest like crazy, I trust you to navigate this decision. For everyone else, I highly recommend the 15-year. Otherwise, the interest you pay will likely devour the appreciation. It basically works out to a rental agreement (with the bank), but you’re also allowed to hemorrhage money on maintenance and remodeling.
Conventional wisdom says not to spend more than 25% of your income on your mortgage. I concur. And let’s be conservative and say 25% of your take-home pay, and include all of PITI when calculating your housing costs. Naturally, you don’t have to spend this much, but don’t surpass it.
And for the love of God, do not pay PMI. Wait and save 20%. Side hustle, cut spending, put all windfalls into your down payment savings, and wait.
Remember, I’m telling all these horrible, awful things because I don’t want to see you strapped by your mortgage, let alone upside down in it. Even if you’re making payments easily, you don’t want it to prevent you from traveling, being generous, or having the financial flexibility to work less or retire someday. Don’t marry your mortgage. You’ll thank me later. 🙂
Homeowners, what advice do you have for prospective home-buyers? How did you determine your budget?