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?
I’ve never owned a home but I’ve watched a lot of House Hunters (lol) and it seems people are always stretching themselves financially when they don’t have to…where a perfectly nice fitting smaller house will do the trick. I think there is probably a lot of trying to impress other people going on…or owing so much stuff they can’t fit it into a smaller place.
I wonder how much those home-buying shows impact people’s expectations or desires when it comes to buying a house. It makes it seem like everyone is buying a gorgeous, turnkey home when in reality those budgets have to be way higher than average! But yes, I think sometimes people feel they need more space than they actually do, or want to appear very successful or like they have wonderful taste.
Many years ago, a friend told me she read that she should buy as much house as she could afford. And she did. But she ended up stuck with a house she couldn’t afford, which affected her ability to pay the other bills.
Your advice on the 15 year mortgage is spot on. If you can’t afford the payment on a 15 year loan, it’s too expensive. Last week, I used an online calculator to see “how much house” I could afford. The results were nearly twice what my house actually cost. There is no way we could pay all the bills and save for retirement/college if we spent that much. Those calculators don’t take into consideration any non-debt expenses or savings – as you point out, all expenses should be calculated prior to deciding how much to spend.
I just love to have wiggle room in nearly everything I plan–including what we can afford. With bigger expenses like a home, that’s even more important.
Thanks for sharing your recent example of calculating how much home you can “afford.” It certainly doesn’t make sense to be completely strapped by your mortgage, leaving no room for other savings or goals.
Great tips! Instead of looking for the most expensive house we can “afford”, my hubby and I plan to buy a townhouse that’s one of the cheapest we can find in our area. We are postponing saving for retirement while we pay off our student loans, so investing a big chunk of our incomes will be a much more important priority for us than buying a big house.
That’s great that you have a plan for what you want to spend on a house, how to make it happen, and where the rest of your income will go. So wise!
A lot of these expenses will either be spelled out and included in your monthly loan costs (Escrow is typically paid along with your mortgage and covers your insurance and property taxes along with interest and property of the house). Also there is nothing to say you need to buy new furnishings when you move in. We waited a few years. Finally if you move yourself you can save big money. It cost us about 50 dollars to move last time. We’re currently in our second house.
However there are 2 big costs. 1) Repairs and maintenance. Check the age of the wear items like roof, heater, and air conditioner. At replacement these items can be a 10K or more bill. If they are old budget and try to get the home price discounted by this much. These are not items you can put off if they occur. Budget 1% of the home value per year in repair costs (for an average year, not the year where these big items go).
2) closing costs. Closing costs and buying aren’t too bad. Its the one on the sale later on that will kill you. Its not uncommon to pay 6-7 percent of the home value for the privledge of selling a home. For a simple 200K home that’s 14K dollars. As such don’t buy unless you plan to stay put.
Yes, PITI will be stated in closing documents, but I have seen deceptive online calculators that don’t include that. Fortunately many others do. I agree that furnishings and moving costs can be minimized, though a lot of this happened for us through our network of friends, which I guess not everyone has. We received lots of help moving and hand-me-down furniture, as well as some housewarming gifts, which all helped a lot. We did have incidentals like a lawnmower, tools for DIY repairs, and the like.
Closing costs for selling are definitely a big ticket item and can eat into the appreciation. I agree it makes sense to plan on staying put for a while after buying, if at all possible, to reduce those costs.
We paid for as much of our house as possible with cash and took a 15-year mortgage on the rest. We don’t have the PMI and all that other stuff, it’s still crazy all the little closing fees you pay.
Our big goal is paying ours off within 5-7 years (10 to 8 years early) and save $10,000 in interest charges. It’s the only divorce my wife & I plan on making.
That’s awesome you were able to put more money down AND take a shorter loan AND pay it off early. You’ll save so much more in interest with those three combined!
Good suggestions. However, even though you may have additional expenses, such as property taxes, don’t forget that property taxes are tax deductible, plus almost the entire mortgage payments for the first few years are tax deductible since most of the payment is made up of interest, which is deductible.
The tax deductions aren’t a huge benefit in my opinion, since they essentially work out to a small discount off a large expense. However, it is a nice perk for something you’re paying anyway. But I wouldn’t keep paying interest for the small percentage less you’ll pay in taxes.
Bought a house when I was 22 and right before the crash and I don’t regret it, those first 2-3 years were extremely tough to make it all work but in the end it did. I now have a second house and the first one became an investment property that generates $1500 a month in passive income, not counting all the tax benefits that we have on the first few years, sometimes you have to risk and sacrifice a bit on the beginning to be rewarded on the end.
I’m so glad your first home purchase worked out and has become a good source of passive income for you. I agree that with rental properties, there is a risk up front but it can really pay off in the end.
I am all about recognizing the actual costs of owning a home before making the plunge but my recommendation only sort of overlap.
I am in agreement that a new homeowner should put down whatever is required to avoid PMI. Usually that is 20% down but occasionally you can sneak around it by getting one loan at the 80% and a second loan to make up the difference between your down payment and the full loan amount.
I am not on the same page with the 30 year vs 15 year argument. If you use a mortgage comparison calculator that includes the time-value-of-money (taking into account the inflation rates) you’ll see that at about 3% inflation the two situations are similar in total cost, and at about 4% you actually spend less money on the 30.
I encourage prepayment of a mortgage on a basic level. For instance, I would encourage making an additional payment each month, of something in the range of several hundred dollars. Small enough to be able to do consistently but large enough to lower the 30 year mortgage into a 20 year mortgage with little commitment. For a 200,000 loan at 5% that number is 250. This is less math and more a nod to changing life styles. Having a debt burden that extends 30 years is not something I appreciate.
If I were to get a new mortgage today, as a new home buyer, I’d avoid PMI, get a 30 year, schedule prepayments on a limited scope, and max the heck out of my retirement options before going any further with prepaying the mortgage. If you don’t have enough funds available to do these things (so that you can stop doing them when the roof blows off so you can redirect the funds) then you may not have enough cash flow to purchase a home.
What did I really do? I put 50% down, on a 5 year ARM at 2.85% and will have the remaining balance on the loan complete before the 5 years are up (next year) but that’s only because I can do that while still maxing all retirement options. Total interest paid is estimated to be right at 8,000.
Way to minimize your interest payments! And interesting to hear how differently you’d do things if you started over. I don’t think someone has to be able to afford a mortgage and be able to completely max out retirement benefits in order to truly afford a home–unless the person wants to retire quite early. I’m with you on the idea that the 15 or 30 year isn’t all about math, it’s about your view of and/or emotions about having debt.
I meant that if you were unable to put significant savings towards retirement, then in years with an emergency it would be very difficult to cash flow. For instance, if you need a new roof one year you can easily drop back on retirement contributions to replenish your emergency fund.
One of the most common budgeting mistakes I see is when people max out their budget, committing every dollar, to something that isn’t flexible. They will create emergency funds but fail to realize that replenishing that emergency fund has to come from somewhere. If you are in the range of maximizing your retirement funds, it can come from that category while you are still able to at least contribute some amount.
Thanks for clarifying, Morgan. I agree that you need to have some flexible cash flow for those extra expenses that inevitably crop up. And what you’ve described–directing extra funds toward retirement, except when you need cash for the new roof, etc., is exactly how we approach it. If you’re going to budget every dollar, you need some buffer going to savings of some sort.
All great advice! Here is my favourite: “Let me also highly recommend that you set your budget based on one income, even if you are a dual income house.” Your advice regarding a yearly budget is also key. Most people rely upon the bank to tell them what they can afford. The bank, of course, is very interested in home buyers as sources of interest payments.
Thanks, Ruth! It’s so true that the bank is purposely too liberal with what you can afford, to benefit their interests. It also can’t take into account your other expenses, which obviously vary greatly from one family to another.
Very good suggestions. I wish I’d waited til I had more saved up, but I ended up paying PMI and buying probably a bit more house than I could afford, then.
I would say that cheap loans are probably why Millennials aren’t buying starter homes, but not the way you might think. It’s a supply issue, in my opinion.
It’s not that Millennials don’t want to buy them, necessarily, as much as it is that low-interest rates make first time home buyers compete with investors for lower end properties, and many of them probably end up as rentals. If you look, entry level housing gets snapped is in. Combine that with the fact that builders aren’t building so many starter homes (the margins are slimmer), and you get a situation that makes it harder for Millennials to get a starter home for a competitive price.
I think there are a number of reasons Millennials aren’t buying starter homes, and agree that supply could be one of them, at least in certain markets. It also seems that, since values have been pretty flat in some areas, it wouldn’t make sense to buy a home hoping for it to appreciate so you can upgrade.
I wanted to share a google sheet I had made for calculating the cost of a Mortgage. I have been evaluation the real estimated cost of a mortgage opposed to renting. Pretty much the only thing I didn’t account for is home improvement and repairs, but everything else including PMI and Extra monthly payments are accounted for. It allows for some modification of values so have fun!
That’s great, Tom, thanks! Very helpful.
I love this advice! Having an annual budget helps you determine what you can truly afford. I tell people to determine what they can afford before they start their home search.
As a word of caution, as soon as you start your home search, EVERYONE involved in the process will try to get you to spend more, including yourself. It’s so easy to talk yourself into a “slightly” more expensive (and over budget) home because it has a cool feature you like.
Determine what’s affordable early on, and don’t let emotions take over your decision. Your lender and realtor may try to get you to spend more, but stick to your budget.
Amazing tips! Instead of looking for the most expensive house we can “afford”, my baby and I plan to buy a townhouse that’s one of the cheapest we can get in our area. We are postponing saving for retirement while we pay off our student loans, so investing a big chunk of our incomes will be a much more important priority for us than purchase buying a big house.
Sounds like a great plan, Adam! That’s wonderful you know this when you’re starting out and before you make your first home purchase.