Buying a home will likely be the most expensive purchase in your lifetime. You want to make sure you are prepared to be in the best position financially. There are some common misconceptions about renting that you may want to understand, but if you are emotionally ready to take on the home buying challenge, here are six questions to ask yourself to make sure you’re financially ready!
1. Do I have any consumer debt? (Student Loans, Personal Loans, Car Loans, Credit Cards)
Adding six-figure debt is a serious challenge and commitment. If you already have a significant amount of debt, you should consider focusing and eliminating these debts prior to incurring mortgage debt. A mortgage on top of consumer debt would increase your overall expenses and give you less financial flexibility. Paying lenders interest on debt is the opposite of building wealth.
2. Is my credit score above 720?
A credit score is simply a calculated score credit rating agencies produce that measures how well you manage debt; the higher the score the better. Lenders use this score to help determine their risk in lending to you. The higher the risk, the higher your interest rate which makes the borrowing cost of your home more expensive. There are several ways to reduce your cost of borrowing, but one is to ensure your FICO score is above a 720. FICO credit scores range from 300-850, but in most cases, a score at or above 720 is considered excellent credit and will get you the most preferred rates. Below 720 and you will pay additional interest because of credit risk. In future posts, we’ll discuss how to increase your credit score to minimize your borrowing costs.
3. Do I have a fully funded emergency fund? (minimum 6 months of expenses)
Having a fully funded emergency fund is essential even if you’re not purchasing a home, however, it becomes more important when you do purchase. You can no longer simply notify the landlord of a water leak, heat/AC issues, or a major appliance outage – it’s on you. Homeowner’s Insurance may cover some particular events, but even so, the insurance also has a deductible that you’ll have to cover out of pocket. We can’t predict emergencies, but we can financially prepare to deal with them knowing they will happen. Don’t allow these situations to send you into a financial tailspin of debt. Be prepared with at least 6 months of basic living expenses (e.g. housing, insurance, food, transportation, utilities) which is not part of your down payment.
4. Do I have 20% cash for a down payment? (Separate from an emergency fund)
A 20% down payment is important for multiple reasons. First, if you’re going to make potentially the most expensive purchase of your lifetime, it’s important that you have skin in the game. This means that you had sacrificed for a period of time to save above and beyond to make this happen and you’re fully invested. It also greatly reduces the probability of an impulse purchase.
Second, 20% of the purchase price as a down payment avoids Private Mortgage Insurance (PMI). PMI is an insurance policy the homebuyer pays on behalf of the lender in case the homebuyer defaults. PMI typically costs about 1% of the home purchase price annually and is added to the monthly mortgage payment. PMI can be canceled by the homebuyer once the homebuyer has 20% equity (Loan-to-value ratio of 80%). The bank is required to cancel PMI when the Loan-to-value ratio hits 78%. Depending on the size of the down payment, this could mean several years of additional fees. So, if that sounds like a rip off to you, then you’re starting to understand.
5. Am I planning to move within 7 years?
Mortgages are structured in a way that front loads interest payments. The lender gets much of their borrowing costs before you get your equity. In other words, the majority of the interest of the loan is paid earlier and the principal of the loan is paid down later. For example, depending on the interest rate, the first year of monthly payments could be 75% interest and 25% principal. That is important because, within the first seven years, you will likely not have much equity. Without equity, you will likely not able to achieve a return on investment (ROI), when you are ready to sell. If home prices fall during that time, you could find yourself under water (the balance owed on the mortgage is more than the current value of the home). If you move sooner than the equity in the home grows, you could end up still having to pay a monthly mortgage on a home that has already been sold.
6. Will my monthly housing costs (mortgage, insurance, taxes) exceed 30% of my monthly take-home income?
If you ask a real estate professional, such as a real estate agent or a mortgage broker, “How much house can I afford?” they will likely hear and answer a completely different question – more like ‘How much risk is my bank willing to take?’ or ‘How much commission can I make?’ That’s not a negative statement about real estate professionals, but they are financially incentivized to give you the largest mortgage they can get approved. It is your job to determine how much house you can afford. We recommend that your housing costs including the mortgage, insurance, and taxes not exceed 30% of your monthly take-home income. Can you afford more than 30%? Of course, but the goal of the financially savvy isn’t to get the largest mortgage possible. The goal is to purchase a home while having the flexibility to achieve other financial goals such as saving for child’s education, paying off the mortgage early and achieving financial independence. You want your home to be a financial benefit to your family, not a financial burden.
Purchasing a home is an important emotional and financial decision. On the emotional side, often people will make the mistake of comparing their first home purchase to their parents’ current home. What you can comfortably afford 15-20 years from now may be drastically different from what you can afford today and that’s okay. On the financial side, to be financially prepared for a home purchase means not allowing the home to overtake other financial goals. Having the biggest house on the block is pretty meaningless if you can’t afford to furnish it, maintain it or take a vacation from it. Keep the bigger picture in mind!