Am I Financially Ready to Buy a Home? 6 Questions to Ask Yourself

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!

Renting Is NOT Throwing Money Away

 
There are many times when conventional wisdom is wrong, especially in personal finance. Many of us were sold on the American Dream of a house with a white picket fence, two cars, and a dog. Many people have discovered, the hard way, that if those dreams were heavily financed with debt the American dream can quickly become a nightmare. The dream isn’t necessarily the problem. There is nothing wrong with having a goal to purchase a home, cars and/or pets; the challenge, however, is putting oneself in a financial situation to truly be able to afford it.
The definition of what one can afford has dramatically changed over the years and our parents have a strong influence on how we define that. The past 40 years have seen dramatic changes in consumer financial products allowing the middle class to participate heavily in the consumer economy. With credit cards, 0% financing, adjustable-rate mortgages and the like, the ‘buy now, pay later’ phenomenon took off and those who save cash for major purchases were marginalized as either unsophisticated or old-fashioned. Like with most fads, many of these financial marketing ploys later displayed disastrous consequences for people over time.
Fast forward to one of the most common themes, “Why are you still renting, don’t you know that you’re just throwing away money every month?” If you’re getting your finances together to eliminate consumer debt, build an emergency fund, save for a down payment or you’re just not ready to commit to an expense that large, renting is exactly what you should do! We are not suggesting that homeownership is a mistake, only that if you’re a renter and feeling social pressure to buy, there are very legitimate financial reasons to rent. Let’s chat about a few of the common myths out there and bust them one by one.

  1. It’s Cheaper To Buy

    In some areas of the country (typically in the South and Western states not named California) it may be relatively inexpensive to purchase a home as compared to renting. However, if you live in or near the 20 most populous metropolitan cities of the US, it’s likely not the case. When people say it is cheaper to buy, they are often comparing monthly rent to the monthly mortgage. Unfortunately, that’s a short-sided view comparing apples to oranges. The additional costs of maintaining a home can costs thousands of dollars each year that renters do not pay. Here are just a few items people typically leave out of the cost of purchasing and maintaining a home:

    • Purchasing: Down Payment, Closing Costs, Home Inspection, Land Survey, Appraisal, Attorney Fees, Title Search, Mortgage Processing Fees
    • Ongoing Costs: Private Mortgage Insurance (PMI), Homeowners insurance, Association fees, Home Repairs, Lawn Maintenance/Snow Removal, Property Taxes, Utilities
  2. You’re Not Building Any Equity

    While it is true that you do not build equity renting, the cost of that equity is important to understand. Also, the additional ongoing costs of homeownership mentioned above like maintenance, property taxes and association fees (not paid by renters) don’t add equity. Those additional costs not paid by renters can be saved and increases a renters’ net worth.
    We’ll use an example for this one: Let’s say you’re diligent and save $20K for a down payment on a $220K home. You get a 30-year mortgage at 4.5% for the $200K balance.
    After five years, you’ve paid a total $68,800 to your lender ($1,013 monthly mortgage payment + $120 monthly PMI X 60 months), but $43,118 of the $69Kwent straight toward mortgage interest and $7,200 went toward PMI. So after 5 years, you’ve only gained $17,684 in additional equity. In other words, it cost nearly $70K to get $18K in additional equity.So the question is whether all the additional homeowner expenses during both the purchasing process as well as five years of maintenance and taxes (not paid by renters) are more than the $18K of equity built. We all know the answer to that.

  3. You Can Save On Taxes

    The mortgage interest deduction is commonly misunderstood and while we’re not going to go into tax policy, there are a few things of note to be informed of when confronting this myth. First, only about half of homeowners receive the mortgage interest tax break. In order to qualify for the mortgage interest tax deduction, youmust itemize your deductions. For many homeowners, the standard deduction outweighs their itemized deduction and therefore, they fail to qualify.Even if one does itemize and qualify for the mortgage interest deduction, note that it is adeduction and not a credit. Some mistakenly believe that it’s a $1 for $1 reduction of taxes, so if you spend $10K on mortgage interest, you’ll save $10K on your taxes, which is false. If you spend $10K on mortgage interest and itemize, you would save $10K multiplied by the income tax rate (i.e. 25%) or $2500. So you would be paying $10K mortgage interest directly to a bank to save $2500 in tax liability. This is not a reason to purchase a home.

  4. It’s The Best Way To Build Wealth

    We imagine there are hundreds of thousands of homeowners who faced the 2008 Great Recession that no longer agree with that statement. The reality is that the housing market is unpredictable. One has to be financially prepared for market swings.
    In the earlier example of the $200K 30-year mortgage at 4.5%, at the end of that loan, the homeowner would have paid nearly $165K in mortgage interest.
    Let’s make that clear, a $200K loan at 4.5% costs $365K, not including PMI.
    So we do not believe paying $365K (plus the additional purchase and annual maintenance costs) to buy a $220K home is the absolute best way to build wealth.Note: for more information on the costs of a mortgage, check out the amortization calculator in our Wine Cellar.

If you are a renter and/or feeling social pressure to purchase, we hopefully have busted some myths about renting. Everyone’s finances are different, so run your own race. Decide on your own terms if or when homeownership is right for you. If homeownership is in your future, be well prepared financially as it may be the most expensive purchase in your lifetime.