I recently sat down with Scott White, a good friend of mine and REALTOR® with Mint2Sell Realty. If you haven’t already heard, the housing market is hot right now. Typically, during times like these many people begin to re-consider writing a monthly rent check and start thinking about becoming homeowners. Scott has worked with many first-time home buyers and we thought given the circumstances, we’d share some tips on how to evaluate the financial aspects if you’re considering buying a home. Enjoy!
The question of whether to own or rent a home—depending on your personal situation—is usually answered by asking yourself two important questions: How much will it cost you up front? And, how much will it cost you on an ongoing basis? However, in today’s competitive housing market, there is a shortage of homes and, as a result, the prices and demand for single-family homes remain at high levels. That means it’s important to evaluate your options in order to set yourself up for success.
How much can I afford?
Determining how much “house you can afford” is an important first step in the quest for home ownership. A general guideline for calculating housing affordability is that a family should plan on spending, at most, two-and-a-half times their annual gross income. Thus, a family with an income of $75,000 may be able to afford a house costing about $190,000. However, let’s not move to fast, this general guideline just gets you started.
Once you know how much home you can afford, it’s important to know two things: how much you’ll need for a down payment and your credit score.
How much do I need for a down payment?
We typically recommend most clients have at minimum 5%, if not 10% set aside for a down payment. Your down payment is important because it gives you instant equity in your home, so if the housing market falls, you don’t end up underwater (owing more on it than your house is worth). In this case, our family would need at minimum $9,500 (5%) or even better $19,000 (10%). If you’ve been a diligent saver and have the ability to make a 20% down payment, that’s ideal, and allows you to avoid the need for private mortgage insurance on your loan.
What about my Credit Score?
Now that we have a down payment in mind, let’s look at credit scores. They are a measure of a person’s reliability to pay back a lender and range from 350-850. Your credit score is important because it will be the primary driver of how low of an interest rate you can obtain on your mortgage. A score above 670 is considered good, but the best advertised rates are typically reserved for those with scores of 750-850, which is considered very good to excellent.
We recommend having these two factors in order BEFORE you start shopping for your ideal home. It may take several months to save up a down payment or work to improve your credit. But by taking the time to address these two factors first, you’ll avoid the heartbreak of falling in love with a home and then losing it because you’re not prepared.
What about getting a pre-approval?
Once you’re set with your down payment and credit score, we recommend getting pre-approved for a mortgage through a lender. It’s an easy process where you provide information on your income and savings and then the lender uses it in combination with a credit check to determine how much they’re willing to lend you and at what rate.
It’s important to have a pre-approval because it lets sellers know that you’re serious when you submit an offer. In a hot housing market like we have today, some sellers won’t even consider an offer without a pre-approval included.
What should my mortgage payment be?
Next, it’s important to find out how much your monthly mortgage payment will be. If you’ve gotten a pre-approval, you will have an estimate, but it’s important to make sure you’re not stretching your budget too far.
Typically, we recommend clients spend no more than 25% of their gross income on their mortgage payment and they should obtain a mortgage with a term no longer than 20 years. Thus, the same family with a $75,000 income should have a mortgage payment of no more than $1,563 per month. Let’s see if they’re on track:
|Down Payment:||-$19,000 (10%)|
|Mortgage Payment (P&I):||$1,181|
It looks like we are on track with the principal and interest of the mortgage payment. But, we still have one more factor to add in that many people overlook: escrow.
What do I need to know about escrow?
Escrow is the amount of your mortgage payment in excess of your principal and interest each month that goes towards paying property taxes, homeowners insurance, and possibly private mortgage insurance. A general guideline for calculating escrow is to take your monthly mortgage payment and add 25% to it. Your lender will give you an exact amount prior to closing, but for our purposes:
|Mortgage Payment (P&I):||$1,181|
|Total Mortgage Payment:||$1,477|
So, for our family, we’re looking good on financing and even came in $86 below the recommended maximum! That $86 will help as we move onto the next step, calculating the monthly cost of home ownership.
What about monthly expenses?
Now that our family knows how much their total mortgage payment will be, we need to factor in how much each month owning the home will cost them. Calculating this is fairly straightforward, just add the mortgage payment to your estimated monthly utility and homeowners association expenses. It’s important to research these costs, BEFORE signing on the dotted line because once you buy a house, you’re stuck with them.
Believe it or not, a couple blocks can be the difference between a $100 monthly electric bill or a $200 monthly electric bill for the entire time you live in a house. It could also mean the difference between $500 per year in HOA dues or $1,000 per year in dues. So be sure to do your homework and if you’re heart’s content on a home where these costs are higher, make sure your budget is prepared to handle it.
For our family, the monthly estimates look like this:
|Cable & Internet:||$140|
What about maintenance and upkeep?
The last factor to consider, and another one commonly overlooked, is maintenance and upkeep expenses. You may have heard people talk about the “joys of home ownership” as a sarcastic euphemism and as a home owner you get to experience those joys firsthand!
When something breaks, there’s no landlord to call to send a maintenance technician to fix it. You’re on your own and whether you’re a regular handyman or will need to hire someone, it’s important to have money set aside to cover the costs of a burst pipe or AC that’s on the fritz. Don’t forget that if you have a lawn, garden, or other area, there will be a cost to keep it in proper condition.
We typically recommend homeowners set aside money in an account each month for just this purpose. The account serves as your “Home” fund and it’s a good idea to put in enough to cover the expected costs, for example lawn service or HVAC tune ups, AND a extra money so a cushion builds up to cover the unexpected situations.
Adding this in for our family:
|(plus Mortgage & Monthly Expenses):||$1,887|
|Total Cost of Home Ownership:||$2,042|
How do I compare my options?
Now that we’ve factored in all of the costs of home ownership, you can evaluate how they stack up to renting. Just compare what you currently pay as a renter to what you’ve calculated the potential cost of home ownership will be and you should have a pretty good apples to apples comparison.
Then, make sure you think carefully about how to move forward. Buying a home is one of the biggest decisions you’ll ever make. Even if it turns out to be cheaper to become a homeowner, ask yourself are you’re ready for the responsibility and will this be a good long-term fit for me? Ultimately, the answers to those questions should be the driving force behind your decision, not just the financials.
Sorting through the financial decisions involved in purchasing a home can be overwhelming, but once completed, owning a home is one of life’s more rewarding experiences. However, whether you are currently in the market for a home, or hope to be in the next several years, beginning to save now may help you minimize possible financial complications later.
If you have any questions or would like assistance evaluating home ownership or the financials behind it, we’re happy to help. Feel free to reach out to either one of us directly and we’re happy to discuss how our team approach can benefit you.
Mychal Eagleson, CFP®, AAMS® is the President of An Exceptional Life Financial, a firm that specializes in financial planning for teachersand families with special needs. He frequently writes and speaks regarding personal finance topics relating to these clients. Mychal also serves on the board of the Financial Planning Association of Greater Indiana as the Director of Public Relations & Social Media. To read more of his articles or learn about An Exceptional Life Financial please visit: www.anexceptionallifefinancial.com.
Scott White, REALTOR® has been around real estate all his life. His father and grandfather have been in the residential, commercial, land, and development business for over 50 years, passing down much wisdom and experience to him. Before launching his career as a realtor, Scott was a mortgage loan officer gaining valuable insight into the financial portion of the real estate transaction. More important than these skills, he has a passion for people and loves using his knowledge to help them with finding a place to call home. Great personal care and communication is what you will receive when working with him. To learn more visit: www.mint2sell.com.