Buying your first home can create needless anxiety. This blog is the first of three on home buying. This one describes how much house you can afford. The second one describes things to do to prepare to make an offer. The third one describes mortgage loan products.
Why buy a house or condo?
You may have fond memories of your childhood home and want to create a similar place for yourself, to raise a family, to be part of a community, and to enjoy the local sights and sounds. And, for some, their home is where they will grow older gracefully.
Notwithstanding these intangibles, a home is often your largest investment and your biggest financial decision. Given the large transaction costs with real estate purchases, you should plan to stay at least seven years to recoup these costs.
Buying your first home involves homework. And like most things in life, prepared buyers are the ones who feel comfortable with their decision and don’t regret their choice.
This blog post assumes you have decided to buy because you aren’t increasing your net worth by renting.
I like to break up home buying decision into four issues:
- How much can you afford,
- Find your home,
- Get your finances together, and
- Get the right loan.
This blog covers the first two issues. I will cover the third and fourth ones separately.
1. How much can you afford?
This is the big question. You don’t want to be house rich and cash poor. If you are, you’ve tied up your cash in your home and you have little room for savings, day-to-day expenses, and emergencies.
Experts recommend your housing costs not exceed 28 percent of your monthly gross income. Housing costs include your mortgage payment (i.e., principal, interest, homeowners insurance, and property taxes). Add other costs associated with homeownership such as private mortgage insurance, utilities (gas, water, electricity), condo fees, and lawn care to make sure you are not overextended. These can add up to $300 to $500/month.
For every $100,000 in a mortgage loan borrowed, your monthly mortgage payment (principal and interest for a 30-year fixed mortgage) is:
- 4% interest rate – $477/month
- 5% interest rate – $537/month
For a rough calculation add another $300/month to these amounts for other housing costs (insurance, property tax, etc.).
- 4% interest rate – $777/month
- 5% interest rate -$837/month
You can now back into the largest mortgage loan you can afford by taking 28% of your monthly income and dividing by the amounts above. Use bankrate.com for prevailing interest rates in your area.
For example, if you can afford $2,000/month for housing costs (28% of your monthly gross income), then your mortgage loan shouldn’t exceed more than $239,000. ($2,000 / $837 at a 5% interest rate).
If you have other debt (student loans, credit card, car loans) then your total monthly debt payment shouldn’t exceed 36% of monthly gross income. If it does, then you may have to lower the mortgage loan amount or wait until the other loans are repaid before buying your first home.
Unfortunately, I’ve seen couples become overextended because they counted on two incomes to make ends meet. Often there are periods of time in which only one half of a couple is working. You don’t think it will happen to you but it too often does.
So calculate the maximum mortgage loan you can afford with only one income. Consider whether this amount is a better starting place for your first home.
You’ll need to make a down payment once you calculate your mortgage loan amount. You’ll receive a lower interest rate the more you put down. Aim for at least a 10% down payment.
Although there are loans available through the Federal Housing Authority (FHA) that allow a down payment as low as 3.5% of the home price, you’ll pay private mortgage insurance. Private mortgage insurance can add hundreds of dollars to your monthly payment until you have at least 20 percent equity in your home. It’s better to avoid these unnecessary monthly costs. A wiser long-term strategy is to save for a larger down payment and avoid private mortgage insurance.
2. Find your Home
We all have certain priorities for our first home: two full baths, an eat-in kitchen, southern exposure, parking for one car, etc. Make a list of your values and find the neighborhood and house that match them.
But be mindful of several things beyond the house. The three most important factors to buying real estate, in order, are location, location, and location. Location can determine whether you’ve made a wise financial investment.
Location means different things to different folks but the following questions can make sure you have the right location so that your property grows in value.
- Check the schools if you are raising a family.
- Study the commute to work. Are there public transportation alternatives?
- Examine the condition of the neighboring properties. Are they in the condition that enhances the neighborhood?
- Where’s the closest commercial district? Do you like the shops there?
- What’s the value of your home compared to others nearby (you don’t want to be the most expensive).
- Are friends and family around?
- Are there development changes to the neighborhood that will alter the value of your property?
Spend a day in the new neighborhood to answers these questions. Walk the streets, check out the open houses, go by the schools and community centers, and frequent the local establishments. Try to think whether this is where you want to live.
Online research can help. But there is nothing like on the going in person and forming your own impressions.
If you are thinking that this property could be an investment or future rental, then check out Airbnb or Zillow for rental rates in the area. These sites can help you determine whether any future rental income would cover or exceed your mortgage payment.
Part two covers how to get your finances together and how to get the right mortgage loan when buying your first home.