What you really need to know about buying a home
By Jennifer Edwards, CFP®, CSLP®
The dramatic jump in home prices across the country has potential homebuyers scrambling to understand the landscape and evaluate their options. At 3rd Decade, we want everyone, who desires to, to own a home at some point. Homeownership helps you achieve financial independence. We are distressed at how difficult it has become for many people to be able to afford their first home. Let’s talk about some of the different factors to consider when evaluating the decision to buy a home with the intention of providing a helpful framework from which to approach this very important decision.
How to Know if You Are Ready to Buy a Home
It can be tempting to just look at the monthly mortgage cost and compare it to what you pay in rent and assume that if the mortgage is cheaper, you should buy a house. But there are many other factors to consider if you want to really be in a strong financial position when you become a homeowner. We have put together the following checklist to help you evaluate your home buying readiness.
- Sufficient emergency savings: We suggest having at least 3 months of essential expenses covered with emergency savings above your down payment.
- A down payment of at least 3% and as close to 20% as possible: Putting more down lowers your monthly payment and increases the amount of equity you have in your home right out of the gate. Putting down 20% eliminates the cost of Private Mortgage Insurance (PMI), which also makes your payment lower.
- Contributing at least 10% of your gross income to retirement accounts: This should already be a habit as once you get into a house and start incurring those added costs, it will be harder to put money aside for retirement.
- High level of job security: Most lenders will look at your income over the last 2 years to determine your long-term job stability. If you take on a mortgage payment and your income decreases, it may become difficult to make your payments.
- One place we see this play out is when a partnered household with two incomes buys a house and then later one partner stops working for a period of time to maybe start a business or take care of children. If you think your income might decrease in the future, don’t use your full current income when calculating the mortgage payment.
- Plan on staying in the home for at least 5 years: This is a typical break-even point over renting when you factor in the cost of homeownership and the mortgage.
- When you buy points, you lengthen your break-even period. This calculator can help you see what that would look like.
- A credit score of 700 or more: The higher your score, the better the terms of your loan will be. An excellent score of 740 or more is best. This will help you get the lowest interest rate and lower your premium if you have to pay PMI.
Further consideration for The Housing Decision can be found on 3rd Decade’s podcast
Your mortgage payment will typically include the Principal and Interest on the loan, as well as the property Tax bill and homeowner’s Insurance premium. This is commonly referred to as PITI. In addition, you may be paying PMI. Because you will probably be paying on your house for decades, it’s important to think through all the relevant factors when it comes to taking on a mortgage.
- Debt ratio: Take the monthly mortgage payment, divide it by your gross monthly income (pre-tax annual income/12) and multiply it by 100. This is your mortgage ratio. For most people getting their first home, a mortgage ratio of 20% or less is going to leave room in the budget for other debt payments, savings, investing for retirement, and discretionary spending. Borrowing the full amount you are qualified for (usually 28%) will probably strain your monthly cash flow. If you can’t keep it to 20%, just try to keep it as low as you can.
- 5% Rule: This rule of thumb can help in determining whether it is mathematically more advantageous to rent or buy. If interest rates are high, you will probably refinance to a lower rate at some point, so the 5% rule probably still generally applies.
- Points: Buying points is essentially prepaying interest and can help you get a lower interest rate. This article explains points and lender credits.
- 15 year vs 30 year: You can secure a lower interest rate and dramatically decrease the amount of interest you pay by getting a mortgage with a shorter duration. BUT don’t get tunnel vision when it comes to lowering the cost of your home. Remember that money invested in a diversified stock portfolio will most likely outweigh the interest savings. From a purely economic standpoint, it’s better to borrow from the bank at a low-interest rate and invest extra money in the market instead of paying off your house early. This is especially true if you aren’t yet maxing all of your tax-advantaged retirement accounts (401k, IRA, HSA).
- Shop around: It is wise to get quotes from several different mortgage brokers and shop around for the best terms. Your credit score is not affected too heavily when you condense many inquiries into a short period of time, like 1-2 months.
- Get creative: You may find that buying an income-producing property makes homeownership more feasible. Consider buying a duplex or a house with rentable guest quarters. There are many house-hacking strategies that could help lower your housing costs.
Refinancing and Home Equity Loans
When interest rates decrease, making it possible to lower your payment, or when you want to access the equity in your home without selling it, you might want to consider refinancing. When you refinance a mortgage, your previous lender is paid in full, and a new loan is issued. You can also borrow against the equity in your home through a home equity loan.
What is equity? Equity is the amount of value of your home that you “own.” If you take the fair market value of your home and subtract the balance of your mortgage, that is how much equity you have. When you own your home free and clear, the entire value of the home is yours. Real estate is a volatile asset class where prices move up and down depending on factors affecting market participants. Your home value can increase and decrease in the short term, so it’s important not to borrow too much or too frequently from your home’s equity.
In general, when interest rates decrease by at least 1%, and you plan on owning the property for at least another 5 years, it is wise to consider refinancing. When you refinance, the break-even period starts all over, so only refinance if you plan on staying in the home long enough to justify the cost of the new loan. Most people will find it easier to retire if their house is paid off, so be careful about extending your mortgage into your retirement years.
Instead of replacing your existing mortgage, home equity loans and home equity lines of credit (HELOCs) are secondary loans taken out against the equity in your house. A default on a home equity loan can lead to foreclosure, just like a default on a mortgage, because the house acts as collateral on the loan. Additionally, many home equity loans have an adjustable interest rate making them riskier than a refinance. But home equity loans and HELOCs generally have lower closing costs.
Most lenders require a loan-to-value (LTV) ratio of at least 10% – 20%. Equity in your home increases as you pay toward the principal in your mortgage and when home values increase. PMI can be removed when your original loan-to-value ratio reaches 80%.
Focus on What You Can Control
We understand how frustrating it is that prices have risen so sharply, making homeownership all that much more difficult. We’re there with you in the pain of lost hope and delayed dreams. It’s important to focus on what is within your control. Write your representatives, vote, and make your voice heard. Reach out to organizations like the Federal Housing Administration, the National Fair Housing Alliance, the National Associate of Real-Estate Brokers, and Bank of America, who all have special programs for people of color and those with lower income to help them achieve the goal of homeownership. Arming yourself with the right information and getting in a strong position financially will help ensure that your homeownership experience is a positive one.