You’re excited, you’re nervous, you aren’t sure if you can afford it, but you have to buy one. All your friends have homes; your parents own a home. Purchasing one is seen as the “American Dream,” a status symbol that shows you have made it, welcome to being an adult.
So you are ready to take the plunge and make the largest purchase of your adult life—your first home.
Location Is Everything
Before you can buy a home, you need to decide where you want to live and how long you plan to stay. Some common questions we ask our clients are:
- Do you want to live in the city or suburbs?
- Would you like to purchase a brand-new home, fixer-upper, or condominium?
- How long do you want your work commute to be?
- Is living near your family and friends important?
- Are you planning on having kids? (If so, research school districts.)
If you and your spouse can’t answer most of these questions with certainty, you probably aren’t ready to buy a house. If you can, let’s move on to the next step.
The down payment is the biggest upfront expense prospective homebuyers can face. Most of the time, you must come up with 20% of the home’s purchase price for a down payment. If you cannot, then you have to pay primary mortgage insurance, or PMI.
Let’s pretend that we want to buy a home that costs $500,000. That would mean that to purchase that home and not have mortgage insurance, you need to come up with $100,000 in cash!
That’s a lot of money!
Fortunately, the banking industry and federal government understand that most people will struggle to come up with the cash necessary for the down payment. If you fit into that category, you can go for an FHA loan, where the minimum down payment is 3.5%. The catch is that your monthly payment will be higher because of PMI.
Before we give our clients the green light on purchasing a home, we like to see a down payment of at least 10%, preferably 20%.
Total Monthly Payment
Once the down payment is taken care of, we can determine how much the total monthly payment will be.
The principal payment will be calculated based on the following factors: loan amount (purchase price – down payment = loan amount), the interest rate, and the length in time of the loan.
Here is an example: The amount borrowed is $400,000, the loan interest rate is 4.00%, and the length of the loan is 30 years—giving you a monthly payment of $1,910. Most people see that payment number and think that is all they must pay.
That is not true.
The payment could also consist of PMI (if you put less than 20% down) and property taxes.
The typical PMI cost is anywhere between 0.5% and 1.00% of the amount borrowed on an annual basis, paid monthly.
Say what? Let’s just do an example and look at the numbers.
Let’s say you purchase a home for $500,000 with 10% down ($50,000 = down payment). That means you borrowed $450,000. Your monthly PMI payment will be $375 ($450,000 * .01 / 12).
The final cost is your property taxes. There are lots of various government rules and regulations with property taxes, but for simplicity’s sake, let’s say the property tax rate in California is 1.50%.
So, if you purchased a $500,000 home, you would pay $625 a month in property taxes ($500,000 * .015 / 12).
What Can You Afford?
To recap, your monthly payment will consist of the mortgage payment (principal), PMI payment (if applicable), and property tax payment. We recommend that our clients pay no more than 28% of PITI (principal, interest, taxes, and insurance) to gross income.
That would mean the family purchasing a home with a PITI expense of $3,500 a month (42,000/year) would need to have gross income of $150,000 to keep their PITI ratio at 28% (42,000 / 150,000 = 28%).
Typically, we like it when our clients are somewhere in the 20%–25% range, as it leaves room in their budget to accomplish more goals.
Own your home—don’t let it own you.
In addition to the down payment and the total monthly payment, there are additional costs you need to consider before you buy a home.
- Closing costs are around 2–5% of the home’s purchase price. You must pay these before you buy the house.
- Homeowners association fees, or HOA fees, are a monthly payment paid to a board for general upkeep of your neighborhood or condo building.
- Homeowners insurance.
- Repairs and maintenance, which can include anything from a new roof or plumbing issue, to a broken water heater or bug infestation—anything that would need to be fixed goes into this category.
- Moving costs.
- Furnishing and upgrading the home.
There are lots of benefits to buying a home. You build equity each month when you make a payment, you get a tax write-off for your mortgage interest and property taxes, and you get the satisfaction of ownership.
That said, there is nothing wrong with waiting to buy a home until you can actually afford one. The last thing you want is for your home to be a burden on your personal finances and your life.
Determine what you think you can afford, and if you don’t want to go it alone, then consider hiring a fee-only financial planner to help guide you through the process.
Happy house hunting!