Am I Ready to Buy a New House?
Many people believe that buying a home is essential. It has been known to be part of the American dream. Owning a home is a big decision, as it usually is a very costly decision. Some people like to point out that buying a home is a great “investment”. Contrary to this belief if you look at long-term housing returns represented by the Case-Shiller Home Price Index: National returns since June 1, 1988 are positive 158.3%. This dramatically underperforms the S&P 500 total return of 1,450% over that same time period. That home price index doesn’t include expenses and upgrades to a home over those years either. In many cases, your return can be a negative real return on your investment after you adjust for inflation. There are many positives to owning your own home, but it is important to assess the following points before taking the plunge.
How long do you expect to live in this new home?
- Renting isn’t always bad. Many people assume you are “throwing money down the toilet” when you rent instead of buying. What many don’t realize is that you are essentially just renting from the bank at the beginning of a mortgage. A majority of your monthly mortgage payment is very similar to renting. For example, with a 4.5%, 30-year, $250,000 mortgage, your first payment will be made and a majority of it will go towards interest only. Over 74% of your first payment goes to interest only and 26% of it goes to paying down your principal. The principal portion being the equity portion or your ownership in the home. Even after 5 years of making payments, the percentage of your total payment in month 120 that goes towards interest only is 67.5%. Over the life of the loan you end up paying $206,018 in interest, which is almost double the home value. If you plan on living in a certain location for only a few years, only a small percentage of your payment is going back into ownership in the home and there is not much financial benefit over renting.
Do you have enough saved?
- Many people underestimate how much they should have saved in the bank and the power of putting money down before buying a home. Even though in many cases banks will lend you a mortgage for as little as 3.5% down or 96.5% loan-to-value (for a first time homebuyer), it makes sense to save 20% as a down-payment. First, you save on private mortgage insurance “PMI”. If you have a conventional loan and you make a down payment of less than 20%, you will be forced to pay for PMI. PMI can range from 0.5% to 1% of the entire loan amount on an annual basis. On the $250,000 loan above, that would cost you $2,500 per year till you have 20% equity in your home. If you make your normal monthly payment, it would take you over 122 months (10 years) until you have 20% equity and you are no longer paying the PMI. This adds thousands of dollars to the original price of your home.
- It is also important that your house is a home. The bigger the house, the more “stuff” you need to fill the home. Buying furniture and decorating a home can be a sizeable expense. Not all homes are move-in ready and many need some handiwork done. It is important to have a good understanding of what type of work needs to go into your home and what that will cost.
- Expect the unexpected. Having an emergency fund for your home is also something to think about. Something as simple as the furnace breaking or a water leak can cost you thousands of dollars and that isn’t something you can wait months before getting fixed.
How much other debt do you have?
- In many cases, you shouldn’t have a lot of debt you are currently paying off before buying a new home. If you have high interest credit card debt or high interest student loans, it may be beneficial to first pay those off before looking for a new home. It is recommended that your total debt payments on a monthly basis do not exceed more than 33% of your total take home pay (after taxes). Anything higher is getting into risky territory of potential problems of default.