Written by: Corey Janoff
This post was originally published on our previous blog website on June 6, 2018 and has since not been revised and/or updated.
It’s that time of year again! The housing market is in full swing as spring turns into summer. People looking to move are timing it for when their kids are out of school. It helps that the weather is nice and the flowers are blooming. Long-time renters are attending open houses and perusing Redfin to hopefully become homeowners, finally.
If you are one of these people, can you really afford to buy the house you want? If not, are you willing to make sacrifices so you can afford it?
When it comes to purchasing a house, you need to have:
- Money for a down payment and closing costs
- The ability to afford the mortgage and property tax payments
- Money for moving expenses
- Money for Furniture
- The ability to afford regular home maintenance expenses
- Plan to own the house at least 5 years
Money for a Down Payment and Closing Costs
This is usually the biggest hurdle to home ownership. Many people could afford to make a house payment (if you can afford to pay your rent, you could likely afford a similar mortgage payment each month), but they lack the funds for the initial down payment.
For most people, a 20% home down payment is recommended. You can purchase a house with less money down, but 20% will give you the most options and avoid having to pay for private mortgage insurance (PMI).
PMI is a pesky little fee that gets added to your mortgage payment as insurance for the bank in case you default on your loan (usually $100-300+/month depending on the house). Ideally you don’t pay PMI.
The whole point behind the 20% down payment is it demonstrates to the bank that you are disciplined with your money and have the ability to save. It also gives you (and the bank) a cushion in case housing markets go through a rough patch and home values decline.
Homeownership is not a right – it is a privilege. It is the lender’s job to thoroughly vet you to determine if you are responsible enough to be a qualified homeowner and be able to pay back the loan. Not everyone is capable of this.
There are lenders out there who will give you a mortgage with less than 20% down, but will require you to pay for PMI in return. Some lenders have become so lenient with down payment terms again that I have seen people get into homes with less than 5% down. 0% down in some cases!
As a buyer, that can be very attractive, but as a financial planner, I get nervous for certain people utilizing those loans. My opinion is, if you cannot afford to make at least a 5% down payment on a house with money saved in your savings account, you probably shouldn’t be buying the house at this time.
If you are considering pulling money out of a retirement account for a home down payment, stop immediately. That is a big red flag with a flashing sign saying you shouldn’t be buying the house. You cannot afford to purchase that particular house at this time. Save up more and try again later.
The one scenario where putting 0-5% down on a house is acceptable in my mind is if you are a physician who is graduating residency or fellowship and entering practice. You are going from making $50-70k/year in income to earning $150-400k/year (or more) overnight. In that scenario, you can afford to make the monthly payments on a home, but likely haven’t had the ability to save enough for a 20% down payment.
However even in that scenario, I often recommend renting initially – especially if moving to a new city. I would estimate over half of my physician clients have left their first attending job within three years of starting. Having to move and sell a house after only owning it for a couple of years is a drain on your finances. We will get into that later.
Finally, don’t forget about closing costs. This could be $5,000-40,000+ depending on the home on top of the down payment. Title fees, transfer taxes, escrow fees, property taxes, lender fees, etc. Every party involved in the transaction (and the city/state/county) wants to get paid.
Ability to Afford the Mortgage Payments and Taxes
This one should be an obvious one, but I still come across people who are stretching themselves thin each month, mostly due to the size of their house payment. This causes a lot of undue stress in their lives. What you can really afford and what a bank will approve you for are two different things.
From the bank’s perspective, all they care about is if you can make your payments each month. They don’t care if you can also afford to save for retirement, go out to dinner, take a vacation, buy toys for your kids, save for their future college, or hire a housecleaner. The bank only cares that you can make your mortgage payment each month. As a result, a bank will approve you for a loan that is way larger than what you should be looking at.
As a general rule, I don’t like to see people finance more than 2.5x their income. Keep in mind, that is a general rule. If you have a small country’s GDP worth of student loans, we might need to revise that ratio down a little bit.
If you had to finance your way through undergrad and graduate/medical/law school, that is your mortgage for the time being. We either need to look at a smaller starter house that you can upgrade once the loans are paid off, or continue renting an inexpensive home and aggressively pay off the student loans before buying the house that other people in your income bracket typically own.
If you are considering purchasing a home that would require a larger monthly payment than you are currently paying, there is an easy way to see if it is affordable.
Let’s pretend the new monthly expense will be $1,200 more per month than what you are currently paying. Be sure to factor in insurance, taxes, and additional maintenance expenses when coming up with this number. If you want to know if that will be affordable, start an automatic transfer from your checking account to your savings account of $1,200 per month. Do that for three months and see how things went for you.
If you were able to handle that transfer without breaking a sweat, then you are good to go. If you had to subsequently dip into your savings account to cover your credit card bill the following month, then you probably can’t afford that larger house payment.
Moving Expenses
This one is small, but often overlooked by people stretching their budgets to buy a house. After you buy the house, you have to move into the house. If you don’t have a lot of furniture and are just moving across town and renting a U-Haul and moving the boxes yourself, then costs might be minimal. But if you are moving to a different state, you are likely hiring movers which could cost thousands of dollars.
You want to make sure that after the down payment, closing costs, and moving expenses, you still have an adequate emergency reserve to cover any unexpected expenses that may pop up.
Furniture
I have yet to meet someone who moved into a new house and didn’t buy any new furniture. Even going to Ikea to get a new dresser counts. There is something about buying a new house that makes people want to replace at least some of their old furniture, or add a few new things for décor.
This can add up quick. Sometimes you end up buying things you didn’t even think about initially, but you end up needing. For example, if you are purchasing a newly built home, there is a good chance you will have to install blinds. Builders don’t automatically put blinds on the windows. Blinds are expensive! You will probably spend at least a few thousand dollars to cover all of the windows in your house.
You may find that you don’t have adequate storage in your closets or garage, so you need to install some shelves.
Some of your dishes will break in the move and you need to buy some new ones.
So be sure to budget a few extra dollars here.
Home Maintenance Expenses
Costs can vary by house, but a good general rule is to plan on spending around 1% of the value of the home per year on average in home maintenance expenses. This could come in small bits such as putting new caulking around your shower, or replacing your broken toilet seat. Or it could be a major expenses, such as replacing your roof or redoing the siding.
Hopefully those major expenses are spread out with several years in between each one so you have time to save up. Sometimes they happen all at once though – the furnace, water heater, and air conditioner all break in the same year.
The larger and more customized the house, the more expensive it is to fix/replace things.
Duration of Ownership
A good rule of thumb is you should plan to own a home at least five years before selling it. Reason for this is the transaction cost of buying/selling. You will feel the pain as a buyer when you have to pay your closing costs, moving expenses, etc. You might find yourself in $20,000 or more on top of your down payment.
Plan on spending considerably more when you sell a home. In addition to the buyer expenses (assuming you are purchasing the next home you move into), you will also have the seller expenses. The big one is the 5-6% commission you will pay a real estate agent to sell your home. So if you sell your house for $500,000, you will not keep all $500,000 of the sales price. $25-30k of that will go to the real estate agent.
You will also have to spend some money to get your home presentable for sale. Maybe slap on a fresh coat of paint. Re-caulk the kitchen and bathroom. Fix the loose toilet handle. Replace the ugly faucet on your kitchen sink. Clean the carpets. Put all of your junk in storage so your house doesn’t look like an episode of Hoarders. Get your roof cleaned – buyers don’t like to see moss growing. Maybe get some landscaping done to improve the “curb appeal” of the home.
Because of the high transaction costs of real estate, when you add everything up, you typically need to own a home at least five years to break even.
Sometimes you can get lucky. If you are currently located in a hot real estate market and if it stays hot (big if), your home could increase significantly in value in just a few years, which could lead to profits if you sell.
However, real estate values ebb and flow like the tides. Our economy goes in cycles. There will be a few years where home values rise, followed by some years where they level off or even decline. Historically, residential real estate values grow by about 4%/year (depending on what data source you look at). This is slightly higher than the historical inflation rate.
So, let’s say we buy a house for $400,000 and we spend $20,000 in closing costs, moving, etc. And we know when we sell it we will be spending $20-24k in a real estate commission (assuming the price doesn’t change). Plus we will sink another $7k in seller closing expenses. Plus we will pay another $10k to spiff things up so we can hope to sell for top dollar.
Already, we are in about $60,000 if we want to sell. So the house needs to appreciate by at least 15%, just to cover transaction costs (which will also increase our sales commission we pay by about four thousand dollars). If you want to walk away with any earned equity, the house will need to appreciate by even more.
So at a 4% growth rate, it will take about five years to get to that point. If we dip into a recession, it could take you even longer to break even. I know some people who purchased a home in 2007 and are still hanging onto it, because they can’t even sell it for what they originally bought it for.
Most of your mortgage payments are going to interest in the first five years also, so don’t expect your mortgage balance to be significantly lower than the amount your originally borrowed.
The longer you own your home, the more likely you will be able to sell it profitably. If you know you won’t live in the home for at least five years but are adamant about purchasing over renting, consider a home that you could turn into a rental property in case you can’t sell it when you want/need to move.
So Do You Really Want It?
Hopefully I didn’t scare any prospective home buyers away from wanting to purchase a house. People who say they want to buy a house because they are sick of throwing money away at rent are being short-sighted. There are additional costs to homeownership that renters don’t have to worry about. That is why you need to be prepared and in a position to afford those additional costs.
If you currently aren’t in that position financially, but you want to own a home, are you willing to make the sacrifices necessary to put yourself in a position to buy the house? This might mean not going on a vacation for the next couple of years, so you can save up for a down payment. It could mean picking up some extra shifts at work to set aside money faster. You may need to eat out less and cook more rice and beans at home, so you can afford the larger house payment. You might have to RSVP “no” to that out-of-town wedding for your college friend who you probably won’t ever talk to again anyways.
If you are increasing your monthly home expense without increasing your income, it could mean doing all of the above things for an extended period of time (years even until your income rises).
Life is all about tradeoffs. If you set your heart on it, you can have almost anything you want. But you can’t have everything you want. If you want the fancy house, it is going to mean potentially doing less of the other things you enjoy in life. If you want to continue doing all of those other fun things, it might mean you need to buy a more modest house.
