Am I ready to buy a house? It starts as a subtle suggestion in the back of your mind. You might hear yourself thinking; “this is ridiculous, rents are so high and I’m throwing my money away” or “now that I’ve landed that job I’m ready to settle down” or “we’ve been saving for years and now is the time to buy before prices go up any more”, or “all of my friends are buying places and they seem to be doing great”. Whatever dialog is whispering in your ear, there comes a time when it may make sense for you to buy a home of your own. But are you truly ready? This article will help first time home buyers to analyze that question and help get you ready to make the purchase.
Is it smart to buy a house? (when I say house I mean any residential real estate) If done correctly, owning a home is for many people best financial decision they ever make. According to the 2014 Survey of Consumer Financing by the Federal Reserve the median net worth of a homeowner was $194,500 compared to $5,400 for renters. During the time frame of 2008 – 2012 many homeowners were adversely affected by the housing crisis and economic downturn that resulted in a record number of foreclosures and short sales nationally. For those who bought just before the crisis or those who needed to sell when prices dropped in many areas (click here to see why Boulder County was named the most stable market in the country) owning a home may not seem like a wealth enhancing endeavor. But over time and for most people real estate is a great investment. Here’s why:
When you buy a home you tap into these three powerful methods of increasing wealth.
- Home appreciation – the prices of homes rise with inflation and local supply/demand factors. Prices rise over time.
- Principle reduction – as opposed to a rent payment, a portion of each payment goes towards paying down the principle balance. With each payment your wealth is increasing a little bit.
- Tax benefits of ownership – the mortgage interest deduction allows those who itemize their deductions on their income taxes to write off the interest paid on their mortgage payment. In effect you get a discount off of your payments made at the end of the year.
You may ask, “if it’s such a great deal why is the homeownership rate in America at just 63% and falling?” The truth is that homeownership isn’t for everyone. Here are some the reasons why it may not be a good idea to buy a house.
- Location instability – Homeownership is a longterm proposition. Buying a house now and then moving six months from now is a sure fire way to lose money. There are costs associated with both buying and selling and it takes time to recoup those costs. I usually recommend that you plan to be in the house a minimum of two years. Any less than that and you are speculating, hoping instead of playing it smart.
- Financial instability – In order to stay in a house you must have the financial wherewithal to withstand some unexpected expenses. If you are one paycheck away from being broke it’s best to save up a nest egg before buying. If you already have a list of debts it might be a good idea to pay those off before taking on another large debt. The more ready you are financially the better chance you have for making homeownership work for you.
- Ready for the responsibility? – When you own a house you must be willing to take care of the maintenance and any problems that come up. There are many items that need attention on an ongoing basis that take time and money and there will no longer be a landlord to call. Once you make the purchase you are in charge of anything that comes up.
Getting Your Financial House In Order
When you determine that in principle you are ready to take take the plunge into homeownership, you must then determine if your financial house is in order enough to make the purchase. Here is what I mean by having your financial house in order: down payment money in the bank (anything less than a 20% downpayment requires mortgage insurance which results in a larger monthly payment with no added benefit to you), in addition to the down payment you need to have a savings account that has 3 to 6 months of your household expenses as a cushion for the unexpected, minimize other debt – for most people they think it’s normal to carry car payment(s), student loan(s), and credit card debt, even if you qualify for all of these payments it may be a smart idea for you to delay a home purchase until these other debts are paid off. The more debt you have the more susceptible you are to losing your house in the case of a layoff or other unexpected financial hardship.
Another facet of having your financial house in order is your credit score. Credit scores have a huge impact on your ability to buy a house. If you have a credit score of less than 760 your qualification or the interest rate you are offered will be negatively affected. To check your credit score for free (with no strings attached) go to www.AnnualCreditReport.com. If you find out that your credit score will negatively impact you, figure out why your have a low score and start fixing your FICO score. This may take time so pay your bills on time and plan ahead.
How much should I spend on a house? There are a few rules of thumb regarding how much you should spend. Some say the total price shouldn’t exceed 2.5 times your household annual gross income. Another commonly heard standard is that your mortgage payment plus other debt payments shouldn’t exceed 40% of your income. However, in my experience I find that many people qualify for more than they should do. The term for allocating too much of your income to your house payment is “house poor”. Being “house poor” means that you are a slave to your monthly payment and don’t have the money to do the other things you enjoy.
My advice is to buy a house that allows you to be very comfortable in your payment. This will allow you to enjoy life and meet your other financial goals. Have a firm grasp of your budget and be sure to add into it the expenses that will come with buying a home, like new window coverings, increased utility expenses, needed upgrades, etc. Many times the actual answer to “how much should I spend on a house” is different than what your lender will qualify you for. Know your budget and think for yourself. Don’t keep up with the Jones’.
It all comes down to what you can comfortably afford and interest rates have a huge impact on what you can afford. My article The Impact of Interest Rates on Home Affordability delves deeply into the subject, but basically as interest rates rise the amount of the mortgage you can qualify for decreases. For example, if you qualify for a $355,000 mortgage and then interest rates rise by .5% you will need to drop your budget by at least $20,000 to keep the same payment. My advice is to pay attention and know that it makes a difference.
This article helps you think about if you are ready to buy a house. In the next article I will start to outline the how to go about buying a home in a smart way, the process.