Take a look at the following chart on year-over-year change in home price appreciation in 2020. The trend continues to accelerate!
With homebuying on the rise, you may be thinking about your prospects as well. A home purchase is one of the most significant financial and emotional decisions you may make.
Before you jump into househunting mode though, there are several factors you will want to consider first. As someone who has been through two home purchases now, I know how easy it is for a dream kitchen to put any financial sanity to the wayside.
A home should be a part of your financial independence journey, not a hindrance to it. If you are working overtime to meet your housing costs or are constantly one paycheck away from missing a mortgage payment, owning a home can feel like a huge burden.
With a little extra planning though, homeownership cannot only be a place that you create lasting memories, but also a key asset in building long-term wealth.
Owning a home can have many benefits from a financial standpoint:
It’s important to not only think about how a home meets your wants and needs, but how it also fits into your long-term financial picture. Here are steps you can take to incorporate both your lifestyle and wealth-building strategies into a home purchase:
1. Determine how long you will realistically live in your new home
When planning a home purchase, you want to be realistic about how long you think you’ll reside within that home.
With more companies moving towards long-term or permanent work from home options, ample geo-arbitrage opportunities to relocate to lower cost of living areas, and increased connectivity, finding a forever home may not be your end goal.
The average American lives in their house for 8 years. I anticipate this number to drop over the next few years.
With this in mind, you can begin to think about your needs within the timeframe you plan to live within your new home. Do you absolutely need a 3,000 square foot home with five bedrooms if you and your significant other only plan to live there for a few years? Would a condo with less maintenance and more amenities be more suitable in your 20’s?
Aligning a home with your needs for the duration of your time there can ensure you find the appropriate amount of space and amenities without making unnecessary financial sacrifices.
2. Establish an acceptable discretionary financial baseline for this timeframe
Once you’ve been qualified for a loan, it’s tempting to find a home that meets the maximum funds you have been approved for. Why not spend as much as the bank allows you to?
Your lender, however, is only looking at a current snapshot of your financial picture. In particular, your debt-to-income ratio.
If you are a couple working two demanding, but well-paid jobs, it’s worth taking a step back and evaluating if you can adequately maintain this income level for the duration of time that you plan to be in your home.
I’ve had several colleagues who were burnt out in their careers or could not spend as much time with their families as they wanted to because they needed a dual income to meet their financial obligations. Millions of homeowners lost their homes during the financial crisis because they found themselves overleveraged in challenging times. Forecasting your misery now costs much less than experiencing it later.
Before you commit to a home purchase, establish a discretionary baseline of monthly expenses (housing + food + other essential needs/obligations) that you can comfortably accommodate amidst life events or unexpected changes in income. From there, you can calculate an appropriate monthly mortgage payment that fits within your personal means.
Tracking your income and expenses now can provide insight into your spending and savings habits as well as help forecast your discretionary expenses in the future.
3. Estimate other housing-related costs
Owning a home includes several other costs that may not be accounted for by lenders when assessing an appropriate mortgage. Some of these costs include:
When planning a home purchase, include these estimated costs in addition to your monthly mortgage payments to get a more accurate picture of your monthly obligations and added expenses.
4. Simulate your future housing costs
Once you have established a mortgage value and have calculated the estimated costs associated with owning a home, it’s time for a test run!
If your current housing costs are lower than your expected costs for a new home, take the difference each month and put it into savings for a period of time. You'll quickly find out whether this new payment would be comfortable or painfully difficult to maintain your desired lifestyle.
When we were planning for our first home purchase, we used this tactic for a few months to make sure we could get by with a higher monthly mortgage and associated costs. All of the money we put towards savings during this time went towards our down payment.
5. Improve your credit score
Your credit score plays a significant role in the interest rate a bank will offer you. The lower your credit score, the riskier you look as a borrower.
The difference of a few points in your credit score can have a substantial impact on your monthly payments due to a higher interest rate. For example, the difference between a 3.5% interest rate and a 4% interest rate on a $200,000 mortgage can cost you a total of $20,427 for a 30-year mortgage.
If interest rate hikes look unlikely for the foreseeable future as they do right now, it’s worth the wait to improve your credit score as much as possible before you apply for a loan.
6. Have 6+ months of future housing expenses covered
Everyone should have an emergency fund, but when you own a home, having sufficient funds to cover your mortgage payments is even more important. A foreclosure will take a massive hit on your credit score and can stay on record for an average of 7 years.
Once you have determined an appropriate mortgage payment and associated housing costs for a new home, make sure you have at least 6 months worth of funds to cover these costs before you purchase a home. Imagine the homebuyers that closed on their homes right before the pandemic and lost their jobs or experienced a change in income thereafter. Anything can happen!
7. Have 20% saved for a downpayment
Many lenders offer plans that allow for a lower down payment than the traditional 20%, however you will most likely make up for the difference in private mortgage insurance (PMI). PMI is insurance coverage that protects the lender in case a borrower defaults on a loan and can range anywhere from 0.55% to 2.5%. PMI is typically paid on a monthly basis on top of your principal and interest payments until you reach 20% equity in your home.
Levering PMI can help you buy a house faster if you cannot afford a 20% down payment, but it’s worth considering the total cost first. For example, if you purchase a $350,000 home with a 10% down payment, 3.00% interest rate, and 2.00% PMI, you will pay a total of $31,549 in PMI alone.
Saving for a down payment is understandably one of the most challenging parts of buying a home. Before you opt for a lower down payment option though, evaluate the costs vs. the additional time it will take to save for a down payment.
Setting up an annual spending plan can provide more transparency on your current savings rate and help you adjust your goals accordingly.
8. Identify the appropriate loan terms for your wealth journey
There are many loan types available for a mortgage, so it is important to evaluate all of your options. Different loan terms offer strategic advantages depending on your circumstances and where you are in your wealth journey.
Take time to think about your full financial picture and which loan would be the best fit.
9. Track the market
If you have a flexible timeframe to purchase a home, it’s worth tracking the market to see how home values are trending.
Although the real estate market is not as volatile in comparison to the stock market, there are some clues and cycles you can look for that could potentially save you a few thousand dollars on a deal.
Winter, for example, oftentimes yields lower demand due to the holiday period and colder weather. Therefore houses are less susceptible to price competition and bidding wars.
Real estate markets also tend to lag behind stock market corrections, meaning that you could find more favorable pricing even after the stock market recovers.
Housing reports are good resources for market data, but they often report trends after the market has moved on.
Instead, follow home sales on online real estate platforms like Redfin and Zillow to see if homes prices are appreciating in different neighborhoods and if they are selling above or below their market values.