In middle-class America, home ownership is one of the most significant rites of passage to adulthood. There are plenty of perks to owning a home, but there are also a sizable number of scary drawbacks – especially if you take out a mortgage you can’t comfortably afford. Despite the challenges, overcoming the hurdles to home ownership and protecting your financial position are realistic goals. All it requires is a little education and some wise, practical decisions.
The Case for Buying Instead of Renting
1. It’s Yours
Even though it’s not a tangible benefit, a sense of ownership is one of the best aspects of purchasing a home. Namely, you’re the boss – you don’t have to answer to a landlord who won’t let you paint your walls, install a new fridge, or remodel. When you own a home, it’s yours to do with what you want.
2. Tax Benefits
Taxes certainly don’t represent the most exciting part of homeownership, but saving money just might. When you own a residence, the interest you pay on your mortgage is tax-deductible. You can also take a federal tax deduction for real estate taxes paid during the year.
You may also be able to take advantage of a capital gains tax exemption if your residence increases in value and you eventually sell it for a gain. Note that you can only claim up to a $250,000 gain for a single taxpayer, or up to $500,000 for married taxpayers filing jointly. And you must have maintained the property as your primary residence for at least two years prior to the sale.
3. Potential Return on Investment
Home ownership isn’t the foolproof investment strategy it used to be. Anyone who purchased a property in the early 2000s and ended up selling for a major loss – or, worse, was foreclosed upon – can attest to that.
However, the other option – spending money on rent – has no investment potential at all. Ownership, despite its risk, at least carries the possibility of return on investment.
Plenty of things can help improve your chances of reaping a return on your home purchase, including taking advantage of historically low interest rates and buying in an up-and-coming location. Of course, one of the most important things to remember is that you’ve got to buy a house you can actually afford in the first place.
The “House-Poor” Trap
Are visions of granite countertops and claw-foot tubs dancing in your head? Depending on where you are in life, characteristics of the ideal home could mean anything from excellent school districts to geographic proximity to a bar with killer happy hour specials.
Of course, big closets, hardwood floors, and garage space are all great, but they mean absolutely nothing if paying for them leaves you flat broke at the end of each month. People who are “house poor” spend a disproportionately high percentage of their incomes on mortgage and house-related costs, leaving them with relatively little discretionary income. Imagine sitting in your gorgeous 3,000-square-foot home eating ramen noodles every night and you’ll get the picture.
Whether you’ve watched too many “Real Housewives” episodes, or you’re simply trying to keep up with your friends, there are plenty of reasons people overreach when purchasing a home. First and foremost, there’s a common tendency to conflate buying a house with buying your dream house. The truth is, though, a home – whether it’s your first, second, or third – doesn’t have to be perfect. It just has to suit your purposes today.
Real Costs of Purchasing a Home
Many folks grossly underestimate the actual cost of purchasing a home. Here’s a list of expenses to keep in mind.
1. Down Payment
The gold standard for a down payment is 20% of the purchase price. On a $250,000 house, that means forking over $50,000 cash.
Prior to the recession, many lenders would let you get away with a much smaller amount, or allow you to rope your down payment into your monthly mortgage payments. However, today, while there are exceptions, almost all lenders require private mortgage insurance (PMI) if you’re making a down payment of less than 20% of the purchase price.
The good thing about a higher down payment is that it reduces the amount of debt you take on when purchasing a home. That means less interest and a better debt-to-income ratio.
2. Closing Costs
If you clear out your bank account for a whopping down payment, hold your breath – because there’s more. You’re also expected to show up at closing with an additional chunk of cash to cover certain costs payable to the lender and other parties. These “closing costs,” associated with the logistics of purchasing a house, typically include title insurance, fees for title search, appraisal, underwriting, survey, and loan origination.
Buyers can generally expect to pay between 2% and 5% of a home’s purchase price in closing costs. For our hypothetical $250,000 house, that translates to between $5,000 and $12,500. Sometimes, buyers can negotiate for sellers to cover these costs, but it’s not something you should count on.
3. Mortgage Payment
Unless you managed to buy your house with cash, you’ve got to contend with a mortgage payment each month – and several factors contribute to the amount.
- Principal. This is the amount of money you borrowed to finance your home. With a $250,000 house, assuming you made a $50,000 down payment, you would owe $200,000 in principal.
- Interest. Interest is essentially the fee that lenders charge in exchange for the loans they give to homeowners. Mortgage interest rates fluctuate wildly, but at the time of this writing they were hovering around 3.7% for a conventional 30-year fixed loan, again assuming a 20% down payment.
- Property Tax. Your local government levies taxes on your property in order to cover snow plowing, street maintenance, tree maintenance, government administration, police, fire department, and other city services. Property taxes also fund public schools, libraries, and parks. These days, lenders generally require borrowers to pay their taxes into an escrow account. Rather than forking over your whole property tax bill in bulk once per year, it’s broken down into monthly amounts that are rolled into your mortgage payment and deposited in a separate account maintained by the lender. When your property tax comes due, your lender pays it for you using those funds. Property tax is calculated as a percentage of your home’s value, and rates vary significantly by location. While 1.2% is a common estimate (when rounding up for our sample house, it equates to $3,000 per year), it’s worth noting that you could pay as little as 0.18% in Louisiana, but more than 10 times that by crossing the border into neighboring Texas.
- Insurance. Your mortgage payment may also include homeowners insurance which, like property tax payments, is deposited in an escrow account. After you take out a homeowner’s insurance policy, your lender can most likely make the payments on your behalf. Lender policies vary though, so be sure this applies to your situation. Different from the private mortgage insurance mentioned above, homeowners insurance policies often cover theft, vandalism, fire, and weather damage. Floods and earthquakes tend to be excluded from standard policies. For a $250,000 house, $1,500 is a solid estimate for annual homeowners insurance.
- Private Mortgage Insurance (PMI). As mentioned previously, your bank is likely to require private mortgage insurance if you make a down payment of less than 20%. In the event that you stop making mortgage payments or you default completely, private mortgage insurance helps protect the lender by covering your obligation. PMI is often rolled into your monthly mortgage nut as well, though some lenders permit a lump sum payment. PMI costs between 0.5% and 1% of the loan amount annually.
To sum up, the following represents a monthly mortgage payment on the $250,000 sample house:
- Principal and Interest: $931.31
- Property Tax: $250.00
- Property Insurance: $125.00
- Total: $1,306.91
These figures assume that you’ve made a 20% down payment. If you haven’t, PMI costs must be taken into account, which would be $1,250 to $2,500 per year in this scenario.
30 years later, after you finally pay off your $200,000 loan, here’s what you’ll have spent in total:
- Principal: $200,000
- Interest: $135,489.29
- Property Taxes: $90,000
- Insurance: $45,000
- Total: $470,489.29
Add in your $50,000 down payment and closing costs, and you’ve spent significantly more than double your home’s original purchase price – and that’s only if you managed to lock in a good interest rate.
Costs of Owning a Home
Of course, the actual purchase is just the beginning. Owning and maintaining a home brings plenty of expenses along with it.
If you’ve ever rented, you’re likely accustomed to utility bills. However, chances are some of them were built into your monthly rent. As a homeowner, you’ve got to pay for all the following:
- Trash and recycling
- Electives such as cable and Internet
A lot of things can go wrong with a house. The furnace can blow up, the water heater could break down, pipes can burst, an HVAC system can go haywire, and your electric system may not be up to code. Plus, your roof might leak, your chimney might crack, your insulation could be insufficient, and your toddler might draw all over the walls in permanent marker.
As a renter, you simply call your landlord when something breaks down or goes awry. But when you own, the buck stops with you.
Homeowners insurance is one solution to these potential problems, but it doesn’t cover routine maintenance, mold, sewer backups, or termites, for example. Plus, even if you have insurance, you’re going to end up paying a deductible when you make a claim, and your rates may increase as a result. To hedge against any difficulties, everyone should keep a substantial cash reserve to cover additional maintenance costs, both routine and unexpected.
Calculating How Much You Can Afford
These numbers are daunting, yes, but it’s important to absorb the realities of home ownership and ensure that you purchase a house that doesn’t stretch your budget too thin. The question to ask, then, is how exactly do you ensure a reasonable purchase price for your income level?
We know that the sample $250,000 house costs a little more than $1,300 per month after the initial down payment and closing costs – not counting utilities and maintenance. The majority of financial experts recommend – and many lenders require – that your housing costs not exceed 28% of your gross monthly income. These costs include mortgage principal and interest, plus taxes and insurance.
For our sample house, you’d need an annual income of about $56,000 to hit that 28%. And, of course, 28% is a maximum recommended number for housing debt-to-income ratio (HDTI). You can be much more comfortable – i.e., less “house poor” – if you can manage 20% to 25% HDTI. You’d need an annual income of nearly $63,000 to have a 25% HDTI for a $250,000 house. At 20%, And your income would have to be roughly $79,000 for a 20% HDTI on the same house.
Looking at it from a different perspective, the following table shows approximately what a buyer can afford at various annual income levels. Of course, these are rough estimates – costs vary by location and interest rates change daily.
Annual Income: $30,000
- 28% HDTI: $118,000 purchase price
- 25% HDTI: $104,000 purchase price
- 20% HDTI: $82,000 purchase price
Annual Income: $50,000
- 28% HDTI: $220,000 purchase price
- 25% HDTI: $193,000 purchase price
- 20% HDTI: $150,000 purchase price
Annual Income: $70,000
- 28% HDTI: $310,000 purchase price
- 25% HDTI: $281,000 purchase price
- 20% HDTI: $220,000 purchase price
Annual Income: $90,000
- 28% HDTI: $414,000 purchase price
- 25% HDTI: $368,000 purchase price
- 20% HDTI: $291,000 purchase price
If you can get away with even lower than 20% HDTI, then by all means, do it.
For most people, housing costs aren’t the only debt. That’s why full debt-to-income ratios (DTI) take all recurring monthly debt obligations into account. These include car payments, student loans, child support or alimony payments, and monthly minimum credit card payments. You don’t want your total debt obligation to exceed 36% of your gross income.
If you currently have zero debt, you can more comfortably get away with squeezing the top end of the recommended housing debt percentage. However, if you are juggling a car loan, a student loan, and paying off credit cards, you must steer far, far away from the 28% housing ratio.
Home ownership is expensive – even in the best circumstances. It’s critical that you’re realistic about what you and your family can comfortably afford. Be sure you can easily make your monthly payments and still have money left over for travel, clothing, and occasional dinners that don’t come out of a microwave. If you approach home ownership cautiously, not impulsively, you put yourself in position to make a wise decision.
Are you thinking about buying a home?