From a young age we were told that the American dream is to buy a house with a white picket fence and two car garage in the suburbs. But is this really the American dream? And if it is, is it even still possible?
In this post we will look at:
- The pros and cons of buying vs renting
- How much house can we afford?
- Do we really need 20% to buy a house?
THE PROS AND CONS OF BUYING VS RENTING:
One of the most common questions I am asked is if a couple should buy a house or rent. When speaking with newlyweds I like to suggest that they rent for at least the first year of marriage and even a little longer. This isn’t for everyone; I know many who could who buy a house before they got married and it has worked out fine. Most of these couples had a firm financial footing going into marriage. A new marriage takes work and the first year/years can be a bit of an adjustment. Learning to merge two lives is enough work without having to worry about the stress of home ownership. Don’t get me wrong there are some tremendous advantages to home ownership but it does take time and work. Spend the first year/ years focusing on your marriage.
ONCE YOU ARE READY TO BUY A HOUSE HERE ARE SOME THINGS TO CONSIDER:
THE PROS OF RENTING:
- Very little time needed
- No worry about decline in home value
- No Emergency home expense
THE CONS OF RENTING:
- Losing out on building equity
- Inability to customize
THE PROS OF HOME OWNERSHIP:
- Building equity
- Home appreciation
- Mortgage interest deduction
- A place to call home
- Ability to customize
THE CONS OF HOME OWNERSHIP:
- Time consumption
- Could lose value
- Lack of flexibility
- Emergency repairs
HOW MUCH HOUSE CAN WE AFFORD?:
Whether you decide to rent or buy you still need to be able to set limits on how much you will spend on the mortgage or rent. First let’s look at the monthly cost. For rent it is pretty straight forward. You will have a monthly rent payment that is protected for the life of the rental contract (typically 1 or 2 years). Keep in mind that this could increase when the contract renews but you have the option to move to a cheaper place if you don’t like the increase. For the mortgage; though you are making a single monthly payment, it is inclusive of multiple factors (interest, principle, home insurance, taxes and possibly PMI). The only variable once you secure your mortgage is if property taxes or the cost of insurance goes up but these will be relatively small.
So how much can you spend? A general rule of thumb is that your monthly payment shouldn’t be more than 30% of your household monthly after tax income. Let’s say the combined income of both spouses is $100,000. After taxes the amount that you receive annually is $85,000 and the monthly amount deposited into your bank account each month is roughly $7,000. Using the 30% rule, 30% of $7,000 is $2,100, which give or take $100 would become your monthly mortgage payment target. This rule could change for example if you live in a high cost city like New York or San Francisco. You may not have a car or other things needed in the suburbs and you will be able or forced to spend more than 30% of your after tax income on your home. You may have a lot of student loan debt and forced to have that 30% lower to afford the monthly repayment of your student loans but 30% is a good target when shopping for a home.
If you are buying a house the monthly payment is going to change based on a few factors that go into the payment:
Mortgage rate (the rate the bank charges you to borrow the money). The higher the rate the higher the monthly payment.
Your credit score- this is used by the bank to calculate your mortgage rate. The higher your credit score the lower the rate the bank will charge you.
The Down payment- The amount of money you can or are willing to pay upfront for your house. The more money you can put down up front, the lower your monthly payment will be. Putting down 20% is customary, however more on that later.
Taxes- How much the town changes you to live there each year.
Home insurance- The cost to insure your home against a disaster like a fire.
PMI (Private Mortgage Insurance) - Buying a house without putting down 20% of the sale price up front the bank changes you an insurance in case you walk away from the house. This is called PMI and is part of your monthly payment.
*You can toggle around with all of these variables on this site: Zillow Mortgage
DO WE REALLY NEED 20% DOWN TO BUY A HOUSE?
The second part to consider is the down payment on the home or the security deposit on a rental. If you are renting a home the security deposit is normally 2 months’ worth of rent. If rent is $2,000 a month you will need to hand over $4,000. Depending how you write the contract you may or may not get this money back at the end. If you are buying a house you will need to decide how much to put down. The goal is to put down 20% of the value of the home. This is the most conservative way to buy a house and a best practice. By putting down 20% you are:
Lowing your monthly payment
You are eliminating the PMI
You are giving yourself plenty of cushion if you need to sell the house in the next few years.
By lowering the down payment amount you will:
Increase your monthly payment amount
Tack on PMI to your monthly payment (increasing it more)
Exposing yourself to the possibility of losing money on the house if you have to sell it in the next few years.
Remember that when you sell a house after just a few years you could be selling it for less than you bought it for. You will also have to pay up to 6% of the sale value to the real estate agents as a commission for their work. So let’s look at a quick example:
I buy a house for $300,000 with 5% down ($15,000) so I owe the bank $285,000. After a year I find out that I have to move to another state if I want to keep my job. I put my house up for sale. It was a tough year in the market so my house will only sell for slightly less, $290,000. On top of that I have to pay 6% of that ($17,400) to the real estate agents so at the end I am handed a check for $272,600. But I owe the bank 280,000 after one year. So I have to come up with the extra $8,000. These numbers can be a lot worse if the house sells for less or if you put 0% down.
For many people 20% is a lot of money. At a minimum try for 10% before you buy. There are circumstances where putting down less than 10% makes sense but keep in mind that you are playing with fire. There is nothing wrong with renting until you can save up for a better down payment.
Home ownership is a big step. It takes work to keep a house up and you will always have the occasional repair need from a water leak to a boiler that goes out. My suggestion is to be patient. People like to jump into a starter house because all of their friends have houses. The reality is that all of your friends are not responsible for your financial health. Take your time and save up for a house that you can afford without all of the stress on your marriage and family.
There are many benefits to home ownership but what is a house worth if it is not filled with a happy and healthy marriage and family?