UPDATE: The housing market is red-hot in the Spring of 2021. Home prices are soaring as lots of people are flush with cash from stimulus payments and new houses can't be built fast enough to keep up with demand.
This leave a lot of people wondering if they should jump into the housing market. This kind of FOMO is normal, but doesn't change the fundamental things you should consider before making a decision of this magnitude.
Buying your first home can be an exciting, but nerve-racking, experience. Many of us grow tired of paying rent and throwing our hard-earned money out the window. With that said, the proposition of buying a home is simply overwhelming.
It is certainly true that home ownership can be an excellent step toward financial success. At the same time, buying a home can become a complete disaster and the wrong home can turn into a money pit. It can leave you begging for your two-bedroom apartment back.
If you are considering buying your first home, you will want to know two things:
1. Good and bad reason to buy a home
2. The exact cost of a home purchase, including any hidden costs
Good & Bad Reasons to Buy a HomeJust like any investment, there are good and bad reasons to buy a home.
Good Reasons:1. Ownership: You want to start the process of building equity (aka ownership) in a property as opposed to just renting.
2. Stability: You are tired of constantly moving and want some stability for you and your family. In addition, you no longer want to be subject to rent increases from your landlord.
3. Growth: While not always the case, home values tend to increase over time. While your rent typically increases from year to year, your mortgage payment will stay constant and your home value could continue to increase.
4. Rental Income: If you intend on buying your first home and keeping it (even after your move), you have an incredible opportunity to earn rental income from future tenants and become a landlord yourself.
Bad Reasons:1. "It's Time": Feeling the social pressure to buy a home is NEVER a good reason to move forward. This could come from your family, friends, coworkers, etc. The idea that you must buy a home to create wealth is very misleading.
2. Tax Savings: A quick google search of “good reasons to buy a home” will lead you to the idea of tax savings as a major benefit. While you will likely benefit from some tax deductions as a homeowner, it’s not a good reason to buy a home. Think of it like spending a dollar to save a nickel. The tax benefits are nice, but they are not the primary driver of this decision.
3. Interest Rates are Low: Similar to tax savings, this is another popular one. While current mortgage rates are an important part of the equation (as we will discuss below), they should not prompt you to make a rash decision.
4. Your Mortgage is Less than your Rent: As you are about to find out, a mortgage payment is just the beginning when it comes to the expenses related to home ownership.
Evaluating the Costs of a Home Purchase
Costs of Home Ownership:For simplification purposes, let’s assume you want to buy a $500,000 home.
1. Down Payment: Typically between 5% and 20% of the home's value. In this example, that could range from $25,000 to $100,000.
2. Mortgage and Interest: If you take the purchase price and subtract the down payment, you get your mortgage balance. Most mortgages are paid over a 30 year period (some less). For example, if you bought a $500,000 home and put $50,000 down, you are left with a mortgage of $450,000. If you finance that mortgage over 30 years at 3%, your monthly payment would be $1,897. Things like your credit score and debt-to-income ratio will impact your mortgage interest rate.
3. Property Taxes: Property taxes vary a lot from state to state. In some of the more expensive states (like New Jersey and Connecticut), you might be paying 2% to 3% of the home's value in taxes. In our example, this would range from $10,000 to $15,000 per year. Unlike your mortgage payment, taxes may increase over time.
4. Homeowner's Insurance: Again, insurance will vary from state to state and with the value of your home. Let’s assume homeowner's insurance for our example would be around $2,500/year (0.5% of the home's value).
5. Private Mortgage Insurance (PMI): In most cases, you will be required to pay private mortgage insurance until you reach 20% equity in your home. This cost is linked to the value of your mortgage and typically ranges from around 0.25% to 1.5% of that mortgage (driven by credit score and the likelihood you will default on the loan).
6. Closing Costs: While the seller of a home typically covers the costs of both realtors in a transaction, the purchaser will still have a number of closing costs. These costs may include things like an appraisal, an escrow deposit, home inspection, mortgage origination fee, and the list goes on. Closing costs can range from 2% to 5%, or more, of a mortgage. Be sure to do your homework on mortgage brokers and do your best to drive down these costs.
7. Miscellaneous Costs: And finally, you have a handful of miscellaneous costs. Things like repairs, furnishing, and moving expenses can add up quickly.
Should You Buy a Home?As you can see, the costs of home ownership can add up in a hurry. A lot of the time, these costs tend to snowball.
In our example, if you put 10% down instead of 20%, you now have a larger mortgage balance (thus paying more in interest over time), you are required to pay PMI, and your closing costs go up. Alternatively, a 20% down payment would result in a smaller mortgage balance, no PMI, and lower closing costs.
You are probably now asking yourself, "should I buy a home?" Like any good question, the answer is, it depends. Consider these final thoughts when making your decision.
1. How much money do you have for a down payment and upfront costs?
2. How long do you plan on staying in this home?
3. When you leave this home, do you plan on selling it or renting it out?
4. Considering all the expenses listed above, what can you afford from month to month?
5. After the purchase, how much money will you have available for unexpected expenses and other investments (i.e. retirement or college savings for your children)?
Buying a home is a complicated process. Sometimes it may be best to consult with a financial professional and allow them to help you evaluate your first home purchase. A good financial planner will look at your entire financial situation and provide you with detailed recommendations related to the topics discussed in this article.
Taylor Venanzi, CFP provides advisory services through Activate Wealth, LLC, a registered investment adviser providing advisory services in Pennsylvania and in other jurisdictions where exempted. All written content by Taylor Venanzi, CFP on this site is for information purposes only and shall not be directly or indirectly interpreted as a solicitation of investment advisory services.