Several years ago, I finally settled down and decided to buy a home after spending 10 years as a renter (and living in 10 different places!). My wife and I were excited to finally have “our own place.” In retrospect, there were things I wish we would have known before we began shopping for a home.
Buying a home is an intense and often emotionally-charged process. If you aren’t careful, it’s easy to spend more than you can afford. Or you could end up taking out a long-term mortgage and paying thousands of dollars in closing costs to find that your new home doesn’t meet your needs.
While buying a home can be scary, you can ease your fears by knowing your stuff. In this article, you’ll learn how to decide if it’s the right time to buy. You’ll learn how to find a house you can afford and select an appropriate mortgage product.
If you expect there to be a major change in your life soon, you may want to wait to buy a home. But if you believe that your home could meet your needs for at least five years, buying now could make sense.
Make sure your finances are in order by improving your credit score and saving for your down payment and closing costs. Also, consider the pros and cons of a 15-year vs. a 30-year mortgage.
Should I Even Buy a Home?
I was recently reading through Doug Warshauer’s new book, If I’m So Smart, Where Did All My Money Go?, and he pointed out something I have a hard time arguing with.
He essentially says (in the fictional narrative of the book) that the following people should rent their homes. Someone who:
- Is not married, but planning to marry
- Has no children, but plans to soon (like we were in 2007)
- Has children, but wants more
- Plans to move soon
- Has a job with relocation expectations
The common thread in all of these scenarios is change. Change in your life can sometimes mean change in the type or location of home you need. When you buy and sell real estate, you incur some fairly significant transaction costs.
Therefore, if you expect things to change for you soon, don’t go from renting to buying. Wait until the dust settles. And then, if no other changes are on the horizon, make your purchase. Following that pattern will leave you feeling glad you didn’t buy a home.
A couple reasons you definitely want to buy a home, though, are if you are both:
- settling down with your family and career, and
- if you are financially driven to own equity in your home over time, and
- you want your home to be your own
In effect, buying a home you know you can afford both generates equity/savings through monthly payments, but can also diversify your portfolio, and allows you to do whatever you want (within HOA restrictions).
Consequences of Buying Too Soon
If you do buy too soon, here are some potential negative consequences:
1. Lose Money on the Transaction
Unless you stumble upon some rare market where homes are appreciating at the speed of light, you will need to stay in your home for a few years before the improved value overtakes the cost of buying and selling. (A home is not typically a good short-term investment).
Buying a home right before a major life change could put you in a spot where you have to choose convenience over money. If you choose convenience (i.e. selling and buying something else), then there’s a good chance you could lose money.
2. The Accidental Landlord
If you buy too early and need to sell just a few years later, you may find that you can’t sell the home without losing a lot of money. This kind of scenario forces people into what I would call an accidental landlord situation. Instead of selling your home, you turn it into a rental unit.
3. Stuck in an Uncomfortable House
If you don’t choose to sell and lose money or become a landlord, then your last option is to stay in the house. If your house is too small for your family or too far from your new job, then you might just be uncomfortable for a while. In Doug’s book, he recommends sticking it out as long as you can and throwing all your extra savings into your mortgage.
When Should You Buy?
After all of this, it may seem like buying a home is only reserved for the most boring of people (i.e. people who rarely, if ever, experience change in their life). But the truth is that most of us do the majority of our moving early in adulthood before settling into our careers and picking an area to raise our kids.
In his book, Warshauer gives a general recommendation of staying in your house 10 years before you sell. He’s right that moving too often can destroy your wealth. However, 10 years is a little extreme in my opinion.
Other experts recommend that you only buy a house if you plan to stay in it for at least 5 years. I tend to lean more towards this rule of thumb. The odds are high that, after five years, your home will be worth more than what you purchased it for. And that means the odds are low that you’ll have to “eat” any money on the sale.
But buying a house is sometimes about more than just building wealth. Buying a home involves wants and needs. If you buy a home when you shouldn’t financially, be willing to accept the financial consequences of doing so.
If you decide to keep renting, take heart that it’s probably the best financial decision you could make.
Understand Your Finances Before Buying a Home
We’ve discussed the general types of people that should be buying or renting a home. Next, let’s dig deep into how you can prepare financially for what will likely be one of the biggest purchases of your lifetime.
Improve Your Credit Score
As a self-employed family, we need our credit score, and debt-to-income ratio to be as rock-solid as possible whenever we apply for a mortgage. That’s why for three months before we start filling out a mortgage application, we only use our debit card to make purchases.
Why do we do this? Like I said, we need our credit score and debt ratio to be optimized. Ironically, using our credit cards like we do helps us to maintain a good score. But, in this instance, reporting a big balance would hurt us. Let me explain.
How Credit Card Balances Can Affect Your Mortgage Application
When you (or a lender) request to see your credit score, the current information on your report gets plugged into a credit scoring formula. The issue for heavy-charging — but otherwise responsible — cardholders is exactly when various lenders report information to the bureaus.
Financial institutions report your information to the credit bureaus at various times throughout the month. Your card issuer’s report date is completely out of our control. To anyone looking to lend us money, if they pull our reports before our statement balance is paid, it could appear as if we have a hefty amount of credit card debt.
This whole thing came into play last summer when we were refinancing our current place. Even after telling the lender how we paid the credit card off every month (and even showing them our statements) the lender asked us to close down the account completely to meet the needed income-to-debt ratio.
I laughed at them, but then realized they were serious. To avoid having to do this, we paid off our low-interest car loan. But moving forward, I decided that I wasn’t taking any chances. So we stop using our credit card a few months before applying for a home loan and I would recommend that you do so as well.
How Much Can You Afford For a Home?
Many people think that just because they have a good job with steady income, they’ll be able to pay off a mortgage over the next 30 years, no problem. But buying a house you can’t afford is a dangerous trap that can cost you dearly.
Even though a mortgage is generally considered a “good debt,” since it’s a loan secured by your house that builds equity over time, debt is still debt. And with debt comes certain risks.
Buying Too Much House Can Be Costly
Buying too much house is a surefire way to start your adult life “asset rich” and “cash poor.”
Many aspiring first-time homebuyers don’t have any money saved for a down payment. And often we don’t even have a clear idea of how much we can afford. For many of us, we just know that we want to be an adult and declare our financial independence by buying a home!
The bank may “pre-approve” you for a mortgage amount. And you may think that means you could afford the monthly payment. But if you don’t take the time to track your spending and stick to a realistic budget, how can you really know for sure what you can afford to spend on a mortgage?
You’ll be much more likely to buy too much house and end up learning a very costly lesson. You don’t want to be in your twenties or thirties, stuck in a house with no money left over to go out and do things.
It’s better to purchase a smaller house, with a smaller monthly payment. Then you’ll still have money left to enjoy your life.
Here are a few rules we used when we bought our home:
- We wanted to be able to put 20% down to avoid private mortgage insurance and have a decent amount of equity in the home up front.
- We wanted a home we could afford using a 30 year fixed rate mortgage.
- We wanted to be able to afford the payment based on either of our incomes alone.
- We wanted to leave enough money in our monthly budget to travel well and enjoy life outside of our home without the feelings of “working for our mortgage.”
The Bank is Not Your Budget
The truth is, the bank is only looking to make money off the interest on your loan. And the real estate broker is wanting to make the commission off the sale.
You are the one responsible to pay the mortgage at the beginning of the month – no one else. So don’t get talked into a mortgage you can’t afford!
Take time to research your options and make the best decision for your own situation. That may or may not include buying a house right now. It’s also vital that you create a budget that’s realistic for your lifestyle.
Learn More: Budgeting – An Easier, Smarter Way
How Much Should You Save Before You Buy?
To avoid getting trapped into buying too much house, you need to create a cohesive plan and budget for everything that encompasses taking on a mortgage.
Ideally, you’ll want to save at least 20% or more towards a down payment on your new home. You’ll end up paying a lot less money in interest payments and will avoid having to pay for private mortgage insurance (PMI).
However, it should be pointed out that you can get a conventional loan with as little as 5% down. And with FHA, VA, and USDA loans, you may qualify to put down even less (or even nothing at all).
After deciding how much you plan to put down, don’t forget to factor in closing costs. These typically range between 3% and 5% of the loan price.
And then there’s real estate taxes and homeowner’s insurance that may or may not be required up-front. If not, then it will be added in with your overall mortgage payment.
Where to Find Money for a Down Payment
So where do you turn to find all this money? There’s a whole spectrum of methods to choose from, each with their pros and cons.
- Down Payment Assistance (DPA) programs: There are more than 2,000 of these programs nationwide. For more information about eligibility requirements, terms, and availability in your area, check out this guide from Freddie Mac.
- “Piggyback” mortgages: This is where you take out two loans instead of one. Your first loan will be for 80% of your home purchase, the second loan will be for 10%, and you’ll put 10% down. These loans essentially halve the down payment that you’ll need to pay to avoid PMI. Learn more about piggyback mortgages from the CFPB.
- Borrowing from yourself: You could borrow from your 401K. But that’s a risky idea as you could miss out on gains. The same rule applies to an emergency fund. You’ll want to avoid tapping it for a down payment or you could end up in an insecure financial position.
- Receiving a gift of cash for the down payment: If you have friends or family who want to assist you in your home ownership quest, then by all means consider taking them up on it! But the lender will need to see a gift letter as proof that the money isn’t a loan.
- The old-fashioned method: The best choice that I see is to build up cash with a combination of reducing debt and expenses and increasing income. This slow and steady method may take some time and effort, but it should produce the best result for the long haul.
Pros and Cons of the 15-Year vs 30-Year Mortgage
How do you decide whether to go for 15 or 30 years? Most people naturally default to the 30-year mortgage. But this wasn’t always the case. Actually, 15-year mortgages used to be the norm And they still are in many other countries.
The 30-year mortgage came along after the Great Depression when the housing market collapsed. At the time, 30-year mortgages made sense because people lived in their homes that long and 30 years covered the typical earning years of the average U.S. worker.
Nowadays you can’t get people to stay in a home for more than 5-10 years. But the mortgage is still around and still the most popular. Here are the benefits of each.
Benefits of the 15-Year Mortgage
If you’re thinking about doing a 15-year mortgage or refinance, here are some of the benefits you’ll enjoy:
- Better Rates: Since you’re borrowing money over a shorter period of time, lenders will extend a much lower interest rate on your mortgage. This, of course, results in savings on the amount of interest you are paying compared to a 30-year mortgage.
- Pay Down Principal Faster: With a 15-year mortgage your first mortgage payment will include much more principal than a 30-year mortgage payment would provide. And in 5 years, you’ll actually have paid down a decent amount of principal. With a 30-year mortgage, you really only pay interest for the first 5 years.
- Less Paid in Total Interest: All things being equal, you’ll pay more interest on the longer loan term. By going with a 15-year mortgage, you are shortening your loan term. And, so over the life of the loan, you’ll pay less in interest.
- Gets It Over With: One last benefit that I know of is the emotional satisfaction that comes with owning your home. A 15-year mortgage could leave you without a mortgage before your kids are out of school. Imagine what you could do with the extra money after your mortgage is gone.
Benefits of the 30-Year Mortgage
While 15-year mortgages offer a lot of benefits, 30-year mortgages have two main things going for them:
- Lower payments: By doubling your repayment term, you’ll usually enjoy significantly lower monthly payments with a 30-year mortgage, even despite the higher interest rate.
- Flexibility: In the short-term, you’ll have more cash flow due to lower payments. But you could always choose to refinance to a 15-year mortgage down the road. Starting with a 30-year mortgage gives you an immediate budget benefit while leaving the door open for reducing your loan terms (and hopefully interest rate) later.
I certainly weighed the 15-year option when we purchased our home. We could have afforded the payment. But, ultimately, we wanted the flexibility that comes with a 30-year mortgage.
Also, we said we’d just pay more in principal each year to effectively end our loan in 15 years (although we didn’t follow through on that promise too well).
Understand a Variable Rate Loan
A variable interest rate is just what it sounds like: an interest rate that varies over time. It’s the opposite of a fixed interest rate, which remains the same over time.
From a consumer perspective, variable interest rates aren’t inherently bad. They’re just more risky. With a variable interest rate product, you’re taking the risk that the rate could change so much that your mortgage is no longer affordable.
To accommodate for the increased borrower risk, lenders offer lower starting rates for their variable-rate loans than their fixed-rate products. Typically, variable-rate loans are only worth considering if you have an expectation that rates will drop soon. But since we’re currently seeing historically-low mortgage rates, locking in your rate will probably make the most sense.
However, if you don’t plan to stay in your home longer than 5 to 7 years, you could consider taking out a 5/1 ARM or 7/1 ARM. With these mortgages, your rate is fixed for the first 5 or 7 years, and then the mortgage converts to a variable-rate after.
ARM loans offer lower interest rates than 30-year fixed loans so they could certainly be worth considering for first-time homebuyers shopping for a “starter” home.
Meet with a Trusted Realtor
You’ll feel more comfortable throughout the offer and loan closing process if we you have a professional with you.
Something I’d recommend to someone who doesn’t already know a Realtor is to go out to Dave Ramsey’s Endorsed Local Providers page and find one.
This is what we did and while we didn’t need them for our home search, they really came in handy come offer time and even made the offer for us (which we got accepted!).
We would have felt out of our league without them.
However, don’t be afraid to do your own research, too.
Another thing we did was do our own research about the neighborhood. I set up a Google Alert to track any news or sales and rentals listings in our neighborhood.
After about a month of searches, I had a spreadsheet filled with sale and rental prices of comparable properties in our neighborhood.
I was then able to see the offer we were making was in fact a great deal for us, and we weren’t paying too much.
How To Find a Good Lender
Often, your real estate agent may have one or more lenders that he or she recommends. But while personal referrals can be a great place to start, you’ll still want to do some of your own rate-shopping. If you could land a much better rate from a lender of equal quality, you’d want to know that, right?
Unfortunately, trying to call up each lender individually for rate quotes can be a time-consuming process.
With Lending Tree, you can compare multiple mortgage lenders at once. In minutes, Lending Tree can show you each lender’s rates, terms, fees, closing costs, and more.
Also, you can see each lender’s recommendation rate and any “badges’ ‘ it may have earned. And you can even read unbiased customer reviews.
Get a Mortgage Pre-Approval Letter
Before you search for a new home it’s wise to go after a pre-approval letter. Your real estate agent might even require you to have one before dealing with you. And the same may go for the selling party.
Most pre-approval letters are good for 90 days. And the majority of them are subject to a full, formal underwriting review once a home is under contract. So getting a mortgage pre-approval letter doesn’t fully guarantee that your loan will go through. But it’s the best foot forward other than having 100% cash.
To increase your chances of pre-approval: save up a big down payment, improve your credit score, and improve your debt-to-income ratio by paying down debt, refinancing debt, and increasing your income.
I should also mention that things can be more difficult when you’re self-employed since you won’t have a W-2 or paycheck to show the lender. In most cases, they’ll want to see two years of tax returns as evidence of your business’s ability to support you.
3 Things To Look For When Buying a Home
Take the time to really determine if a home will be a good fit now and in the future. You’ll protect yourself from the lure of a “shiny” home that will leave you feeling dissatisfied down the road. Here are three things to look for when buying a house.
The professional inspection is meant to ferret out any major issues with a house. But the problem with relying on the inspection for this information is that by then, you’ve already decided to put in an offer.
That means you may have already started imagining yourself living in the house and are invested in making sure that you get the place. That can lead to you shrugging off major structural issues that should be a deal breaker.
Instead, it’s important to make sure your tour is not just looking at the best features of the house. You should all be paying attention to the home’s detractions. Even a layperson can recognize some major warning signs such as cracks in the foundation and water stains on ceilings or walls.
It’s also a good idea to take a look for shoddy repair work (duct tape is generally a good indicator) and evidence of deferred maintenance. Is there caulking that is coming undone in the bathroom? Are the gutters full? These can all indicate that the owners have not been taking great care of their home.
So while some of the issues of livability are next-to-impossible to predict while you’re touring the home, many are not. For example, as you’re walking through the home, imagine you have to clean it. That might make you rethink the beauty of the two-story entryway with the enormous chandelier. That will almost certainly be a major pain to deal with.
In addition, think about maintaining the home. If the idea of painting your new home makes you depressed, it might be a good idea to move on to another one. Even if you never intend to wield a paintbrush yourself, difficult-to-paint (and maintain) homes are also going to be more expensive to contract out.
One final thought exercise to go through is to imagine what it will cost to heat or cool the home. In general, the larger the home, the more expensive it will be to heat. You can also take a look at the level of insulation in the attic and the age of the house and HVAC system. All of that can give a better idea of just how much of a bite heating will take from your budget.
While we all have an idea about what sorts of neighborhood questions to ask before moving into a new home, that doesn’t mean we always end up in places we’ll like.
After you’ve had a chance to tour the house, take a tour of the neighborhood. Go for a walk around the block. See how your prospective neighbors have decorated their homes.
Look for evidence of neighborliness and friendliness. Some good indicators are things like kids’ sidewalk art, people out gardening or sitting on their front porches, dog-owners out on walks, etc.
Also, get a feel for the businesses of the neighborhood. Do they reflect the sorts of places you’d like to frequent? Will you be able to get your needs taken care of close to home?
Finally, be sure to check the crime in your neighborhood by using a tool like SpotCrime.
Tips for First-Time Homebuyers
With the all-time low-interest rates currently being offered, there’s likely never been a better time to be buying your first home (I’m so jealous).
But just because you have that to your advantage, it doesn’t mean you should just throw out common sense when it comes to keeping other costs down. Here are a few ways you can spend less on your first home.
- Pay some costs annually: It’s in the lender’s best interests to require you to pay all your costs (property taxes, insurance, etc) on a monthly basis. But you may have the option to pay these costs on your own annually. That way you get to keep your money the entire year and have it working for you. Also, you may be able to avoid installment fees.
- Strive for a big down payment: The more you put down on the price of the home, the less in interest charges you’ll pay over the life of the loan. And by putting at least 20% down, you’ll avoid that pesky private mortgage insurance (PMI).
- Consider furnishing the home as you go: You don’t have to go out and rack up a bunch of high-interest debt to fill every room of your house with furniture. Take your time completing the rooms. Use cheap or old furniture until you’ve saved enough for the stuff you want.
- Meet with a trusted realtor: Ask your friends and family for realtor recommendations. Or simply look around to see which real estate agent has the most listings in your area.
- Do your own research: Read books on the home buying process. Set up Zillow alerts to track any news or sales and rentals listings in our neighborhood. And be sure to research the best mortgage rates in your area.
- Shop for really low mortgage interest rates: Use comparison shopping tools like Lending Tree to to make sure you get the lowest rate possible. Just a few percentage points can shave off thousands of dollars in interest over the life of the loan.
Also, make sure that you shop around for the best home insurance rates. Check out our guide to insurance to learn about how to find the best deal on homeowner’s insurance.
A Hard Question to Ask After You Buy Your Home
The coronavirus pandemic has caused massive unemployment throughout the United States and many homeowners are feeling the pinch. Yes, there are temporary federal forbearance programs in place. But many people are starting to feel worried about what’s next.
Some homeowners are underwater on their homes. They are worried about how long it will take to move from negative equity to positive equity. Others not only have negative equity but are also having trouble making payments.
With tough choices ahead, the prospect of strategic default (i.e. to walk away from your mortgage) can become increasingly attractive. But is it something you should do?
Should You Ever Consider Walking Away from Your Mortgage?
From a strictly financial standpoint, strategic default can make sense in some cases. If you are struggling to make your mortgage payments, and you can’t refinance your mortgage or get a modification, foreclosure might seem inevitable.
As a result, some choose to stop making mortgage payments. With the backlog, it can take anywhere between three months and more than a year for a foreclosure to go through. That means that you could live in your home — and save up what you would have paid on your mortgage — free of charge for a few months.
Others, concerned about how long it might take for the housing market to recover, might decide to cut their losses now by walking away, rather than continue to make mortgage payments without building equity. Still others don’t want to deal with the hassle of trying to sell (or rent out the home) if they are in a position that requires them to move. A strategic default can rid them of the home.
However, it’s important to realize that a foreclosure can have a big impact on your credit score. Foreclosure can drop your credit score by as much as 200 or 300 points. It can take two or three years after your foreclosure for your credit score to return to a level where you could even consider buying a new home.
Moral Considerations of Strategic Default
Once you have considered the financial ramifications of walking away from your home, you need to examine whether or not you consider strategic default a moral option. For some, it’s a no-brainer if walking away has the greater financial benefit.
For others, though, not paying on an obligation is seen as a moral problem. After all, when you walk away, you are breaking a contract. You aren’t fulfilling your end of an agreement. Morally, is it right to borrow such a large sum of money, and agree to pay it back, only to renege because you regret your decision?
Most people, though, seem to think that a foreclosure is acceptable if you really have no other viable option. Being forced into it creates a situation in which you can honestly say that you did all you could to avoid foreclosure, but to no avail.
The Bottom Line
Between the property taxes, homeowner association (HOA) fees, repairs and lawn maintenance, the true cost of owning a home can be shocking if you aren’t financially prepared. And not everyone is cut out to be a homeowner.
If you decide to move forward with home ownership, thinking through everything covered in this article can help you find the right home for your financial situation and personal needs.