With the end of spring and school out for the summer, the real estate season swings into high gear. One of the most common questions I get asked is, "How much house can I afford without compromising my other financial goals?" This is an on-point question that does not usually have a quick and easy answer. What follows are some financial considerations that you should think about before buying a home.
Fundamental truths we must consider
First, let's consider the fact that most lenders require 20% equity down on a home purchase. For example, if you want to buy a home that’s listed at $100,000, you’ll need to come to the closing with $20,000 cash as a down payment. Anything less than that, and you’re typically looking at extra lending costs such as private mortgage insurance (PMI) premiums. You’ll also need to show that you have enough income to cover your mortgage payments. So, in order to qualify for a mortgage, your debt-to-income ratio should be 43% or less. This means that if you have other outstanding debts (e.g., a car payment or credit card debt), then in order to qualify for a mortgage, you’ll need to show that there’s enough money coming in to pay those debts, plus cover the mortgage payment. If your debt-to-income ratio is greater than 43%, then you’ll probably want to look at paying down the balances on the debts so that you can get below the 43% threshold.
In addition to principal and interest payments on a home loan, you’ll also need to factor in other on-going costs such as property taxes, homeowners insurance, maintenance, utilities, and in some cases homeowner association (HOA) fees, condo assessment fees and/or flood insurance. This means it isn’t as simple as looking at the ticket price of the home. You’ll also need to budget for many other costs associated with home ownership, because neglecting to do so can negatively impact your financial lifestyle.
Recent tax reform has changed the calculus for many homeowners. Most no longer receive a tax break for mortgage interest and property taxes because they no longer itemize their tax deductions on their tax return. Most taxpayers now take the standard deduction, which is nearly double the amount it was prior to tax reform. Even if you do itemize your deductions, the cap on home acquisition indebtedness (i.e., the amount of the home loan) was decreased from $1,000,000 to $750,000, so if you’re financing your home purchase and the loan balance is greater than $750,000, then any amount over $750,000 will not be tax deductible. And to add even more salt to the wound, there is now a cap on the amount of property tax that can be deducted (currently, it’s limited to $10,000). In short, because of current federal tax laws, owning a home today doesn’t provide the same tax benefits that it once did for many taxpayers.
Other things we can discuss together before buying that home:
Be sure to budget your expenses and have an idea of how much your new home will cost you over time, factoring in property taxes, homeowners insurance, utilities, etc.
If you move frequently (say, every 5 years or less), then you’re probably better off renting than buying.
Know your credit score and be sure to apply best practices to keep your score high, as this will affect the interest rate on your home loan (i.e., the higher your credit score, the lower your interest rate).
Primary residences are not investments. On average, they barely outpace inflation.
I don’t recommend this in most cases, but you can use retirement accounts such as a 401(k) or Individual Retirement Arrangement (IRA) to finance the down payment of a home. There are many nuances to this strategy, so I recommend that you consult with a tax professional before utilizing this approach.
Buying a home is probably the biggest purchase most people will make in their lives. Be sure you do your due diligence and know what you’re getting into.
If you’re ready to get help figuring out how much home you can afford--without compromising other financial goals--please schedule a consultation with me here.
Happy house hunting!
Mercer Street offers financial planning and investment management services to young professionals and growing families. We do not require account minimums. Check us out at www.mercerst.com.