This topic is currently top of mind for me personally, as I have just begun the process of purchasing my first home. This process can be daunting for first time home buyers, as there are so many financial questions that my wife and I have asked ourselves before purchase – what can we realistically afford without damaging our overall financial plan? How will this purchase affect my monthly cash flow? When should I begin saving?
We thought that many people have similar thoughts and concerns, so we decided to make this a two-part topic. In this article, we will discuss the top 5 considerations before the purchase of your home. In the next article, we will get into the weeds on the actual homebuying process.
#1 – What Should I Consider for the Purchase Price Range?
Before you even begin looking for the home of your dreams, it is critical that you try to understand the purchase price range that you can realistically afford and stick to it. My uncle always told me when I went to Las Vegas and dabbled in Blackjack, I should take out the limit of cash I am willing to lose beforehand and stick to it. The same can be said for purchasing a new home.
You need to understand a purchase price range before you even begin looking at homes because it is very easy to get seduced by homes outside your financial comfort zone. I have seen many clients get overextended – in the heat of the moment, an extra $50,000 or even $100,000 does not seem all that significant when you are already spending hundreds of thousands of dollars for a home, but that can significantly affect not only your short-term cash flow but also your personal financial plan long-term.
You may need to begin saving several years prior to the home purchase. In order to properly save for this new home, it is best to start this process early – this may mean several months or even years before you even purchase the home in some instances (more on this below).
#2 – Purchase Price Target: How Will This Range Affect Me in the Short Term?
The next step is to determine this purchase price range. In order to do this, you need to understand the short-term ramifications of this particular range, and that means understanding how it will affect your monthly cash flow.
Thus, we need to back into your expected monthly payment, which includes the mortgage payment, property taxes, and home maintenance. I would recommend utilizing NerdWallet’s calculator[1] given its simplicity, but you can find several others on the web. This will help you determine your monthly payment (it does not include maintenance costs, so you will need to factor this into the monthly payment).
You then need to compare this monthly payment range against the rest of your monthly expenses to understand whether it is feasible given what you are earning. You could look at this payment and compare it against your current living situation as a “quick” litmus test. How much more am I spending as compared to my current living situation? Is my new monthly escrow payment (mortgage/property taxes) well above my current rent (I.E. double etc.)? While imperfect, it will at least signal whether you are headed down the right path. The better way would be to do a budget if you have not already done so – this will push you to do one for the first time (see my article “Choosing the Best Budgeting Software” if you would like to learn more about this).
#3 – Purchase Price Target: How Will This Range Affect Me in the Long Term?
The better approach would be to look to the future – if I purchase a home in this price range, how will this affect my goals for retirement, funding children’s college, and any other current/future obligations I have?
It is incredibly important that you look ahead – many first-time homebuyers are purchasing for a particular reason, and many times this is because a child is on the way. I have seen situations where a homebuyer didn’t consider the future cost of child care expenses when purchasing a home, or any other future wants/desires they may have – since child care may mean several thousand dollars out the door each month, overextending yourself may mean you will not be able to save for retirement or your child’s college education (or worse yet, not even affording the monthly nut). Do you want a home outside this price range so bad that you are willing to have your children take on significant student loans, thus affecting their own ability to purchase a home in the future? Is this price range worth a less fruitful retirement? These are questions you need to ask yourself.
The very best means of understanding the long-term ramifications is through a Financial Plan. A good financial planner can project ahead for both the short-term (over the next 5 years) and long-term (throughout the rest of your working years and into retirement) based on a range of varying purchase prices. Many times, we run our models for clients based on the ideal home (higher price) and a more practical home (lower price) so that the client can see the effects on their lives for both – we sometimes include future children in our models (and thus include childcare/college) and can also demonstrate the effect on retirement.
#4 – To PMI or Not PMI?
We will preface this section and the next by stating that the amount you will need to put down on a home, in order to avoid Private Mortgage Insurance (PMI), is different for everyone. There are some that may not be able to save the optimal amount (more on this below), so we will talk generally. We will also not get into FHA loans, which are a bit more complex – we will tackle that topic in another article.
The conventional wisdom is that you will need 20% as a down payment for a loan, as this is the very best method to avoid PMI. For those that don’t know, PMI is an additional monthly payment that is required for those loans that typically have less than a 20% down payment. PMI is a lender's protection if you default on your primary mortgage and the home goes into foreclosure – it typically ranges from 0.5-1.5% of the value of the mortgage (NOT the home).
Many lenders will allow for a lower down payment but will either a) add PMI to the loan until the homeowner has paid off enough of the loan to get to 80% loan-to-value, or b) increase the interest rate in lieu of PMI.
Thus, you need to consider whether you are willing to put down less than 20% and cope with PMI, or whether you prefer to save the traditional 20%. There is very good reason to avoid PMI – it is essentially a dead weight additional payment that offers nothing to the borrower (outside of allowing them to put down less on the home). However, there are some instances where it makes sense to go the PMI route – this may be true when a) interest rates are low, b) the housing market is ideal for buyers (if we are at the low end of the housing cycle/buyers are in a non-competitive market), c) renting is expensive in your market, and/or d) your situation deems it necessary to purchase a home (having multiple children for instance).
#5 – What is the Best Method of Saving for a Home?
Now that you have decided on the Purchase Price Range and the down payment on your dream home, you can execute a plan to save for the home.
Next, you will determine a realistic timeframe for purchase given your target down payment. Realistic is the key adjective – if you have nothing saved currently, chances are you won’t be able to purchase a home in the next year. You then need to plot out how much you are able to save monthly for the down payment and keep that money aside in a separate account. You don’t want to commingle this in your day-to day cash accounts, as you need to have an accounting of your down payment savings and don’t want to spend it inadvertently.
You need to factor in a few key variables. First, you should continue to save for your retirement. You can curtail retirement saving a bit if the home purchase is short term (I.E. 1-3 years), but beyond that you need to continue to save for retirement (for those in employer plans, at the very least obtain the employer match). You also need to factor in having enough emergency back-up cash at the time of purchase (3-6 months of your take home pay) – you don’t want to get in a situation where you purchase a home and then lose your job with no Rainy-Day fund. Lastly, you also need to consider furnishing your home. Even if you plan on furnishing over time, there are always some fixtures you will desire immediately.
If you are a first-time home buyer, we hope this article helped you, and you should always feel free to reach out to us if you have any questions. In Part II of this article series, we will tackle the homebuying process itself.
[1] https://www.nerdwallet.com/mortgages/mortgage-calculator/calculate-mortgage-payment
Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors. Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors.
*Licensed but not practicing on behalf of Lincoln Financial Advisors.
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