I’ve purchased two houses in my young life. One I did well and one I did not.
Didn’t realize what I was getting into
Paid too much
Lost money when I sold it (in a good market)
Had collection agency call me
Crushed my credit score
Doubled my credit card balances during this time
Spent half as much
Enabled me to pay off the rest of my debt
Enabled me to increase my savings account substantially
No late payments – fits into a very comfortable monthly budget
One purchase made my life easier and one caused me nothing but stress and financial turmoil. I’ve been on both sides of the fence on this one. I’ve learned from my own experiences, but maybe even more impactful, I’ve learned from the mistakes of others in my job at a bank. I’ve seen what the wrong choice can do, the ripples that it can cause throughout your entire life. I’ve seen people with six-figure incomes being called by our collections department, running up massive credit card debt, or filing bankruptcy in large part due to the home that they bought.
Your home is the biggest, most important purchase that you will make, so you need to make sure you do it right. Here is my plea to all you future home buyers.
What NOT to do when buying a home
1. Don’t buy what you can “afford”
How do most people determine how much home they can afford? Working at the bank, I see this all the time. Most people do one of two things.
1) They take the bank’s word for it.
The bank or mortgage company that you contact will most likely have some sort of underwriting guidelines as to how much house they’ll finance for you. The guidelines vary from bank to bank, but the industry standard usually allows around 28% of your gross monthly income to go toward your housing expense (including escrow) . So, if you make $4,000 per month, then you can “afford” a $1,120 per month payment. Other factors are, of course, considered during the process, but if you have good credit and reasonable debt levels, this ratio will be a guiding force in the bank’s decision.
Here’s the problem. The bank doesn’t know everything about your finances. They know your credit report, your income, and most of your debt, but they don’t know your lifestyle. Don’t leave the decision up to the bank. They’re not considering how much you spend at the grocery store, what your next vacation is going to cost, or how you’re going to be able to save for retirement. They’re worried about whether they think you’ll be able to pay them back, not whether this is a smart move on your part.
Not to mention, just because there’s a guideline for how much you should spend on your home doesn’t mean you need to follow it. My wife and I ended up spending less than 1/2 of what the ratios say we can afford and it’s worked out well. I personally believe that the guidelines are high.
2) They look at their budget, find out how much is left over for a mortgage payment, and use up every penny.
Let’s say that your budget has a $1000 per month hole in it. You could do one of several things. You could plug that hole with $600 of house payments and use the rest to pay off debt or invest, you could designate $800 – $1000 for house payments and save anything leftover, or you could end up falling in love with a house and “stretch” to a $1200 per month payment, assuming that you’ll cut back in other areas.
Here’s the problem. You’re going to need that extra money one of these days. Once you’ve locked yourself into this mortgage, it’s a fixed cost that isn’t going anywhere unless you’re able to sell (no easy task right now). Be conservative. You can always buy more house later if you need. You can’t always go back.
Also, make sure that you’ve already worked a savings and retirement plan into your budget before determining how much extra money is left for a home.
2. Don’t get a 30 year mortgage
Plea #1 and plea #2 are connected. It’s easy to fall in love with your dream home and apply for a 30 year mortgage because it’s the only way you can “afford” it, but my advice is to look only for homes that you can afford using a 15 year mortgage (or less).
There are two reasons. First, you don’t want to be burdened with a mortgage for 30 years. You want to be debt free, so the shorter the amortization of the loan, the quicker you will reach your goal. Second, the amount of interest you will save by switching from a 30 year mortgage to a 15 year mortgage is remarkable. Here’s an example.
In the case of a $200,000 mortgage at 4.5% (let’s say the rates would be the same), a 30 year mortgage will cost you an additional $89,416 over the life of the loan!
3. Don’t think of it as just another monthly payment
Think of your purchase in terms of the whole kit-n-kaboodle. A $200,000 house doesn’t cost $1000/month – it costs $200,000 in cash. I know people who are worried about making sure that they cut out a 50 cent coupon for Cap’n Crunch, but don’t blink an eye at their $200,000 mortgage*. Why? Because we tend to think of our mortgage as just another monthly payment instead of what it is - a TON of money.
When you head to Target to purchase a coffee maker, you don’t think of it in terms of monthly payments. Instead, you think, “do I have $60 to buy this coffee maker?” However, when we consider large purchases like cars and houses, we think almost exclusively in terms of monthly payments, which deceives us of what the true cost is. Did you know that adding $25,000 to your house budget will only cost you a little over $100 per month? $100 per month doesn’t sound so bad, but $25,000 plus interest should make you sit down and think about it for awhile.
When you go to the bank and sign the loan documents, think of it as cash changing hands, because it is. In essence the bank is giving you $200,000 in cash to purchase your home. You are giving them an IOU. If you imagine having to pay them back $200,000 + interest (more on that in a second) you may have a different perspective on the transaction and the contract that you’re signing.
4. Don’t forget the interest, property taxes, and insurance
As we saw in Plea #2, interest plays a big part in your mortgage. The bank asks for something in return for loaning us the money to buy our dream home. So, let’s take Plea #3 one step further…don’t just think of the full purchase price of the home, consider all the interest too. The full cost of a $200,000 home at 4.5% interest for 30 years is actually $364,813.42. Would you have changed your mind if you had thought about it in those terms to begin with?
Also, when you’re calculating your payments make sure you include the taxes and insurance or you’ll be sorely disappointed when those big bills arrive in your mailbox.
I can sum up my plea to future home buyers in two words – “Be Careful”.
Your home can be the anchor of your personal financial statement, your most important asset, appreciating in value, and gaining equity every year…
OR it can be the anchor that pulls you deeper and deeper into debt.
Remember, dream homes are usually most dreamy the day you move in – a dream home can turn into a nightmare in a hurry.
Shelter is, on average, our #1 largest expense and it’s not really all that close. Therefore, it’s also the one area where you can make the biggest splash in your budget. All of our choices have consequences. However, the consequences of this choice will echo throughout your whole lifestyle for years to come. Be careful.
* Footnote from a previous paragraph: I’m fully aware that certain areas of the country and the world are much more expensive than the rural area that I live in and that $200,000 is a drop in the bucket to those folks, but the point is still the same.