Owning a home – a.k.a. “The American Dream” – is considered by many as the true sign of “making it”. There is a right way and a wrong way to make this dream a reality. The last couple of years have shown that if you do not go about it the right way, you could end up with a real mess on your hands. Foreclosures and short sales are at an all time high, so I wanted to discuss a few tips to help you avoid negative housing situations.
Save for a down payment
It is possible to get a mortgage loan with very little down. This could be considered good in certain circumstances, but overall it’s a bad thing. It makes buyers think they can afford more than they can. I suggest instead, saving up at least 20% for a down payment. So, if you’re looking at homes in the $100,000 range save until you have at least $20,000. That sounds like a lot of money, because it is!
There are two advantages to this strategy: (1) it will insure that you will get a house you can afford. If it takes you a couple of years to save up $20,000, it will appear clearer to you that you probably shouldn’t push yourself further by purchasing a $150,000 house. Saving will also prevent you from making an impulse buy. Trust me, you will want to think through a decision much more critically when you are writing a $20,000 check versus just coming up with $500 to cover closing costs. (2) it will help you avoid PMI insurance. Most banks require that you pay for this insurance if you don’t have at least 20% down. It protects them, not you, if you default. For you PMI is a waste of your hard earned money. PMI rates vary, but common amounts are $65-$70 per month on a $150,000 mortgage. That’s money you could be putting to better use right? Like paying down credit card debt or saving for something awesome.
Monthly mortgage payment amount
This is extremely important. If you want to do anything to get ahead financially (insert your favorite use for money here), it will be almost impossible if you are house poor. For example, if 50% of your take home pay goes toward your mortgage, you will be lucky to cover the rest of your essentials such as food and utilities. The math just doesn’t work. Instead keep monthly mortgage costs down below 25% of your gross income (after taxes).
Matt’s note: I suggest you keep you mortgage costs down to 10% of your monthly income, especially if you’re looking to buy in this amazing buyers market.
Here’s another tip if you’re a two income family – base the 25% rule on just one of your incomes. Are you really comfortable assuming you’ll both be making the same income for the next 15-30 years? I know we’re not! Many young couples I’ve counseled start with two incomes then want to go down to one when a baby comes along. When Mandy and I bought our first house, we kept our payment under 25% of our take home pay but we based it on both incomes. When our oldest daughter was born and Mandy wanted to quit her job to stay home, it caused a problem. All of a sudden our payment was closer to 30-35% of our take home pay. It wasn’t killing us, but we could no longer accomplish many of the goals set when we had two incomes. We ended up having to sell our house and move into something more economical. It would have saved a lot of hassle to buy our current home the first time. Even if both spouses continue to work, you can always use the extra money to give, save, or do whatever you wish.
Shorter mortgage terms
This tip is simple math. What law says you must take out a 30 year mortgage? Hint: there isn’t one. Why is thirty years the standard? Banks set that as the standard so they could make more money (interest on your debt).
Let’s look at an example. If you take out a 30-year, $100,000 mortgage at 5%, your monthly payment will be $537. The total interest you pay over 30 years will be $93,259! If, instead, you took out a 15 year mortage, your monthly payment would be $791, but you would only pay $42,347 in interest over the life of the loan. I don’t know about you, but $51,000 in savings is a lot of money to me!
Buying a home is a decision to think through very carefully. Mandy and I learned these tips the hard way and my hope is that you don’t have to.
Use these tips to make sure your American Dream is a dream come true… and not a 30-year nightmare!