Buying a home is one of the biggest financial endeavours you’ll undertake and while it comes with a ton of expenses, it also comes with many upsides. Your home is where you’ll make a lot of memories with your family and have the space to learn and grow as a person. However, the process of finding your dream house can be daunting and exciting at the same time. Luckily, you don’t have to break the bank to find the perfect home that you can afford and here’s how you can ensure your house isn’t an ongoing financial burden!
Looking for the perfect home can be overwhelming especially if you’re a first-time buyer. You’ll have to decide on the type of home you want, the size, and location and of course the price. That final aspect is of the upmost importance and prompts many questions. For example, where are you going to get money to pay for the home? Can you afford to buy it? But not to worry, I’ll be answering all these questions especially the ones that have to do with how to buy a home without overstretching your means.
Buying a home is going to be one of your biggest expenses, no doubt. However, you don’t have to say goodbye to all your savings or fall into a debt you can’t afford to pay because of your new home. However, you also must remain mindful that mortgage payments can be financially taxing if you overextend yourself when buying a home. Therefore, you must be aware of some of the common reasons why people end up spending too much when buying a home.
Why People Overspend
Firstly, people spend too much money on a home because they have not considered all of the costs involved with homeownership. They only consider the mortgage payment forgetting that they still have to pay for taxes, maintenance, and repairs in the home. As a tenant, you don’t have to worry about this because you have a landlord. However, as a homeowner, you’re on the hook for all of these costs and you must factor in these expenses before any homebuying decision.
The next group of people who overspend on a home are those who don’t have a budget. You must know how much you’re willing to pay to finance a home monthly if you don’t want to end up buying a property that you cannot afford. Buying a home is more than having enough money saved as a down payment. Would you be able to finance the home in the long-term? To help you answer this question, I will explain later how to create a budget that you are comfortable with.
Another reason why people overspend on a home is that they allowed others to influence their decision. Maybe a friend of theirs just bought a new home and so, they assume it’s time for them to follow suit. Lenders and realtors may also try to talk you into buying the most expensive home available. However, they are doing this for their own interest, so you had better do your research before putting down money on a home that may cause buyers remorse.
Finally, people spend too much on a home because they assume that their income will increase in the future which means that in the present it’s okay to splurge on their new home. Let me liken this to another buying scenario. Have you ever seen a pair of shoes you loved so much and you thought, it wouldn’t hurt if you paid a little extra money to get them? Well, the process of buying a home is almost the same. You might see some properties that match your dream home and fantasize about how amazing it would be to live in them. However, this might not be the best decision as you may end up overstretching your means because you loved the idea of living in a particular home.
Buying Vs. Renting
Now before we go further, let’s talk about why you would choose to buy a home instead of renting. It is very easy to start an argument just by raising this particular topic. It’s still one of those topics that even financial experts have a hard time agreeing on. Those in support of renting a home believe that it’s better than buying because you won’t have to pay a huge upfront cost of owning a home. Also, they believe it offers more flexibility as you can live wherever you want and move on a whim. Finally, there’s no doubt that it’s cheaper than owning as you avoid paying expenses like home maintenance, repairs, and utility costs. However, I’ll talk more about why you would choose to buy instead of rent.
If one of your goals is becoming a homeowner then you’ll agree with me that nothing beats the feeling of moving into your home. The emotions are priceless and you’ll be missing out on this if you chose to rent a home instead. Again, it’s your own and you can do whatever you want in your home. You can choose to have a pet. If you no longer like the paint, you can decide to change it to the one that suits you. The freedom you get from owning a home can never be compared to when you rent.
Furthermore, one of the reasons why you should choose to buy a home is that it can be cheaper than renting in the long-term. The initial cost of owning a home can be expensive at first. You’ll have to save enough money for a down payment and there are extra costs of running the home such as taxes, maintenance, repairs, and utility. However, when comparing the cost of buying a home and renting in the long-term, buying is often a better option. Keep in mind, you’ll never get back your rent but every payment you make towards your mortgage is you paying yourself in a roundabout way because eventually you will own the property outright. However, when rent, you will always owe someone money, the outflow never ends. Not to mention, real estate appreciation can offer you the ability to reap great returns over time which again is not a benefit you gain when renting. So if you’re looking at the longer term, buying a home is a great way to build wealth and memories!
So now, let’s also talk about how you can afford to buy a home without overstretching your means using the rule of 200. The cost of owning a home is expensive and only a few people might be able to afford to pay without a loan. Therefore, one of the steps that you’re going to take if you want to buy a home is to look for a means to finance the purchase. In most cases, you’ll need to be pre-approved for a loan from a bank or mortgage broker. They’ll tell you the maximum amount of mortgage loan that you are pre-approved for using information such as your income, your savings, any other loans you’re currently paying, and your credit score.
Furthermore, they use two affordability rules to determine how much loan you can be preapproved for. The first rule is that your monthly housing cost should not be greater than 32% of your gross monthly income. That is, you should be able to pay for your housing costs with 32% of the amount you earn before taxes and other automatic deductions. The second rule is that your monthly debt load should not be greater than 40% of your gross monthly income. That is, your monthly housing cost plus any other loans you’re currently paying should be below 40% of your gross monthly income. In other words, you don’t even have to pay off your student debt before buying your home!
In many cases, people are surprised when they realize how much mortgage loan they’ve been preapproved for. Suddenly, they find out that they might be able to pay for their dream home after all. However, should you buy a home simply because the bank preapproved a mortgage up to that level? I don’t think so. Remember that the banks and realtors would like you to spend the maximum amount possible for obvious reasons. The higher the price of a home, the more the commissions a realtor receives and the larger the loan, the more interest you’re likely going to pay to the banks.
Also, buying a home is just one of the expenses that you’ll have. You have to consider how buying an expensive home will affect your other financial goals such as funding your children’s education or saving for retirement. Therefore, this is where you need the rule of 200 to be able to determine whether you can afford to buy a particular home. To help explain this concept further, I’ll now share with you a quick example.
Let’s assume you have a job that pays a gross income of $100,000 every year. That is, the amount you earn before taxes and other automatic deductions. You also pay a monthly rent of $1,500 and $400 in student loans every month. According to this information, the bank would assume that you should be able to afford $32,000 per year or $2,667 per month on housing costs and $40,000 per year or $3,333 per month on debt load. Another assumption is that you’ve been able to save up to $50,000 for a down payment. With this information, you may be surprised to find out that the bank would pre-approve you for a loan up to $560,000! The monthly payment would be about $2,650, which is 31.8% of your gross income. Adding the student loan would bring your total debt load to 36.6% of your gross income.
You now realize that you have a chance to buy a home worth half a million dollars! Now you’re looking for a bigger home with a spacious bathroom and kitchen. While there is no problem with wanting to live in a better home, there is a problem with this calculation because it is based on your gross income. Your take-home pay would be lesser than your gross income, therefore, you might want to reconsider your options. If you’re left with $75,000 annually after-tax and automatic deductions, it means that your mortgage payment and total debt load are 41.6% and 48.8% of your net income respectively.
But the good part is that you’re comfortable paying $1,500 as rent already. Therefore, all you have to do is multiply this amount by 200 to know how much you can comfortably pay as a mortgage payment every month. The rule of 200 is so simple that you can easily estimate how much you can afford to pay as a mortgage based on your current monthly rent. You can get the selling price of the home by adding the down payment and subtracting the mortgage insurance if applicable. Keep in mind that often, lenders will require that you pay for private mortgage insurance if you’re putting down less than 20% on the purchase of your new home!
Using this example, you’ll multiply your monthly rent of $1,500 by 200 and add the down payment of $50,000. The mortgage insurance, in this case, would be about $9,000, therefore, you should be looking for a property with a selling price of $341,000 to have a monthly mortgage payment of $1,500. The assumptions behind the 200 rule are 25 years mortgage and 3.5% interest rate. However, this rule may falter in markets with high housing costs as your monthly rent multiplied by 200 may not be enough to pay for a home.
In conclusion, it is better to go for a home you can afford. By doing so, you can ensure you can tackle your other financial responsibilities and avoid the unenviable position of being house poor!