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Home Financing Guide
While the traditional wisdom has always been that buying a home is your best investment, becoming a homeowner is no longer the slam dunk it used to be.
For decades in the late 20th century, housing prices rose much faster than inflation. With no end to this in sight, families bought as much home as they could afford in order to set themselves up for as much appreciation as possible. Since housing prices had only gone up in the recent past, they figured there was no way to lose.
Sadly, the idea of constantly rising property values died a hard, sudden death when the housing collapse of 2007-2008 showed us how wrong our preconceptions really were. Suddenly, millions of Americans felt house poor for the first time ever as they found out they now owed more than their house was worth, or worse, could no longer afford skyrocketing payments. Foreclosures surged 81% in 2008 from just the year before, and a full 225% from the number of foreclosures in 2006. People were suddenly fearful, and almost no one has looked at real estate in the same way since.
The housing market has continued to claw its way back, even making a full recovery (and then some) in several pockets across the United States. However, the housing crash was a telling and influential moment for the vast majority of Americans. Although we had to learn it the hard way, we realized that, yes, housing prices can crash in the blink of an eye. And worse, a house really wasn’t the bulletproof investment we had always thought it to be.
During this time, however, the rental market for houses and apartments boomed. As of early 2016, we’ve reached a time in history where both renting and buying are expensive propositions.
That’s why it’s crucial to consider a wide range of factors before you purchase a home or decide to continue renting. Where you live, how long you plan to stay, and the price of the home you’re considering will all play a role in whether you’re better off buying or renting a home.
If you plan to stay put for the long haul, buying a home may indeed be your best bet. But if you plan to move every few years, renting might leave you much better off. Since real estate values vary widely depending on where you live, the entire scenario can be turned upside down at the drop of a hat as well. At the end of the day, you have to consider every factor that comes into play to make an informed decision.
Should I Buy or Rent? Some Examples to Consider
When you’re trying to decide whether to buy or rent a home, the first thing you should do is consider the average cost of both buying and renting in your area. Don’t forget that owning a home comes with costs beyond your mortgage, such as property taxes, insurance, water bills, and maintenance. Once you wrap your head around those core components of your decision, you can factor in everything else. Here’s what we mean:
Let’s say you plan to settle down in Pittsburgh, and hope to stay five years or longer. Comparing the average monthly mortgage payment of $560 and the average rent payment of $1,069 appears to make owning your home a no-brainer.
While buying might be the best deal over the long haul, that won’t always be the case. Here’s how that math works: Renting for five years will cost you around $64,140, while owning the home will run you only $33,600 in mortgage payments. That’s a difference (and potential savings) of $30,540 over five years. Plus, a mortgage payment is typically fixed, while rent can continue to increase year after year.
While buying a home appears to be cheaper in Pittsburgh, several factors actually influence the final outcome. For example, if you paid a realtor the standard 6% commission to sell your home five years from now, you could easily fork over $7,000 or more in seller’s costs. And as we said, a mortgage payment isn’t the only cost associated with home ownership: There are local real estate taxes, homeowner’s insurance, and other monthly expenses renters don’t pay.
Plus, if the home needed any number of repairs in that time (e.g., replacing a leaky roof, furnace or air conditioning repairs, plumbing issues) or you made significant upgrades (new appliances, HVAC system, windows, etc.), you could be out thousands of dollars more – though some of those investments could be recouped if they substantially increased the value of the home.
Meanwhile, if housing prices were to drop during the next five years, you could be forced to sell your home at a loss if you really needed to move. Consider that home values plunged by about 30% nationwide from March 2007 to March 2009. Even in what appears to be a slam-dunk buyer’s market like Pittsburgh, you could end up spending more to own your home than you expected under such conditions, and even more than if you had rented instead.
These same variables should be considered no matter where you end up – and how long you want to stay. In some rural areas, the decision to rent makes perfect sense when you consider the slow growth of housing prices in relation to how long you might end up living in the area. In large urban areas and coastal cities, on the other hand, the story might be entirely different.
New York City, for example, has seen the average monthly mortgage payment surge to $2,399 in recent years. When you consider the average monthly rent of $2,056, it’s easy to assume that renting is the better deal — and it may be. However, housing prices in the Big Apple continue to break new records, with the total market value of taxable real estate in New York surging from $969.4 billion in early 2015 to $1.072 trillion for the current fiscal year.
At that rate, owning a home – even for the short-term – could become an excellent, if unpredictable, investment. Again, it really depends on the specifics of your situation, the home you buy, and how long you want to stay in the same place — not to mention the real estate market.
Reasons to Buy or Rent a Home
When deciding whether to rent or buy, there are other external factors to consider as well. For example, owning a home involves much more than just making regular mortgage payments. In addition to being financially responsible for repaying your home loan, you’ll also need to pay for upkeep, repairs, taxes, and any improvements to your property. Renting, on the other hand, allows you to be much more “hands-off” with your housing situation. Once you pay your monthly rent, your landlord is responsible for repairs, upkeep, property taxes, and any problems that arise.
In addition to expenses you can plan for, there is also an element of the unknown. If you’re unsure what your career or living situation might be five or 10 years from now, buying a home might be a pricey gamble. With housing prices as unpredictable as they are, you never really know whether your “investment” will pay off the way you hope. All anyone can ever do is attempt a best guess, which is little consolation for people who buy a home only to sell it at a loss later.
Renting, on the other hand, ensures you won’t take a loss when you move — but it also guarantees that you won’t have any equity, either. Renting is less of a gamble in that respect, but that doesn’t mean it’s right for everyone.
While individual circumstances will play a huge role in whether buying or renting is the smartest move in your situation, here are some common reasons it might make sense to go one way or another:
You might want to buy a home if…
- You plan to live somewhere for 10 or more years. If you plan to stay in the same general area for 10 years or more, you are in a good position to see decent appreciation of any property you buy.
- You want to lock in a housing payment you can afford. If you’re worried about rising rent costs in your area, buying a home lets you lock in a monthly payment that won’t rise unless your property taxes do.
- You want to decorate and make your place “your own.” When you rent, you may not be able to paint walls or make cosmetic improvements that fit your style or décor. Buying a home, on the other hand, means you’ll have the right to modify your property any way you want.
- You don’t mind paying for repairs, or are “handy” yourself. When you own a home, you’re responsible for everything from yard work to maintenance and repairs. If you’re able to do some of the work yourself, you could save considerable sums of money over time. Having to hire out for each and every task, on the other hand, could prove costly.
You might be better off renting if…
- You might want or need to move in a few years. If you don’t know where you want to live a few years from now, buying a home can prove disastrous. Since local real estate markets can tick up and down from year to year, bad timing can easily cost you tens of thousands of dollars if you need to sell at the wrong time.
- You aren’t sure what type of home you want to end up in. Do you want a traditional home or something more modern? Do you want an open floor plan – or plenty of separate rooms for more privacy? Without the life experience that comes with having lived in several different dwellings already, you may not even know what you want.
- Your job could change in the next few years. If there’s some uncertainty at your workplace or you’d consider moving for advancement opportunities, renting might be your best bet, since it offers far more flexibility in terms of relocating. As a renter, you won’t have to go through the hassle and expense of selling a home if you need to move for a new or better job.
- You don’t want to pay for repairs. If the prospect paying for a new roof, a furnace repair, or landscaping has you on edge or would threaten to burst your budget, you might be better off renting until you have better control of your finances. When you rent, your landlord will take care of these costs for you, leaving you with fewer financial responsibilities and less stress overall.
Rent vs. Buy Breakeven in Major Cities
While renting is the best move in certain situations, buying a home can be a smart and financially savvy move in others. It really depends on the local housing market, how long you plan to live in your home, and the anticipated increase in local rent and housing costs. Although some of these factors can be hard to predict, the following table shows the breakeven point for several major cities across the United States:
|City||Breakeven Point||Average Monthly Mortgage Payment||Average Monthly Rent||Average Home Price|
|New York||18.3 years||$2,399||$2,056||$591,895|
|San Jose, Calif.||16.7 years||$3,162||2,503||$779,975|
|San Francisco||14.6 years||$3,643||$2,915||$898,706|
|Los Angeles||8.8 years||$2,110||$2,061||$520,559|
|San Diego||8.6 years||$2,167||$2,134||$534,695|
|Portland, Ore.||6.9 years||$1,285||$1,428||$317,085|
|Washington, D.C.||6.5 years||$1,909||$2,127||$471,071|
|San Antonio||4.2 years||$607||$1,189||$149,757|
|Charlotte, N.C.||4.1 years||$757||$1,168||$186,693|
|Austin, Texas||3.7 years||$742||$1,454||$183,134|
|St. Louis||3.6 years||$667||$1,131||$164,493|
How Much House Can I Afford?
If you’re leaning towards buying a home, you’ll need to know how much house you can actually afford. To reach this figure, you’ll take a look at your monthly income as well as your other financial obligations. By considering your financial situation in its entirety, you should be able to find a number that is both affordable for your budget and reasonable considering your local housing market.
The 36% Rule: The Original Mortgage Calculator
If you’re unsure what “affordable” means in relation to your mortgage payment, lenders have set certain guidelines that can help guide you in the right direction. In order to avoid a situation where borrowers buy more house than they can afford, banks have historically taken the position that your total debt payments should make up no more than 36% of your pre-tax income.
If you grossed $6,000 per month as a family, for example, your total debt payments should cost no more than $2,160 each month. Not only should that figure include your house payment, but it should include your property taxes, homeowners insurance, private mortgage insurance (PMI), car payments, credit card payments, child support, and any other bills you must pay each month.
While banks will occasionally let you fudge this percentage somewhat, most are hesitant to lend money to people whose debt-to-income ratio is out of whack. Since more debt means you have more monthly obligations, lenders feel those whose debts surpass the 36% threshold pose a greater risk of defaulting.
Obviously, the interest rate you pay on your mortgage will play a role in how much you can afford as well. The higher your interest rate, the higher your payment will ultimately be. In that respect, paying a higher interest rate means you’re usually stuck looking for homes with a lower purchase price. That’s why it’s important to shop around for the best mortgage rates; if you wind up paying more than you should, you may end up with a lesser house than you could afford otherwise.
- Related: Best Mortgage Rates for 2020
Consider Your Down Payment and Cash Reserve
Another important factor to consider when you’re buying a home is your down payment. Ideally, your down payment will be 20% or more of the purchase price of your home. That way, you can avoid paying private mortgage insurance, or PMI. Since PMI can cost up to 1% of the value of your home each year, you can easily pay $2,000 or more per year for this coverage on a $200,000 home loan. By saving up for a 20% down payment, you can avoid paying PMI altogether and pocket those extra dollars instead.
Whether you have a large down payment or not, you’ll need some cash reserves to deal with the inevitabilities of owning a home. For the most part, this means having money set aside for upkeep and repairs. In the meantime, you’ll need an extra emergency fund set aside to cover your housing costs if you were to lose your job or experience a medical emergency that prevents you from working.
Most experts suggest keeping an emergency fund stocked with three to six months of expenses. With that kind of money in the bank, you should be able to weather financial storms while keeping up with your mortgage payment so your loan doesn’t go into default.
Some Advice on Housing Affordability
While decades ago it was common to “buy all the house you can afford,” today’s housing market shows there is little to be gained by stretching your wallet. The constant growth in the value of real estate has been replaced with a constant uncertainty instead. If you want to position yourself for as little heartache and stress as possible, it’s always a good idea to buy exactly as much house as you can truly afford – and not a penny more.
When you’re figuring out how much money you can borrow, give yourself a break – and a little leeway. Instead of maxing yourself out with total debt payments amounting to 36% of your gross income or more, shoot for a lower percentage that will leave some room for error.
The Consumer Financial Protection Bureau (CFPB) offers this advice for families as they begin their home search: “Only you can decide how much you are comfortable paying for your mortgage.” In other words, you should only borrow an amount you find affordable, even if your bank or lender is willing to loan you more.
It’s hard to predict what type of costs you might face during your first few years as a homeowner, or what type of home repairs or upgrades are on the horizon. At the end of the day, you don’t want to wind up “house poor” due to poor planning. Even better, when you borrow less money to begin with, you won’t have to save as much to make a substantial down payment.
Reasons to Postpone a Home Purchase
If you think you want to purchase a home but aren’t entirely sure, don’t rush it! You’ll be much better off waiting to make sure you’re ready versus forcing a home purchase that doesn’t feel quite right. Depending on your situation, there could be myriad reasons waiting might be the best option on the table. Here are some common instances were waiting might leave you better off:
- You want to save up for a down payment. If the idea of paying PMI on top of your home loan is troubling, you might want to save up a down payment of 20% or more.
- You need time to improve your credit. Your credit score can play a huge role in your ability to secure a mortgage with an affordable interest rate. If bad credit means you’re missing out on more favorable interest rates, taking some time to improve your credit could save you a lot of money in the long-term.
- You want to qualify for a mortgage with a shorter term. If the idea of a 30-year mortgage is too much for you to handle, you might want to consider a home loan with a shorter term. But since the monthly payment on a 15-year mortgage loan will be much higher, it will skew the affordability factor by making your debt-to-income ratio look more severe than it really is. When this is the case, it might make sense to wait until you earn more money or have a larger down payment.
- You need time to build up your emergency fund.If you don’t have cash set aside to deal with the realities (and inconveniences) or home ownership, it’s best to start saving before you buy your home. Taking a year or more to build an adequate savings cushion will likely make the experience of owning a home a lot less stressful – at least in financial terms.
These are all valid reasons for waiting to buy a home, but there are many other factors that could influence your decision to wait as well. If any aspect of the purchase is stressing you out of making you feel uneasy, take a moment to step away from the situation and reassess. While you may need to rethink your plan altogether, you might just need some time to save up a bigger down payment, get your credit straight, or build a cash cushion for emergencies.
If you have considered everything mentioned in this article and still plan to buy a home, you’ll want to get your financials together right away. Even if you’re on cloud nine and excited to get started, buying a home will likely be a stressful process on your end. It helps to get your ducks in a row so that you’re prepared for anything that pops up.
Our free mortgage calculator can help you figure out the logistics of your home purchase. For example, how much can you borrow if you qualify for today’s best mortgage interest rates? And, how might your payment change if you chose to buy a less expensive home?
As you craft your financial plan for the next decade or longer, these details will be especially crucial. Securing an affordable mortgage payment is one of the best ways to set yourself up for financial success while building equity in a property you might want to sell one day.
Why Should I Use The Simple Dollar’s Mortgage Calculator?
The fact that you took the time to read through the first 3,000 words of this resource shows you are dedicated to being an informed consumer. So, don’t stop here! Our mortgage calculator offers the opportunity to see how your home purchase could play out in real life.
Best of all, our mortgage calculator is entirely free. So, what do you have to lose? After entering your the numbers specific to your situation, you’ll be one step closer to knowing how much you can afford as you begin searching for your dream home.
How to Use The Simple Dollar’s Mortgage Calculator
Once you’re ready to give our mortgage calculator a whirl, the first thing you’ll want to do is gather some basic information about your future home and financial situation. For the most part, this includes:
- Your target home price: How much do you plan to spend on your new home?
- Your down payment: How much money do you plan to put down?
- Your mortgage type: Do you want a fixed rate or variable home loan?
- Your expected interest rate: What type of interest rate do you qualify for?
- The length of your mortgage: How long do you want to make payments on your home?
Once you gather and enter this data, you’ll be on the fast track to seeing what your new monthly mortgage payment will look like. And if you don’t like what you see, you can use the calculator to change the details to your liking.
For example, a higher-than-expected payment can normally be fixed by shooting for a lower purchase price for your home purchase. By buying a home that doesn’t cost quite as much money, you can usually score a monthly payment that will be easier to manage.
You can also play around with the numbers to see if you can afford a more aggressive 15-year mortgage or just a traditional 30-year loan, or if a five-year variable rate might work better. At the end of the day, our mortgage calculator can help you picture any number of scenarios.
How Does My Mortgage Payment Change Over Time?
Our mortgage calculator will break your monthly payment down into two separate categories – principal and interest. Meanwhile, it also includes an amortization calculator that shows how the principal of your loan will decrease each year.
Before we dive into how your mortgage payment will change over the years, let’s first define the two main components of your monthly mortgage payment – principal and interest. Your mortgage principal is the amount of money you still owe on your mortgage at any given time, whereas the interest you pay is a monthly interest amount charged in relation to your APR, or annual percentage rate.
If you choose a home loan with a fixed rate, your monthly payment towards mortgage principal and interest will never change. However, the amount of money you pay towards each piece of the puzzle will change as you pay down the principal and the amount of interest you pay decreases.
Since the bulk of the mortgage interest you pay is front-loaded on a fixed loan, your monthly interest payments will be higher at first, but ultimately decline over time. Meanwhile, the amount of money you pay towards the principal of your loan will only get larger with each passing month.
There are two other components of your mortgage to consider if you choose to pay them monthly through an escrow account. These components includes your monthly homeowner’s insurance and your property taxes. Even if you secured a mortgage with a fixed rate, these two variables can change your home loan over time.
If you pick a variable rate mortgage, your monthly payment will fluctuate over time as interest rates rise. This is why many people prefer fixed rate mortgage instead; while a variable rate can help you secure a lower payment when interest rates are low, rising interest rates can leave you stranded with a higher mortgage payment than you ever wanted.
Tips for Closing on Your Home
Before you head to the closing table to close the loan on your new home, it’s important to make sure all your ducks are in a row. The Consumer Financial Protection Bureau (CFPB) offers these tips for new homeowners getting ready to seal the deal:
Know what’s going on and prepare adequately. “Prepare for your closing in advance, so you can be confident and prepared on the big day,” notes the CFPB. You’re committing to a mortgage payment that could last up to 30 years. Make sure you know what to expect and that you’ve got all your paperwork in order.
Read the fine print. “Know you have a right to understand 100% of what you are signing.” Pay attention to all details at your closing so you aren’t surprised down the line.
Ask questions and don’t be afraid to walk away. If you’re in doubt about any detail of your closing, don’t be afraid to ask. And if you find yourself uneasy about any of the paperwork or responses you receive, don’t be afraid to walk away. “Know that walking away at closing may be better than signing a deal you’re not comfortable with,” notes the CFPB. “Trust your gut and speak up. Now is your chance to prevent future problems.”