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How to Financially Plan for Your First Home Purchase

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When it comes to the purchase of a new home, there is one thing that everyone can agree on; A homebuyer should never purchase more “house” than they can afford. As we have repeatedly mentioned here at Educounting.com, budgeting is crucial in planning any major purchase, and buying a home is no exception. However, the waters get muddy as we delve into what constitutes an “affordable” home.

Finding that affordability sweet spot will require more than just a mortgage lender’s pre-approval. The median sale price of new homes sold in April 2022 was $450,600. That means some folks will pay much more for a new home, while others will spend a lot less. What might be affordable for some may not be affordable for others. Regardless, for most Americans, purchasing a new home will likely represent one of the most significant purchases they will make in their lifetime.

It is not uncommon for first-time homebuyers to make the mistake of shopping for homes based on home much money a mortgage lender is willing to give them while failing to consider other expenses involved in purchasing a new home. Often, this approach sets the homebuyer up for financial hardship and can put them at risk for a potential foreclosure down the road if the monthly mortgage payment on their homes becomes unmanageable.

Use the 28% Rule to Get Started

The easiest and most effective way to determine your personal home-buying budget, according to most experts, is to use what is known as “the 28% rule.” This rule is considered the common “rule of thumb” for how much money an individual can afford to spend on their monthly mortgage payment.

The 28% rule states that your monthly home mortgage payment should not exceed 28 percent of your monthly gross income. The Federal Housing Administration (FHA) tends to be more generous, using a 31% rule, allowing consumers to use 31 percent of gross income on mortgage payments. However, many potential homebuyers fail to consider their other debts, which are crucial to determining how much they can genuinely afford. In other words, even if you follow the 28% rule, you can still find yourself in hot water, unable to afford your monthly mortgage payment.

Before lending you money to purchase a home, a mortgage lender will look at your debt-to-income ratio. If your estimated monthly mortgage payment is, for example, $1,000 per month, and the total of all other expenses is also $1,000 a month, your monthly financial obligation is $2,000. If your gross monthly income is $6,000, the debt-to-income ratio would be 33 percent, which might be too high. Generally speaking, 43 percent is the greatest debt-to-income ratio that a qualified mortgage lender will allow. 

Are you having trouble saving money? Here’s a video we made on how to get money motivated and start making the right money decisions.

Consider the Expenses of Owning a Home Beyond Your Mortgage Payment

Home loan pre-approval is an essential early step in purchasing a home. However, it is just one of many considerations moving forward. A mortgage payment certainly isn’t going to be your only recurring expense. There are many ongoing costs associated with homeownership that buyers must anticipate before taking the plunge. Additional costs include utility bills, maintenance, homeowners’ insurance, and repairs. Maintenance costs alone can seriously add up. You’ll need to mow the lawn, shovel the snow, and rake the leaves. If applicable, you’ll also want to consider your property tax payments and homeowners’ association dues. 

These expenses can make a home that seems like it is affordable on paper quite expensive in reality. Therefore, when determining how much you can afford, you must include these costs and any other regular monthly expenses.

The bottom line is that a $1,500 monthly mortgage payment might be doable for you, but when you add an additional $1,500 in monthly expenses, your obligations are doubled and can easily become unmanageable.

Down Payments Should Dictate Your Purchase

A mortgage lender typically expects the homebuyer to pay at least 20 percent of the home’s purchase price in cash. In situations where the homebuyer cannot make a 20 percent down payment, they may still be able to secure a mortgage but will have the added expense of having to pay for private mortgage insurance (PMI), thus increasing the amount of their mortgage payment. PMI can increase a loan amount by as much as one percent.

The cost of your PMI will depend on home size, your personal credit history, and potential property appreciation. The higher your down payment, the less you’ll pay in interest over the life of your loan, and the lower your monthly payment will be. Even if you cannot swing a $60,000 down payment on a $300,000 home, buyers should aim for ten percent at the very least.

Your down payment will often depend on several different factors, including what the seller is willing to accept. Conventional mortgages typically call for 20 percent of the sale price as a down payment. FHA home loans expect a buyer to spend 3.5 percent of the home’s sale price as a down payment.

The amount of money you save for the down payment on your new home should also influence your choice in which home you purchase. For example, if you are trying to decide between two houses and the money you’ve saved represents a 20 percent payment on one house and ten percent on another, it’s obvious that the cheaper option will get you more of a bang for your buck in the long run.

As a potential homebuyer, you will need to put aside money to cover your closing costs, which may cost between two percent and five percent of the total purchase price. When you purchase a home for $200,000, you can expect to pay $4,000 to $10,000 in overall closing costs.

When Choosing a Property, Always Go With What You Can Handle

In determining a home’s affordability, you’ll want to consider the property’s size and condition. A large house isn’t always a good choice, particularly if heating and cooling costs have the potential to hurt your budget. Similarly, the small cottage atop a steep picturesque hill might be your dream home, but managing snow removal on a long, steep driveway may become costly. Along these lines, that affordable, historic 3,500-square-foot fixer-upper might seem like a great deal until you see just how much the renovation will cost.

Always investigate utility costs on every property that you consider buying, and be sure to have a trusted construction professional estimate the cost of any repairs that might be needed. Anyone planning to renovate or repair the homes on their own should be realistic about their time constraints and skills. Quite often, homeowners will bite off more than they can chew on a home improvement project, and mistakes in the process can cost more money in the long run.

The Bottom Line About Planning for Your First Home Purchase

Homeownership has always been one of the quintessentially American dreams and continues to be even today. However, that dream can become a complete and total nightmare if you don’t make the proper calculations and fail to create a smart budget and action plan related to your home purchase. It is particularly common for first-time homebuyers to have unrealistic desires when looking for the right home, and they can get more than they bargained for. That sets them up for being “house rich and cash poor.”

Someone who is “house rich and cash poor” has more equity in their home than they do cash in their bank account. Homeowners who house rich and cash poor have most of their money tied up in the home while having few accessible liquid assets. Should you find yourself in a bind and in need of quick cash, you may find yourself in a difficult situation if all your money is tied up in your home. Having a significant amount of home equity may allow you to access cash through a home equity loan or home equity line of credit.

In the end, the key is ensuring that the house you purchase is affordable. However, determining affordability takes more than just determining the amount of your monthly mortgage payment. Always remember that setting up your home-buying budget involves much more than affording the monthly mortgage payment. Always calculate your total debt-to-income ratio, and be sure to include all of your monthly expenses and divide them by your gross income in order to determine if the home is affordable. If you don’t make the right calculations upfront, you might find yourself in a house-rich and cash-poor situation, leading to a world of financial hurt.

Homeownership involves many ongoing costs, from homeowners’ insurance and property taxes to repair and maintenance expenses. It is important to take the time to create a budget and financial plan for the purchase of your dream home long before you even start looking for that new home. Always shoot for at least a 20 percent down payment on your home purchase to avoid needing private mortgage insurance. Remember, great federal home-buying programs offer mortgages tailored to first-time homebuyers, such as FHA and VA loans.

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