Buying a Home…
…especially for first time homebuyers, typically begins with a sense of excitement. However, without a good plan and team around you, that initial excitement can quickly turn into an overwhelming process. This is especially the case in competitive neighborhoods like Nocatee, Ponte Vedra Beach, and Jacksonville Beaches, where the bidding wars can get out of hand very quickly. It’s why having a plan of attack from the beginning is crucial to ensuring a successful outcome. Afterall, the ultimate goal of homeownership is getting that place you always dreamed of without that awful feeling of being house poor. With that in mind, my most important home buying tip is this… Only pay for what you can afford.
Sounds simple, right? I’m sure some of you are probably saying “no kidding.” Unfortunately, due to all the moving parts that are associated with buying a home, buying what is considered affordable isn’t as straightforward as it may seem. Most new buyers are usually surprised to hear all of the other expenses that come with home ownership. To that end, a buyer needs to be mindful of such expenses as: the down payment, closing costs, title fees, mortgage payment, property taxes, homeowners insurance, private mortgage insurance (PMI), community development district (CDD) fees, and homeowners association (HOA) fees.
Start With a Plan
The best way to jumpstart a smart plan is to first set your targets in terms of the total monthly payment you can comfortably make, and then work backwards by adding in each cost to get an accurate estimate of your total monthly housing payment. Notice how I said housing payment, and not mortgage payment. A great plan doesn’t leave anything out and rounds up any calculations where an estimate is necessary. This seems obvious, but it’s human nature to round down. We have a funny way of “rationalizing” our decisions when we really want something. Truthfully, the most essential part to planning for a home purchase is to set a minimum and maximum range for your down payment and housing payment.
Determine a House Payment Budget
Let’s start with the housing payment first. However, it’s important to note that both types of payments go hand-in-hand because the amount you put down will affect your mortgage payment. So the question is, what is an appropriate limit for a homebuyer that doesn’t know where to begin? A useful benchmark is a commonly used financial rule of thumb that limits a person’s housing payment (renting or owning) to 28% or less of their total gross income.
In other words, a family making $150,000 per year should limit their monthly housing payment to $3,500. Note that if other substantial debts exist, like student loans and expensive car payments, it is better to reduce this limit to 20% of gross income. That’s because your total debt-to-income ratio should never exceed 36% of gross income. A good example is someone with sizable student loan payments should keep their housing payments reasonably in-check. Otherwise, that person might be making 2 mortgage-like payments.
Once you know your housing payment limitations, you can then back into the purchase price you can afford by using Zillow’s mortgage calculator. Their calculators are a great resource because they capture all of the necessary housing expenses like the mortgage payment, homeowners insurance, property taxes, PMI, and association fees. You can even search by property and use that particular property’s market value data to get a more specific estimate of what that home will cost you.
How to Determine a Down Payment
In addition to setting limits on your housing payment, it’s also a good idea to set boundaries with how much money you put down. The ideal scenario for a buyer is to put 20% down because doing so ensures the borrower doesn’t pay the dreaded cost known as private mortgage insurance (PMI). Anything less than 20% will likely mean the borrower is paying PMI. This expense typically averages 0.50% of the borrowed amount (it can range between 0.3%-1.15% depending on a handful of factors) divided by 12. However, not every buyer has enough to cover such a down payment, which is why it’s okay to pay PMI if owning a home is the right long-term financial decision.
To put the magnitude into perspective, 20% down on a $400,000 home requires at least $80,000. It’s really going to be more than that because that $80,000 doesn’t include title fees and closing costs – additional fees that get lumped together with your down payment at closing. To anticipate such costs, I recommend using the following closing cost calculator. At any rate, the key to setting a limit with the down payment amount is knowing the price range of the homes you are looking to buy. It is also important to be realistic about the cash on hand (or will have available from the sale of your old home) to cover such a down payment.
For example, let’s say you are buying a $400,000 house and have $50,000 in savings with little equity in your current home. Under these circumstances it would be wise to limit your down payment to 5%. Why? 20% is simply unrealistic unless the buyer is able to wait a couple years to allow them to save accordingly. Even 10% is too much. There are 2 reasons: 1) the additional closing costs and title fees will deplete the remaining $10,000 in savings, and 2) it’s smart planning to always keep at least 3 months of living expenses in savings for a rainy day. Unfortunately in this scenario whatever remains in savings won’t cover the surprise expenses that are inevitable in life – like a roof repair or replacing a bad A/C unit.
So what’s next?! Check back next week for Part 2 of this Financial Planning Series brought to us by Scott Snider with Mellen Money Management.
About Scott Snider and his company’s services….
Scott is the founder of Mellen Money Management, a fee-only, independent financial planning firm locally based in Jacksonville, Florida. In a nutshell, Scott helps clients plan for the financial impact of major life events, so that they are prepared for life’s biggest moments. Such an approach has helped his clients live a more fulfilling life. Mellen Money Management’s financial services include investment management and comprehensive financial planning. While their specialty is all things college — they help families pay less for college and young professionals tackle their student loans. It is their mission to end the student debt crisis one client at a time. To do so they believe the cost of college cannot be solved in a vacuum and that financial trade-offs, like saving for retirement, must be prioritized in a way that one goal doesn’t come at the expense of the other.