When it comes to home buying, there’s a well-known critical rule: Avoid purchasing more house than you can afford. However, what represents “affordable” will differ between homebuyers. Therefore, one of the most important things for a first-time home buyer to do is plan and budget in advance. Diving into a potential multi-decade financial commitment is one of the most daunting experiences for an individual (or a couple, for that matter) in their lives. It is also highly probable that it will be your most expensive purchase. Before doing so, strategically allocating your money is essential. Otherwise the costs are steep. Before you know it, you may quickly find yourself getting buried in financial hardship, or the ultimate worst nightmare: foreclosure. To avoid this, we recommend the following five tips for first-time homebuyers.
1. Strongly consider getting started with the “28 Percent Rule”
The “28 Percent Rule” dictates that your mortgage shouldn’t be more than 28% of your gross income each month. While the Federal Housing Administration (FHA) recommends a slightly more generous allowance of 31%, first-time homebuyers in particular ought to air on the side of caution, considering they are likely repaying some other forms of debt. Additionally, there are the normal monthly expenses (food, transportation, healthcare, etc.) that any working-class individuals would have to account for.
2. Your down payment should dictate your home’s budget
Generally, lenders will look for homebuyers to put at least 20% of the property’s purchase price in cash. Though you can utilize other resources to obtain an approval, such as private mortgage insurance (PMI), this will inflate your monthly mortgage payment by roughly 1% (Fuscaldo, Investopedia). It’s important to note that the PMI depends significantly on the size of the property, your credit score, and the potential for the value of the home to increase over time. It’s equally important to note that it is in your long-term best interest to avoid these kinds of instruments, as they’ll tie up more and more of your monthly disposable income in interest repayment. On top of everything else, it’s critical to remember closing costs, as they’ll cost you anywhere from 2-5% of the home’s purchasing price, depending on what state you live in (Fuscaldo, Investopedia). Avoid over-leveraging yourself. Put as much money down as you can afford to, but certainly aim for higher than the bare minimum 10%.
3. Precisely track your debt-to-income ratio
It’s a very well-known fact that mortgage lenders will look at a prospective homeowner’s debt-to-income ratio when determining if they will extend a loan to the borrower. Therefore, keeping track of this ratio on a monthly basis is a good benchmark for prospective homeowners to calculate themselves, in order to ultimately decide if a home they’re interested in is affordable. Suppose your gross monthly income is $5,000. Then, if your mortgage payment is $1,500 and the total of your other monthly financial obligations is $1,000, this puts your debt-to-income ratio at 50%. Qualified mortgage lenders very rarely will approve a borrower with a debt-to-income ratio above 43%. Thus, in the above example the hopeful homeowner would unlikely to get approved and even if they did, it’s probable they would be setting themselves up for failure.
4. Don’t forget all homeowner expenses, not just the monthly mortgage
There’s no question getting approved for a home loan is an essential step in the process, yet this is only one obligation (though it’s by far the largest). The tough reality is your monthly mortgage payment will not be your only reoccurring expense as a homeowner. Consider additional monthly homeowners’ insurance, utilities, repairs, and maintenance costs. Depending on the season, the snow will need to be shoveled, or the lawn will need to be mowed, or the shrubs will need to be trimmed. Many find that over time, the list just keeps growing. When you calculate the affordability of a home, you may find that an affordable $1,500 monthly mortgage payment is no longer palatable when you factor in an additional $1,000 in monthly expenses. This is a large reason behind the idea of putting a considerable downpayment on the home; it frees up money for those other monthly costs, rather than irresponsibly squandering it on interest.
5. Settle on a property you can handle managing
Not only are the additional monthly homeowner expenses important to factor in, but you also need to be mindful of the condition and size of the property. In a situation when you’re concerned about a large utility bill from heating or cooling, less is more. A 4,000-square-foot property that needs serious repair may be a tempting proposition, until it breaks the budget. You may find you’re better off financially with more of a picturesque small home on a quaint hill, in a quiet neighborhood instead. For your own benefit, have a construction or homeowner expert look into the homes specifications to ensure you haven’t missed anything vitally wrong.
The bottom line is that to many, home ownership is still considered to be the American Dream. In reality, it can quickly turn into a financial nightmare when you miscalculate your monthly expenditures. First-time buyers in particular often want more than they can take on at that moment. Without taking the time to properly prepare for the single biggest purchase of one’s life, they can find themselves house-rich and cash-poor, leading to ultimate financial misery. We urge any future homebuyers to take the necessary preparation steps. Do not sign up for a dream you are not exceptionally confident you can afford.