What to Consider Before Buying a Home
For many people, owning a home brings a sense of pride and freedom that cannot be matched by renting. When you own your own home, you aren’t bound by a landlord’s rules, and your monthly payments are building equity. Although buying a home may be the first step you take toward building long-term wealth, it is important to understand the pros and cons of home ownership before taking the plunge.
First, let’s take a look at some of the advantages of buying a home. The most obvious benefit is that it’s yours. You can paint your kitchen pink, change the landscape, install a basketball hoop, or turn your unfinished basement into a movie theater. Provided you work within any building or zoning regulations, you can do almost anything you want with your home.
Another major benefit of owning a home is that some of your monthly mortgage payment comes back to you in the form of equity. When you pay rent, you will never see any of that money again. On the other hand, part of your mortgage payment will partially be applied to the loan principal, which builds equity.
Since your home can become an asset, you also have the potential to make money if you can sell it for more than you originally paid. In some cases, this profit may even be tax-free. Also, you may be able to tap into the equity of the home while still living in it to make improvements or consolidate debt.
Finally, let’s not forget that there may also be additional tax benefits from owning a home. In many cases, the mortgage interest and property taxes you pay are deductible, which means you will be lowering your overall tax burden.
Even though there are many positive aspects to buying a home, let’s not overlook the potential drawbacks as well. Do you remember a time when a major appliance in your apartment broke down? You probably just had to call your front office or landlord, and they were out to fix or replace it at no cost to you within a matter of hours or days. When you own your own home, there may be many unexpected repair and maintenance costs that you otherwise wouldn’t have if you were renting.
Another thing to consider is the potential to lose money on the house. While over time real estate has generally gone up in value, there are times when the real estate market stays relatively flat or declines. Depending on the costs associated with the sale and the actual amount you sell the house for, you could lose money.
Finally, buying a home is a long-term proposition. When you rent, you may only be bound to a month-to-month or annual lease, so picking up and moving can be done on relatively short notice. Once you buy a home, it isn’t as easy to pick up and move. You have a significant financial obligation, and the process of selling a home may take several months to complete.
So, when you are buying a home, take the time to understand the benefits and drawbacks, and make sure you are doing it for the right reasons.
Determine How Much Home You Can Afford
If you have decided that buying a home is right for you, the first step is to determine what you can afford. One of the common guidelines to use is the debt-to-income ratio. Most lenders suggest that your total debt-to-income ratio should not exceed 36%, and your mortgage debt alone should be less than 28% of your monthly income.
To calculate your debt-to-income ratio, first, add up your total monthly gross income. Once you have that figure, multiply it by 36%, or 0.36. This number is the maximum amount of monthly debt payments you should have, including your mortgage.
Next, add up all of your current monthly non-mortgage debt payments and subtract it from the previous total you just calculated. This number will give you an approximate maximum mortgage payment you can afford. Ideally, this amount should be 28% or less of your monthly income.
Even with these guidelines, it is important to remember that your situation will ultimately dictate what you can truly afford, so take all aspects of your situation into consideration.
Finding the Right Mortgage
After you have determined how much you can afford, it is time to shop for the right mortgage. Since you are likely to be financing a loan for hundreds of thousands of dollars, it is crucial that you make a smart decision. A bad mortgage can significantly affect your finances over time.
The good news is that there is a type of mortgage available for almost every situation. The bad news is that choosing the wrong one can cost you tens of thousands of dollars in interest over the term of the loan. The most common loans come in two styles: fixed and adjustable interest rate loans.
A fixed interest loan will provide stability for you. The interest rate won’t change for the life of the loan, so your payments remain stable. One benefit with a fixed rate loan is that if interest rates go up, you continue to pay your same lower rate. On the other hand, if rates go down, you may be paying more than the current rate, although it may be possible to refinance for a lower rate.
With an adjustable rate loan, you sacrifice some of the stability in payments for the ability of the mortgage to adjust with prevailing interest rates. When interest rates are going down, this can be to your benefit. But when rates are increasing, you can find yourself with a higher monthly payment.
The Down Payment
In addition to understanding what type of loan to look for, consider the down payment. In a traditional mortgage, you would provide a down payment of twenty percent or more of the price of the home. Twenty percent is the magic number because, for most lenders, this is the amount of equity they require so that you can avoid paying private mortgage insurance, or PMI.
When you are unable to put 20 percent down, the lender generally requires that you also pay the PMI premium, which can be anywhere from twenty dollars to a few hundred dollars each month. When shopping for a mortgage, consider this and ask if there are alternatives to paying PMI if you will be unable to come up with the full down payment.