Ah yes…the dream of homeownership.
Oh to be the lord of the white picket fence, front and back yard and all that comes between it. This is a standard dream that many Americans routinely have. Even after an intense housing and sub-prime lending crash that resulted in millions of foreclosed homes and billions of dollars in lost home equity. Home ownership was at a high then, just over 69%, and fell steadily before settling at the long-term average of 65%.
You have to admire the resilience.
So in the interest of making smart financial decisions, here is a guide to understanding exactly how much house you can afford. (You could also check out this awesome three part course for further information on how mortgages work).
The cost of a house is relative.
One thing that’s important to understand is that you can always find a more expensive home. You might be able to run down to Detroit and pick up some dilapidated shacks on the cheap or fly over to Bel-Air and drop a couple million dollars on a McMansion with a heated Jacuzzi and a parking spot for your Gulf Stream jet.
Like time, it’s all relative. A bad house in a good neighbourhood may be more expensive than a good house in a bad neighbourhood.
So with that in mind, don’t go chasing after the gold at the end of the rainbow. There’s always another, nicer-looking, better-located house in the metaphorical distance.
Think about any large purchase you might make. For example: a car. There’s actually a lot of similarities to buying a car when it comes to buying a house. What do you do when you buy a car? You have to decide to either pay it off all at once (unlikely for most of us) or you save up, make a deposit and then finance the rest. Data from the National Association of Realtors tells us that 87% of home buyers used mortgage financing for their purchase.
How much should that deposit be?
Well, it’s not as easy as saying, “I earn $X a year and so I can afford Y%”. Ideally, you’d like to make the biggest down payment you can make but there are things to consider, like the interest rate on your mortgage loan.
You may hear that the typical down payment is about 20% of the total property value. That’s actually pretty high and if you can manage the full 20% then good for you. The average down payment for first time buyers ranges between 5 and 10%. Take note that anything below a 20% down payment tends to make lenders ask for mortgage insurance, which is just another cost to bear. During the years before the subprime lending crisis mortgage insurance was actually ignored in many cases, and full 100% financing (0% down) became available. You can see why this is not the best idea.
Ultimately, if you can handle a higher down payment, do it. It means a cheaper mortgage for you.
Over the length of a 25 year mortgage, small differences in interest rates can add up to big savings. On a $350,000 principal and a 4% mortgage rate you can expect to pay $202,301 in interest payments. A 1% reduction in your interest rate nets you a savings of nearly $60,000!
Now, say you’ve found your dream home. A beautiful 3 bedroom, 2 bath house with a pool in the back yard and an ample and roomy kitchen with fantastic cabinets. The crown moulding is to die for. Crown moulding you guys!
It lists for $400,000. 20% of that is $80,000 so that’s what you should save up before you buy, right?
What are the (hidden) costs of a house?
There are a number of costs associated with buying a house and a lot of them are borne in the first year.
If you are not having the house built from scratch, then you would want a home inspection performed to determine if there are any issues. Are there termites? Will your house collapse under your feet? This will cost you $300-500.
Your lender will order an appraisal, or a rendering of the value of the property. The bank or credit union that’s giving you the money wants to make sure that the home you are buying is worth the money you say it is and that everything lines up. This will put you back another $300-500.
A survey that indicates the boundaries and measurements of the land and positions of major structures, or encroachments (like a neighbour’s tree hanging over into your side of the yard) on the property. Approximate cost: $600-1000
This may be paid for by the seller but nonetheless be prepared to pay closing costs. This is just a name for miscellaneous fees that you can be responsible for. Title transfer fees, a fee to transfer the deed and title for the house in your name, land transfer taxes and basically any other type of fee can be lumped into “closing costs”. Expect this to add up to a few thousand dollars.
So there you have it. It seems that the only certainty in life is that there are hidden costs to everything. And we haven’t even talked about the property taxes that you’ll have to pay every year, not to mention the numerous costs of regular home maintenance and upkeep.
It’s no wonder then that Millennials are, en masse, buying fewer homes.
Between 1980 and 2000 the number of late twenty-somethings owning homes declined from 43% to 38%. If you think about it, a home isn’t really a good investment. Many people buy a home thinking, “well at least the value of my home will go up”.
It’s just not true. When you consider inflation and include all the associated taxes and maintenance costs most home owners will lose money over the lifetime of their “investment”. Also most people are blissfully naïve as to how long they will stay in their home. The average homeowner changes their house after just 7 years.
A house is not an investment. If you must have one, make sure you read all the fine print.
To learn more, head over to Wall Street Survivor.