Financial Checklist: make sure you can afford your new home.
We’re Bursting at the Seams!
Recently, I had two very similar conversations with two different households. Here’s what they said (paraphrasing a bit here!):
Client Family 1: We have to move. We bought our home a few years back, but now we have kids and a dog. Stuff is underfoot everywhere. We’re bursting at the seams! But we don’t want to give up our current low interest rate, and we’re worried about higher interest rates affecting what we can afford. Can you help?
Client Family 2: We are getting older and our home doesn’t work for us anymore. There are too many stairs, and we trip on the carpet as we walk into the living room. But we’re worried about whether we can afford a home payment when we’ve gotten used to our house being paid off. Can you help?
Although in very different life stages, both of these families came to me asking if they could afford to move into a new home. Here are some things for you to consider if you are wondering whether you can afford to buy a new home.
Higher – or Lower – Interest Rates
Interest rates have risen since their lows around 2020, and that makes the monthly amount you pay on a mortgage much more expensive. Added to that, home prices in many parts of the country over the last couple years haven’t declined as much as you would think due to higher rates – and in fact some markets prices are still going up.
Here’s an example: Say you buy a $600,000 home and put 20% down, or $120,000. You’ll borrow $480,000.
According to the St Louis Fed, average 30 year mortgage rates as of 1/11/2024 are 6.66%. With a 30 year loan, that’s a monthly mortgage payment of $3,085. The total amount of interest you pay over the life of the loan is $630,459 without any early payments. (This only includes principal and interest, not other common costs like property taxes, homeowners insurance, or homeowners association fees.)
In comparison, what if rates went down to 5%? The same loan would now have a monthly mortgage payment of $2,577. The amount of interest paid over the life of this loan is $447,628.
Interest rates make a big difference in the cost of your mortgage. So it’s no wonder that folks don’t want to give up the 2 or 3% interest loan they got back in 2020.
What’s interesting about this though, is that the mortgage rate range we are in now is a lot more “normal” than a 2% mortgage rate. Here’s a chart showing mortgage interest rates going back to 1971 from the St Louis Federal Reserve. Given this, it doesn’t seem like it would be a good strategy for a potential homebuyer to wait on the sidelines until rates go back down to 2%. They might be waiting a long, long time.
So if you shouldn’t wait for rates to come down, what should you do?
Use Your Capital by Putting More Down or Making Extra Payments
One strategy to make your new home more affordable is to put more money down. We tend to think of putting down a payment of 20% when we make a home purchase. However, if you own a home today, it’s possible that your home has appreciated since you bought it. Perhaps the sale of that home would result in enough cash to put more than 20% down on your next home. Alternatively, can you save extra from your cashflow towards your down payment? If you plan to move in about a year, how much extra cash can you accumulate by setting up automatic savings towards a down payment fund?
Once you purchase the home, you have the ability to make extra principal payments. This can significantly lower the total cost you pay in interest over the life of the loan. Consider the example above, of the $480,000 loan at 6.66%. If you were able to make $200 in extra principal payments each month, you would pay $508,900 in interest over the life of the loan, a savings of $121,500, and you’d shave off about 5 years from your 30 year term.
How Much Home Can You Afford?
Here I’d like to talk for a moment about rules of thumb, or benchmarks. Rules of thumb can be helpful in financial planning to give us a place to start, but they aren’t so helpful in the particular – because your personal situation is different. Everyone’s is! That’s why these posts are not intended to be personal financial advice.
However, let’s use some basic rules of thumb as a benchmark here. An income statement shows general categories where you spend your income. Here’s a benchmark income statement showing gross pay allocated by spend.
According to The American College of Financial Service, benchmarks indicate basic housing costs should be less than 28% of your gross income. Basic housing costs include mortgage or rent payments, property taxes and insurance; but they do not include utilities or home maintenance.
So, back to my example earlier, the $600,000 home, 20% down, $480,000 loan amount. Let’s assume 2% property taxes or $12,000 per year, and $3,000 homeowners insurance, adding another $1,250 to your monthly payments.
- With 6.66% mortgage interest, basic housing payment = $4,335 >> your gross income should be over $186,000
- With 5% mortgage interest, basic housing payment = $3,827 >> your gross income should be over $164,000
Be careful of these benchmarks, however, because there are a few other factors that trip folks up when they think about how much house they can afford:
- Closing Costs: For a buyer in Chicago, closing costs can be 2% of the purchase price. For a seller, they can be 7%. With our $600,000 home, that’s $12,000 for the buyer and $42,000 for the seller. Ask your realtor or mortgage broker to provide you a breakdown of closing costs for your specific situation.
- Moving Costs: Moving costs can really add up, especially when you include all the things you need to do to the home before you move in, such as painting, replacing flooring, making small repairs not done by the previous owners. Do you have enough cash on hand to cover these costs in addition to closing costs?
- Home Repair, Maintenance and Improvement: A bigger home can result in bigger maintenance and repair costs. For a single family home, expect to spend 1-3% of the home value in annual maintenance costs. For our $600,000 home, that’s $6,000-18,000 per year. And this doesn’t count any big home improvement projects, like moving a wall or improving a bathroom.
- Inflation: I’ve heard from many, many clients over the past couple years that they aren’t doing anything differently, but their lives cost more these days. That’s inflation! According to the US Bureau of Labor Statistics, from November 2022 to November 2023, inflation was 3.1%. Can your income accommodate an extra 3% to “Live on” while still affording your proposed home payments?
- Childcare or Education Costs: The benchmark spend above assumes that all your day to day regular expenses are 37% of your gross income. If you pay childcare costs or private school tuition, be sure to factor this in. Some of my clients pay $2,500 per month on childcare. Private school tuition can cost $16-32,000 per year. These are costs for one child!
- Other Debt: Do you have other debt, such as credit card debt, a car payment, or student loans? The above benchmarks assume no other debt. If you have other debt, the home loan amount you qualify for could be lower than these benchmarks.
A Few Last Thoughts
You may qualify for much more in a loan amount than the numbers shown above. That doesn’t mean you should use the full amount that you qualify for! Don’t let the large amount you qualify for sway you to look at more expensive homes if you really don’t think you can afford it.
Get on the same page with your spouse or partner. I’ve seen situations where one partner felt some concern but let the other partner proceed, only to find they were in over their heads. Keep the lines of communication open between you both.
Would waiting another year or two make more sense? Although you may feel desperate to move right now, perhaps in 2 years your youngest child will be in public school and you’ll no longer have that expensive daycare cost. Is your child ready for high school? Chicago high school applications can be a whole different challenge depending on where you live and your child’s individual needs. Maybe it’s worth looking ahead a couple years to see what might be coming in your life that would impact your home choice.
On the flip side, are you close to retirement? It might make sense to apply for a mortgage and move now, while you still have income from your job to qualify for a loan. Be careful here though, that these home payments will also be affordable once you’re in the retirement years and drawing down your savings instead of accumulating.
Still unsure about your situation? Consult with an expert. Talk to a real estate agent. Reach out to a mortgage broker. These professionals are not exactly neutral parties, but they have experience and knowledge about real estate that you don’t have. Learn from their experience.
And don’t forget to talk to your financial advisor. They know your personal financial situation and can assist in acting as your Financial Planning Thinking Partner to help you make one of the biggest financial decisions of your life.
Don’t have a financial advisor, and thinking about buying a home? Reach out to see if we may be a fit for working together.