A home purchase can be the most expense purchase you’ve ever made, which may feel pretty daunting. Are you planning to buy a home in the next year or so? Here are some tips.
Home Ownership Benefits
In addition to gaining control over your living space, and not being at the whim of a landlord, there are many potential financial benefits of owning a home.
- Stabilized housing costs. A fixed rate mortgage allows your monthly home payment to remain flat over time (with some variance for real estate taxes). When your income goes up over time, you can lower the percent of your income that goes towards housing, allowing you to allocate the funds elsewhere.
- Forced savings tool. Accumulating home principal through monthly mortgage payments can help build a nest egg or give you more financial flexibility.
- Tax benefit. You may qualify for mortgage interest tax write offs. Also, when you sell, if you meet certain criteria, you may avoid the capital gains tax on any gains.
Real Estate Appreciation – Home vs Investment
Real estate may experience some appreciation in value, however don’t make a home purchase expecting appreciation to substantially outpace inflation.
For example, per this calculator, a home purchased in the Chicago area in Q1 2022 would have appreciated 2.8% by Q1 2023. Contrast this with inflation: for the 12 months ended March 2023, per bls.gov the Consumer Price Index Urban Consumers increased 5%.
Also, you have to live somewhere – so is your home going to be considered an “investment” that you would sell when it appreciates to a specific amount, regardless of whether you want to move? Or is it going to be considered a “home” that you will stay in as long as it’s comfortable for your family, regardless of how much the value has appreciated or depreciated over time?
Monthly Payments – what’s included?
Check with your mortgage broker on what’s included in your potential mortgage. There are typically several components of a monthly payment:
- Principal: this is the amount you borrowed that you have to pay back. If you took a loan for $400,000, each month you’ll pay a small amount of that $400,000 back. You can pay extra principal at any time, helping you pay off your mortgage faster.
- Mortgage Interest: this is the interest you pay to the lender based on the amount of the loan.
- PMI: This is private mortgage insurance, and insures the lender against you defaulting on the loan. This is not a benefit to you. It’s charged when you put down less than 20% in a down payment. You don’t get this money back.
- Property Taxes: The lender wants to make sure your property taxes are paid, otherwise your property could be seized by the county for unpaid taxes. So, the lender often pays the property taxes for you, charging you an amount each month to go into an “escrow account” where it will sit until the lender uses it to pay your property taxes. The amount you pay to the escrow each month will change every year or so as your property tax amount changes. If you overpaid into the escrow, the lender is obligated to give you a refund.
- Homeowners Insurance: Similar to property taxes, the lender wants to make sure your home is insured against catastrophes. So the lender sometimes pays your homeowners insurance for you, charging you an amount each month to go into an escrow account until the lender pays your insurance. Be sure you know whether this is included in your mortgage payment, because if it’s not, you still need insurance!
Financing with a Mortgage
Speaking of mortgages, what are they and how do they work? It’s simply too difficult for most buyers to accumulate enough cash to buy a home with all cash.
Instead, most buyers will finance their purchase with a mortgage. The buyer brings a certain amount of cash to the closing, often 20% of the purchase price. The other 80% of the home purchase is financed with a mortgage. Essentially this means the lender owns 80% of your home, and you must pay back this loan over time with a set amount of interest.
Back when mortgage rates were 2-3%, many homeowners chose a 30 year fixed rate mortgage. This means that the mortgage interest rate of, say 3%, was “fixed” for the life of the loan. In this case, the life of the loan was 30 years.
Adjustable Rate Mortgages
With the rise in interest rates over the past few years, alternative financing options have arisen that haven’t been popular for many years. One example is an ARM – adjustable rate mortgage – such as a 5/1 ARM. This type of mortgage has a fixed rate for a specified number of years like 5 years. Then, in the 6th year, the rate adjusts to a new rate based on interest rates at that time, and it adjusts again every year subsequently. For the first 5 years of the loan, the rate is typically lower than what you could get for a 30 year term, fixed rate loan.
The problem with these loans is that you as the borrower are taking on a large risk in that 6th and future years – what will rates be at that time? How will your monthly payment adjust? Will you still be able to afford to pay it?
This risk is a big reason why most borrowers taking a loan like this will refinance or sell their home before the ARM ends. An ARM loan can be good for a borrower who expects to move before the ARM expires, or who expects that interest rates will fall before the ARM expires.
30 Year Term Flexibility
The term of the mortgage is how long you will have to pay off the mortgage. Common terms are 15 or 30 year term mortgages. The interest rate on a 30 year mortgage might be higher than interest rates on a 15 year mortgage. A 30 year mortgage typically has a lower monthly payment, since you have longer to pay it off.
A 30 year term can offer some flexibility though. For example if you lose your job or struggle financially, having a lower mortgage payment can make the loan more affordable. On the flip side, if you have extra cash, you can make an extra principal-only payment to the mortgage, which will ultimately help you pay off the loan faster and pay less interest.
Your Credit Score Impacts Your Rate
Your credit score impacts the interest rate you receive from a lender. Have good credit? It can pay off with lower interest rates, saving you a significant amount of interest over the term of the mortgage. If you’re in the early stages of a home purchase journey, now is a great time to check your credit report, don’t miss any monthly payments, and don’t accumulate other debt. Think of this as early “house cleaning” for your credit.
Saving for a Down Payment
How to accumulate the cash needed for a down payment? For many first time buyers, the process can take years. For many clients, I recommend setting up automatic savings each month. On each pay period, set up an automatic funds transfer of a set amount to go towards your Down Payment savings. This way, you don’t have a chance to spend the Down Payment money since it already moved out of your bank account. Also: apply any “found” money towards Down Payment savings instead of spending. Found money might be a bonus, tax refund, or cash gift from a relative.
Where to save? There are several possibilities. A high yield savings account is a good choice for many. Look at rates offered by credit unions or online banks, as they tend to have higher rates than your local bank. You could also open a brokerage investment account, and invest the funds in a short term cash reserve portfolio with expected higher returns than online savings banks. But beware: don’t go chasing returns with high risk investments – the risk is not worth the potential volatility of your money not being there when you’re ready to buy your home.
Are you considering buying a home in the near future? Let’s talk about how you can prepare for one of the biggest financial decisions of your life.