How do I know if a home is right for me?
- Understand the risks and benefits.
- Compare renting versus buying.
- Balance a home against other goals.
What are the all-in costs of home ownership?
Conventional wisdom may lead you to believe that the only costs of home ownership are the down payment and the monthly mortgage payment. However, if you budget with only these two factors in mind, you'll likely be caught off guard when the bills come rolling in.
Some additional costs to keep in mind:
Closing costs on a home
A typical home buyer pays around 2% of the cost of the home to obtain the loan and complete the real estate transaction. This amount goes towards things like an appraisal of the home value, attorney fees, title search fees, transfer taxes, prepaid taxes, insurance, and some required fees your lender might charge.
Interest payment
Monthly mortgage payments consist of two main components — the principal payment and the interest payment (although they can also sometimes include taxes and insurance). The principal payment goes towards paying down the debt, while the interest payment is what the lender charges to make the loan.
Property tax
Most local governments levy a tax on your real estate. The rate ranges significantly by state and county and is applied to the value of the home.
Insurance cost
A homeowner will on average pay about $180/month for insurance against property loss or damage. In regions that are more prone to natural disasters the average rate can be substantially higher.
Maintenance cost
Routine home maintenance and repairs will vary depending on where you buy a house and the age of that house, among other factors. Some experts recommend earmarking 1% of your home’s purchase price to address these costs as they arise.
HOA fees
Most homes aren’t part of a homeowner association (HOA), but about one third of homes nationally are. HOA fees range by location and dwelling type, but are $259 per month on average.
This cost breakdown is not meant to discourage you from exploring homeownership. Rather, this information should help you better anticipate the costs you can expect when you become a homeowner.
What if there's a market downturn?
Unfortunately, if the real estate market declines, so will the value of your home. On the other hand, if the real estate market rises, homeowners will benefit from the appreciation of their home value. Just like financial markets in general, the only sure thing in the real estate market is that it will go up and it will go down.
The market is unpredictable.
The impact of volatility in the real estate market is unavoidable, even if you’re not a homeowner. If you rent and the real estate market is on the rise, you can surely expect your rent to increase. But rent prices do not always increase one-to-one with home prices.
In the event of a downturn, if you have a fixed-rate mortgage your monthly mortgage payments should not be affected by any market volatility. However, you may be at risk if there’s a significant drop in real estate prices and you have a sudden need to sell your home, say for a job opportunity in a new location. In this case, you may be forced to sell your home at a loss. If the value of your home has decreased significantly, you may not have enough to repay the remaining balance on the mortgage. In general, the larger your down payment, the lower the risk that you face this particular issue.
Don't be discouraged by uncertainty.
It’s wise to understand what can potentially go wrong. But in the face of certain uncertainty, our home-buying philosophy is the same as our philosophy about investing: The risk of a downturn is a part of life. Having a long-term time horizon, staying the course, and not using too much leverage is your best path forward.
What are the benefits of owning your home?
Even if you don’t buy a home, you still need to pay something for lodging. For most people, this is in the form of monthly rent. When you buy a home and pay a mortgage, you’re actually saving into a permanent asset. Plus, you get automatic protection against rising rent costs.
Owning your home comes with a few potentially significant tax breaks. While you don’t get a tax deduction for paying rent, as a homeowner you can deduct the interest you pay on up to $750,000 of your mortgage balance and up to $40,000 in property taxes. When it comes time to sell your home, you can exclude capital gains up to $250,000 (or up to $500,000 if you file a joint tax return with your spouse).
The most significant benefits to owning your home are likely not financial. You want to buy a home because you want a place to call your own, a place that gives you freedom to live the life you want. Your reasons are often justifiably emotional, which is why the case for buying a home can’t simply be rationalized by a financial model.
How do I compare buying versus renting?
When it comes to home ownership, it's tempting to compare your monthly rent with your potential monthly mortgage. While this is a logical way to evaluate costs on a monthly basis, it actually ignores a number of significant considerations.
To make an accurate comparison between renting and owning, you should understand the full costs of homeownership. In addition to monthly mortgage payments, there are a number of additional monthly home expenses to consider, such as property taxes, insurance, and HOA fees. These other expenses can add significantly to your total monthly costs.
In order to be approved for a mortgage, you will need to make a down payment. Putting at least 20% down lets you avoid mortgage insurance, but there are loan options with as little as 3% down. The average first-time homebuyer puts about 9% down. In addition, the amount of down payment you make affects the terms of your mortgage.
While buying requires more upfront costs, you also own the house outright, albeit with debt from the mortgage. Over time, the monthly mortgage payments you make will start increasing your home equity. The money you pay on rent, on the other hand, is money you'll never get back.
How does a home fit in with my other goals?
The right home is one that still allows you to meet your other financial priorities with confidence. This means understanding how much home you can afford, and also having a clear sense of your other goals — both short and long term.
Before you start saving for a home, consider putting money towards paying down high interest loans. There are differing opinions about what constitutes a “high interest loan,” but as a rule of thumb, you might want to consider paying down loans with interest rates greater than 8%, such as credit card debt.
Next, consider contributing to your company-sponsored 401(k) if your employer offers a matching contribution. An employer match is basically free money, making it much more attractive to participate.
After you pay down debt and put money towards your 401(k), it's time to understand what your financial priorities are. Do you want to cover your children's college education costs in full? What about having a comfortable lifestyle in retirement? Do you need to buy a home sooner than later? Once you've decided the relative importance and timing of these priorities, you can then determine how much of your savings to allot to each goal.
The reality is you only have so much money to work with, so prioritizing one goal will have an impact on the others. To illustrate how to consider trade-offs, let’s walk through a very simplified example. Let’s say you’re deciding between buying a larger home that costs $800,000 or a more modest home that costs $500,000.
Example: The trade-off between home size and retirement lifestyle
Buy a $500K home
If you retire at age 65 and spend $7,500/month in retirement, you’re covered until age 95.
What's next?
A home purchase is both a major financial and life decision. Once you carefully weigh the costs and benefits of a home purchase, you can start to make decisions on the details — finding the perfect neighborhood, determining what size home you need, and figuring out your timeframe.