Buying a home is supposed to be the American Dream, right? Most of us want to settle down and find a place we can call home, especially those of us with children.
But we learned in 2008 that buying a home can become a nightmare.
Fortunately, there are solid financial principles we can follow to avoid the type of disasters we experienced or watched our friends go through.
Make sure your career is established before buying a house or condo
Put your outdoor work in order and get your fields ready; after that, build your house. (Proverbs 24:27)
This is huge and probably the principle that gets most people in trouble. If you’ve recently started a business, you shouldn’t buy a house. If you’ve recently changed careers, you shouldn’t buy a house.
If you’re early in your career and still trying to figure out what you want to do, you shouldn’t buy a house. If you’re late in your career but still haven’t figured out what you want to do, you shouldn’t buy a house.
If you’ve just moved cities for a job, you probably shouldn’t buy a house. Bottom line, if you don’t feel like the next 7-10 years are fairly secure with your career and income, then you shouldn’t buy a house.
There is no need to rush this decision.
Yes, you may miss out on a great time to buy a house from an investment standpoint.
But, you won’t get stuck with a large mortgage and put yourself in the position of being a “motivated seller”. You won’t take a bath if the business or the job doesn’t work out. You won’t get stuck as a landlord because your home is underwater and you can’t afford to sell it.
There is no harm in renting. It gives you flexibility and options and it’s usually much cheaper than owning…at least in the short term. You don’t have to worry about HOA fees, property taxes, appliances breaking, water leaks, or natural disasters.
With renting, you don’t have the pressure of new furniture or renovations. You can get away with less space and the house doesn’t have to be perfect.
Don’t be afraid to wait until your career is where you want it to be before you make the major decision of buying a home.
Make sure you have an emergency fund in place before buying a home
You really want to have at least 3-6 months of living expenses in an emergency fund before you purchase a home. And you don’t want to use this money for a down payment either.
The last thing you want to do after taking on a large debt is to be in a place where you have no cash reserves. Inevitably, the air conditioner will break or you’ll decide you have to remodel the kitchen or whatever it is. If you don’t have an emergency fund in place, you’ll be looking at debt on top of debt!
Stick to a fixed rate amortizing mortgage ideally 15 years or less
There are really a few principles within this principle:
- Fixed rate mortgage – do not be tempted by the variable rate mortgages or ARMs. Yes, the rate might be lower today, but you risk paying a much higher rate over the life of the loan.
- Amortizing mortgage – if I can’t talk you out of a variable rate mortgage at least make sure it’s amortizing (meaning that you’re paying principal + interest) and not an interest only mortgage. The interest only mortgage will keep your life cheap today, but you will be stuck in debt and paying interest forever in this scenario. Cheap today = expensive tomorrow!
- 15-year mortgage – you’ve probably heard 30-year mortgages are the norm and you’re right. Financial institutions love these because you can “afford more house” and because you’ll be on the hook at a higher rate for 30 years. Even with a 4% rate, you may end up paying twice the purchase price of your home thanks to 30 years of interest payments. Ouch!
Put at least 20% of the purchase price down
Banks will require you to pay PMI (primary mortgage insurance) if you don’t put 20% down. This is just money you’re flushing down the toilet to reduce the bank’s risk of lending you money when they probably shouldn’t.
Be patient and save money until you can afford to put 20% down. You won’t have to waste money on PMI, you’ll be much less likely to get underwater when the next recession comes, and you’ll experience the joy of delayed gratification!
Make sure your total monthly payment with escrow is no greater than 25% of your take home pay
Yes, the bank will lend you a lot more money and your mortgage consultant and realtor will remind you of this. If you google typical ratios, you’ll find 28-36% of your pre-tax income is the norm.
However, you don’t want the norm. The norm is no margin and in debt for life. If you want to be able to save money, to be generous, and to provide a decent lifestyle for your family, then you simply can’t afford to go over 25% of your after-tax take home pay.
Just do some quick math. Let’s say you follow the bank’s advice and your mortgage payment is 30% of your pre-tax income. Then you pay 30% in taxes and benefits. You want to be a good steward so you give 10% and you save 10%.
That’s 80% of your income out the door before you even open your wallet, before you turn on the lights, before you eat, before you drive, before childcare, before education. Good luck with that!
Don’t increase the length of your loan after your first purchase
I’m probably getting to you too late with the third principle about the 15-year mortgage. Or you just won’t listen to me because you want a nicer house and can’t afford it unless you do a 30-year mortgage.
I get it and I’m not trying to shame you. It’s the norm and house prices have been inflated ever since it became the norm.
However, make sure you don’t start the 30-year process over. This is when you really get stuck in debt for a long time.
You might already be on your second, third or even fourth home purchase. And I’m guessing every time you started over with a new 30-year mortgage, right? And you probably bought a more expensive home each time too, didn’t you?
It’s ok. Again this is the norm. But make sure it stops now. Take advantage of low rates by refinancing into a 15-year mortgage today if this is you. Or at the very least, make sure you use a 15-year mortgage with your next purchase. Or at the very, very least, make sure you structure the length of your mortgage to end by your retirement date!
Let’s recap the 6 principles to make sure we’re on the same page:
- Make sure your career/income is stable before buying
- Save at least 3-6 months of living expenses before buying
- Finance your home with a 15 year fixed rate mortgage
- Put down at least 20% of the purchase price
- Keep your mortgage payment with escrow to 25% of your take home pay
- Don’t increase the length of your mortgage after your first purchase
You may be saying this is impossible. You may think you’ll never buy a house. But if you want to actually enjoy your home and have margin in your life, then you want to stick to these principles.
It might mean 10 years of diligent saving before you’re ready, but you’ll be in a position of financial strength. Your home and your mortgage won’t be a constant source of stress.
The mortgage payment is typically the highest monthly bill in your spending plan so be patient and make sure you get this one correct. If you do, the rest of your financial life will fall in place.