Home Buying Tips from a Financial Planner
“How much can I spend?” is a common question asked when buying a home. For Eric Roberge, CFP of Beyond Your Hammock, this is the top financial priority for many of his clients. Roberge specializes in helping 30- to 40-year-old professionals manage their finances, and a popular goal for this age range is buying a home. To guide buyers in their home search and prepare their finances for a purchase, Roberge offers two main tips.
1) Limit your housing costs to 20% of your gross income
When shopping for your dream home, it’s important to look at more than just the price tag. Though a sales price can give you a good estimate on how much a home will cost, it doesn’t give you the full picture. To determine how much a home will really cost, you need to look at all the components of your monthly payment including the principal, interest, taxes, and insurance, or PITI.
Your principal payment is essentially the purchase price of your home. If you purchased your home for $350,000, that’s your principal payment. After a 20%* down payment, your principal would be $280,000. Only a fraction of your monthly payment goes toward your principal. In the beginning of your loan term, this fraction is notably smaller and will increase over time.
Interest payments aren’t included in your purchase price. Interest is the cost of borrowing money from your lender. If you put 20%* down on a $350,000 home and got a 3.5% interest rate, your total interest over 30 years would be $172,637. This makes the total cost of your home $522,637 (excluding taxes and insurance).
Taxes refer to the property taxes you will be required to pay as a homeowner. Eventually, they help fund libraries, public schools, and other community development projects that improve the home values in your neighborhood. The cost of your property tax depends on different factors including your city or county’s tax rate and the property’s size. Normally you can expect to pay around 1% of your home’s value for your annual property tax. For a $350,000 house, you could pay about $3,500 in taxes per year. If you include your taxes in your monthly payment, it would be about $292 per month.
There are two types of insurance that are included in your monthly mortgage payments – homeowners insurance and mortgage insurance. You can calculate a rough annual estimate by paying $3 for every $1,000 of your home’s value. That would be around $1,050 for a $350,000 home. Mortgage insurance can be slightly more expensive, ranging from 0.5 to 1% (of your loan amount) annually.
Though Roberge recommends you limit your housing costs to 20% of your gross income, others say that it is fine if your PITI takes up to 30% of your gross income. To calculate your PITI, you add up the various monthly costs (principal payments, interest payments, property taxes, and insurance). Let’s say you are applying for a 30-year fixed-rate loan with a 3.5% interest rate on a $350,000 home. According to our calculator, your first month’s principal payment would be $551. Your interest would be $1,021. If your annual property tax was $3,500, then your monthly payment would be $292. If your homeowners insurance is $1,050, then your monthly payment would be $88. With a 0.75% annual mortgage insurance fee, your monthly mortgage insurance would cost $219. To calculate your total PITI, you would add these together to equal $2,169.
If you earn $8,000 a month, then your PITI would take up about 27% of your monthly income.
2) Save 25% of your gross income for long-term investments
Roberge offers this tip to all his clients – whether buying a home or not. Long-term investments refer to retirement accounts or investment accounts. By prioritizing your long-term investments, you can better determine how much you have to spend on other expenditures like a house. Though buying a house is an important investment, it isn’t worth it to risk your retirement savings over.
If your monthly income is $8,000, you should strive to save around $2,000 for long-term investments, according to Roberge’s rule. However, there are other savings recommendations say that 20% is a good target as well. Additionally, if you high interest debt, like credit card debt, you should prioritize paying that off first. According to the 50/30/20 budget rule (widely popularized by Senator Elizabeth Warren), you should allocate 50% of your post-tax income for needs (like mortgage payments, food, etc.), 30% towards wants (clothes, entertainment, etc.), and 20% towards savings. Many financial experts recommend that you save at least three months of emergency savings and then focus the rest on investments and retirement accounts.
Buying a house will likely be one of the biggest investments of your life. It’s important to thoroughly assess your finances before buying a home. It’s also crucial that you understand all the costs involved. This way, you can get a better idea of how much home you can actually afford. If you would like more help determining how much you can spend on a house, let us know.
*Conventional Payment example: If you choose a $250,000, 30 year loan at a fixed rate of 3.3% (APR 3.5%), with a loan-to-value of 80%, you would make 360 payments of $1,122.61. Payment stated does not include taxes and insurance, which will result in a higher payment.
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