Buying vs renting
When you are determining if you should buy a home or rent one, there are a few things to consider.
If you don’t plan to stay in a home for at least five years, renting may be a better option. In five years, you may not have enough time to build equity in your home, and it may cost you more to sell your home than the home is worth. Selling a home requires fees and expenses that can eat up any equity you’ve built up and can even put you in a position where you own more than you receive from the sale of your home.
If you don’t have a down payment of at least 10% saved up, excluding your 10% emergency fund, then you will not only pay a higher interest rate, you’ll have to pay Private Mortgage Insurance (PMI); we’ll talk more about this in a moment.
Maintenance and associated expenses
In thinking about buying versus renting, you should also consider the level of interest you have regarding home maintenance and your ability to afford maintenance expenses. When you rent, often property maintenance is the responsibility of the landlord; when you own a home, it’s your responsibility. If you are considering home ownership, you should determine if you plan on being a home maintenance do-it-yourselfer or if you will hire someone to assist. In either case, you should have money set aside, in addition to your emergency savings, to cover these expenses.
THE HOUSING MARKET
Another factor to consider is the current housing market. The housing market can be defined as a buyers’ market, a sellers’ market or a neutral market.
Home buyers may be at an advantage in a buyer’s market. In this type of market there are more houses for sale than interested buyers. As a result, house values tend to drop, and buyers can have more control in asking the seller to make certain concessions.
Sellers may be at an advantage in a seller’s market. In this type of market, there are more buyers than houses available which positions the seller to not only command a higher asking price, but the seller also may find that buyers are willing to pay more than listing price and make other concessions, such as buying a home “as-is” or agreeing to make up any appraisal deficit by bringing cash to the closing.
In a neutral market, there is a relatively balanced number of sellers and buyers, placing each in an even position regarding the home buying/selling process.
How do you really know how much home you can afford?
Generally, it is suggested to budget 25% of your monthly take-home pay for a mortgage payment. For example, if your household take home pay is $8,000 after taxes and other deductions, you could afford a monthly mortgage payment of $2,000.
There are several online resources available at NerdWallet to help you understand what a mortgage payment could look like. As a rule of thumb, these resources provide an estimation of how much a home could cost you. When using these tools, it’s important to look at the variables used in the calculation, such as the interest rate, down payment amount, taxes and insurance. Additionally, you will want to take into consideration other expenses associated with owning a home, such as general maintenance and utilities.
Paying Private Mortgage Insurance (PMI)
When you purchase a home, a lender wants to know that you can afford your monthly payments and that you have equity in your home. Lenders have generally agreed that putting 20% of the purchase price down at closing, provides them assurance that you can afford the monthly mortgage payments. However, if you can’t come up with a 20% down payment, the lender is more at risk and requires additional protection should you default on paying your mortgage. So, they have you take out PMI which guarantees they’ll get paid should you default on your loan. This PMI amount is added to your monthly mortgage payment. Mortgage insurance rates typically range from 0.58% to 1.86% of the loan amount and depend on your credit score, loan-to-value (LTV) ratio, and debt-to-income (DTI) ratio.
The easiest way to avoid paying PMI is to pay at least 20% of the purchase price of your home as a down payment. If you don’t, you’ll continue to pay PMI until you have 80% equity in your home. There may be options for Lender-Paid PMI and special loan programs that don’t require PMI. Check with your real estate agent and lender to discuss possible options.
Home buyer programs
If you are buying a home, there are a handful of programs that are designed to help certain individuals. Here are some of the most common.
Insured by the Federal Housing Administration, FHA loans are designed for first-time homebuyers and typically come with smaller down payment and lower credit score requirements than most conventional loans.
The U.S. Department of Agriculture, or USDA, guarantees loans for some rural homes and are geared toward low to moderate income earners. With these loans, borrowers can get up to 100% financing. This doesn’t mean you have to buy a farm or raise livestock, but you do have to buy a home in a USDA-eligible area.
Qualified U.S. military members (active duty, veterans and eligible family members) can apply for loans backed by the U.S. Department of Veterans Affairs (VA). Other VA loan perks include no minimum credit score or mortgage insurance requirements.
Saving for a down payment
Deciding to purchase a home comes with planning and preparation. After you’ve built your 10% emergency fund, determine how much home you can afford. Again, it is generally recommended that a monthly payment not exceed 25% of your take home pay. If, for example, you can afford a $300,000 home, then you’ll need to come up with $60,000 for a 20% down payment to avoid paying PMI. Some home buyers find it easier to save less than 20% and then pay the PMI. Note that most lenders require a minimum of a 5% down payment.
After you decide how much you need for a down payment, you may consider the following steps:
Look at your budget and determine how much you can realistically afford to save each month to put toward your savings goal. It is important to treat this amount as a line item, like an expense, on your monthly spending plan to ensure you are setting these funds aside each month.
After determining how much you may need for a down payment and how much you can set aside each month toward this goal, you should evaluate the timeframe in which plan to purchase a home. If the amount you are putting away each month does not align with the timeframe in which you would like to buy a home, you may need to revisit your budget and either temporarily cut back on expenses, look at ways to increase your income or extend the timeframe in which you purchase a home.
Review your credit score. While this is not directly related to your down payment, improving your credit score can impact what a mortgage will cost you. Those with better credit scores tend to secure mortgages with lower interest rates. While you are saving for a down payment, look at ways to improve your credit score. For example, pay down debt and don’t take on new debt leading up to the time you wish to apply for a mortgage.
Buying a second home or rental
If you’re at the point in your life where you are considering purchasing a second home or a rental home, it’s important to understand the tax perspective. If you purchase a second home and are interested in renting it out, note that as long you live in your rental home for more than 14 days out of the year, it’s considered a second home which will provide the tax advantages of owning that home. If you choose to rent the home, you must pay taxes on any rental income, provided it’s rented out for more than 14 days. For more information on how taxation works, consult your financial or tax professional.
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