Buying a house is an essential part of the American Dream. A home is not only a great investment, but it also provides vital safety and shelter for us and our families. However, while buying a home or condominium is exhilarating, it might not be in your best interest financially. Buying a home is a huge financial transaction and involves decisions that need careful consideration and thorough planning. There are three important tests that will help you determine whether you can really afford a house: the housing ratio, debt obligation ratio and down payment percentage.
Take Alan, a marketing manager for a large company, as a perfect example. Alan plans to eventually have a family and wants to move out of his apartment and get settled into a home. He consulted a financial planner to assist in answering his question, “Can I afford a house?” To help Alan realize his goal of homeownership, the financial planner crunched some numbers using the three calculations listed above. Here are the results.
Housing Ratio
30% of gross monthly income
The housing ratio is the percentage of your gross monthly income that will be devoted to housing expenses when you are living in your new house. There are many hidden costs when it comes to homeownership, including utilities, repairs, maintenance, and insurance. It’s important to prepare a budget for these expenses before you move into your new home.
Financial experts recommend this prepared budget number to be 30%, plus or minus a few percentage points. To calculate this number you can take your gross income and multiply by .30. This number should be the total annual amount to be allocated for housing expenses. When Alan asked, “can I afford a house?” the financial planner used his gross income of $85,000 and multiplied it by .30, then divided the sum by 12 for the number of months to come up with $2,125. Therefore, Alan can afford a mortgage payment of just over $2,000 including insurance costs and other fees.
Total debt obligation ratio
No more than 36% of gross monthly income
The total debt obligation ratio is the percentage of your income that covers housing expenses and other obligations such as credit cards or car loan payments. Financial experts recommend that this number not exceed 36%.
Luckily for Alan, he has already paid down all of his debt, including his car payments. Alan currently drives a used car and plans to keep it for several more years. He also has an emergency fund stored in his checking account at the local bank to protect him in case of unforeseen expenses.
Down payment percentage
20% of full mortgage
The down payment on a house is one of the biggest hurdles for new homeowners to get past. Buying a home requires having a large lump sum of money saved to put down on the mortgage. Several years ago, a mortgage could be taken out with as little as 5-10% of the total price used as a down payment. Currently, 20% down is almost all but required to secure a mortgage. If you put down less than 20%, you will have to pay PMI, also known as private mortgage insurance.
Alan’s budget for his new house is around $300,000. Using money he stashed in a savings account, he can put 20% down, which amounts to $60,000. Alan will then be financing $240,000 at an interest rate of 6% for a period of 30 years. Using these hypothetical numbers, his monthly payment will be roughly $1,438.92, which is well within his budget.
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Plan for the future
There are many things to consider before taking the plunge into homeownership. When you find yourself asking the question, “Can I afford a house?” these are the key points to keep in mind. First, do your goals and future plans align with the decision? Next, can you afford the mortgage payment on your new humble abode? And lastly, should you rent instead of buying a house?
Each person’s goals and future plans are very different. Certain jobs, like those of business consultants, require moving to different locations throughout the year. Other jobs, like those of lawyers, mean you can stay in one city for years without worrying about having to relocate. It’s important to focus on your time horizon when making any investment. If you reasonably plan to be in the same location for at least five years, then buying is an option. However, if there is a chance you might be leaving in the near future, then renting would be a safer bet.
Luckily for the Alan, he plans to stay in one location for a minimum of 10 years. This satisfies the time horizon requirement on the list of questions for a potential home buyer. Furthermore, although the home will probably prove to be a good investment in the long run, it is not intended to be used solely for investment purposes. As a result, his decision is not purely a financial one. Alan plans to eventually start a family in his new home, and the memories from that may outweigh any downside risk of depreciation in the short term.
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Overall, homeownership isn’t for everyone. There is no shame in renting until you can save up enough money to put 20% of the price of the home toward a down payment, pay off all your debt and earn a high enough gross income to continue to pay the mortgage.
courtesy askmen