The purchase of a home is one of the most important financial decisions you will make. When making a home purchase decision, you have to work hard to avoid letting your emotions and global economic conditions call the shots. Nobody can predict with any consistent long-term accuracy exactly what is coming around the corner for our nation’s economy or for the housing market. That is why it is essential that you examine your own personal financial life plans when making any major purchases.
Here are some important guidelines you can use to avoid making a major mistake during the home buying process:
Create a revised spending plan prior to stepping foot into a home you are considering purchasing. It’s one thing to put a budget in writing. However, living and experiencing the reality of a spending plan is what matters the most.
If you plan on taking on a new mortgage payment (or any loan for that matter), it is strongly recommended that you get used to that payment as early as possible. Make the new payment a part of your life and go ahead and adjust your budget to make sure it fits. Create a personal spending plan that factors in your future mortgage payments PLUS insurance, taxes, HOA dues, and maintenance expenses.
For example, if your rent is $1,000 per month and you are expecting to make payments on a $1,500 mortgage in the near future, you should go ahead and automatically shift the difference into savings each month to prepare yourself financially and psychologically for the coming change. You can also use home searching sites like Zillow to get an estimate of utilities, insurance, and taxes on the new property. This information will help you obtain a true estimate of how homeownership will impact your bottom line. Of course, it’s also the good old fashioned concept of “paying yourself first” as you can use the money to build up your savings for a down payment or closing costs.
Action Step: Create a personal spending plan using a simple worksheet, online software programs such as Mint, or the old school paper and pencil method. Factor in any changes in overall expenses and begin saving the difference through an automatic process of direct deposit or ACH transfers.
If you have to completely drain your emergency savings to purchase a home, you are not ready to own. This is one of the biggest mistakes eager homeowners can make setting the stage for future financial stress. The excitement of finding that home and the sense of urgency to take advantage of low interest rates, rising optimism, and a strong desire to own can lead to impulsive decisions.
It has widely been reported that the average American does not have an adequate emergency savings fund. Financial Finesse released a financial stress report that indicated only about half of employees in the workplace reported having any emergency savings. Bankrate found that 29% of Americans have no savings.
Without a rainy day fund, homeowners are more vulnerable when things simply don’t happen according to plan. This is why it is a financial planning best practice to avoid the temptation to raid an emergency fund to make a down payment on a home. It is also important to keep the savings for a down payment and the emergency fund in separate accounts.
Action Step: Prioritize building an emergency fund ahead of a down payment on a home. How much should be kept for emergencies? Anywhere from 3-6 months of basic living expenses is the general rule these days.
Assess the importance of having a little flexibility in your financial life. Take some time to seriously examine your career path and other life goals. When you frame the home buying decision in the grand scheme of your overall life plans, the process can add some clarity. But in the so-called “real world” that is full of uncertainties and known unknowns (see what I did there) it can be difficult to predict our next challenge in life.
Deciding where to set down roots and create your nest can have a major impact on future life decisions. Generally speaking, buying tends to outperform renting in the long run. However, if your lifestyle and life plans require flexibility, renting may not be so bad after all. Most financial planners advise staying in a home at least 5-7 years to offset borrowing and closing costs as well as the risks of having to sell the home in a down market. Consider renting if you have an unstable work situation or simply don’t plan on staying at a residence too long since this option will give you more short-term options and flexibility.
Action Step: Use a Buy vs. Rent calculator to estimate how long it will take to break even on the purchase of a home.
Never rely on a lender’s formula to determine how much house you can afford. The most ineffective way to approach the home buying process is to go in with tunnel vision and only focus on the maximum monthly payment you can afford. The general rule when home shopping is to keep your debt-to-income ratio at 36% or lower. This figure is often referred to as the “back-end-ratio” and compares monthly housing payments and all other debt obligations to total monthly income.
These days, some lenders may allow debt-to-income ratios as high as 45%. But this doesn’t mean you should necessarily use a 36% debt-to-income ratio as your goal. Focus on your other financial life goals (e.g., saving for retirement, paying off student loans) and stick with what works for you rather than some financial institution’s risk parameters.
Action Step: You can use this Debt-to-Income calculator to determine your projected debt-to-income ratio if you are trying to determine how much home you can afford.
Do not significantly drain your retirement plans and IRAs in order to make a down payment. Just because the IRS permits penalty-free withdrawals does not mean that it is always the best route to take to raise funds for a down payment. Withdrawals from an IRA can be made penalty free up to $10,000 if you haven’t owned a home during the past 2 years. But this does not mean these withdrawals are tax-free because they are still subject to federal and state income taxes. (Note: One exception to this rule is if it’s a distribution of contributions from a Roth IRA as these withdrawals can be made tax and penalty-free as long as you don’t touch the earnings).
The biggest downside of taking money out of any retirement plan is that your retirement nest egg just got a setback. Run a basic retirement calculation to estimate the potential impact of draining retirement savings. If you are still on track for this long-term goal, the impact may not appear significant at first but the longer you keep money invested the greater the potential growth. Also, you don’t want to get into the habit of viewing your retirement accounts as an ATM machine for short-term goals.
Action Step: Use the home-buying process as an opportunity to see if you are on track for retirement by running a basic retirement calculator.
Another potential area of vulnerability is related to the use of 401(k) loans. Many of these retirement plans have loan provisions that allow you to access 50% of the account balance up to $50,000. This may sound like a great option because it’s your money, right?
However, when you factor in the opportunity cost of that money no longer staying invested, this short-term fix may not seem so appealing. Also, you may be subject to taxes and penalties on any unpaid balance if you leave your employer before a retirement loan is paid and you are unable to pay off the loan in full 60 days after you leave your employer. In summary, 401(k) loans are risky and should be viewed as a last resort.
Action Step: Check to see if your retirement plan allows for repayment of retirement plan loans if you are no longer with the company.
Perhaps the biggest challenge when deciding whether or not now is the right time to buy a home is to keep your emotions in check and focus on your overall financial plan. It is easy to get tunnel vision when you are working hard to reach any goal in life. Sometimes it is helpful to take time to re-assess your priorities and get some outside guidance from an unbiased financial coach or trusted advisor.
This is the final but most crucial mistake to avoid because when our emotions and money matters get mixed together, this volatile affair can be extremely costly. But it is human nature that they will be present during this important financial decision so keep them in check with a financial plan and make sure your financial plan is in place before you ramp up the search. Otherwise, you may later deal with negative emotions such as regret.
Action Step: Complete a thorough financial check-up prior to signing on the dotted line to buy a home.
For many people, buying a home is the single biggest financial decision they’ll ever make. A good choice can end up being your most valuable asset while a bad one can leave you in the poor house. Regardless of what you choose, make sure it’s an educated one.