Let’s start with the bad news: Houses are outrageously expensive. So the generic answer of how much money you need is “a lot.” But you already knew that.
How much do you actually need to save before buying a house?
I’m going to make the case for 26% of the purchase price plus about $10,000. That might sound unreasonable, but I’m going to defend it below. It’s also important to remember that home ownership is expensive and that there’s nothing wrong with renting.
The Case For a 20% Down Payment
You don’t need to put 20% down these days. In many cases it’s possible to get a loan by putting just 5% down (or less)!
Let’s talk about some of the reasons why 20% is still a good number to shoot for.
Private Mortgage Insurance (PMI)
When you have less than 20% equity in your home, your lender will force you to pay for something called private mortgage insurance, or PMI.
What is PMI? It’s protection for the bank against the risk that you default on your mortgage.
Think for a second about what a lousy deal that is. Most insurance is something you buy for yourself to protect against something bad happening. And most of the time it’s still a rip off. PMI is insurance that you buy to protect the bank against you. You are the “something bad happening” when it comes to PMI.
How much does PMI cost? The usual ballpark figure that’s thrown out is .5% to .1% of the loan amount per year. So on a $300,000 home, you could be flushing an extra $3,000 a year down the toilet through PMI.
The only good news is that PMI can go away when you have enough equity in your home, although you’ll likely need to pay for a home appraisal to prove the value of your property.
All in all, PMI is a lousy deal.
Don’t Get Caught Upside Down
Another reason why a 20% down payment is good is that it protects you from market risk in case you need to move.
Thin about it like this. Let’s say your a year or two into a mortgage that you put 5% down to acquire. But your life circumstances have changed and you’re forced to move.
If the market has shifted and you can only sell your house for 94% of what you paid for it, there’s a good chance you’ll end up paying money to get rid of your house. Especially when you factor in closing costs.
Owing the bank more than the house is worth is called being upside down on your mortgage, and it isn’t fun. To be honest, you aren’t even completely immune from this happening with a 20% down payment. But it’s a sliding scale and the more you put down, the less likely you are to ever find yourself upside down.
Can You Really Afford this House?
The people selling you the house want to make money. The people offering you a mortgage want to make money. They don’t really care if you can afford the house.
Wait a minute, you might be thinking, if they want to make money, of course they care. Nope. They don’t. Or, more accurately, they don’t care nearly as much as you do. The mortgage company wants people in general to be able to repay their loans, but they know that they achieve maximum profitability if a certain small percent of people default. And again, they have PMI to protect them when that happens.
And even if they did care about your ability to repay the loan, they certainly don’t care at all whether you can do it comfortably.
The only person who can determine how much home you can afford it you.
When you’ve saved up enough for a 20% down payment, you’ve proved that you are skilled enough at spending less than you earn to buy the house you are looking at.
Don’t Forget Closing Costs
There are fees everywhere you turn when it comes to home ownership. It’s not just the principle and interest on your loan. There’s taxes. And insurance. Maybe home owner’s association dues. Maintenance costs. Don’t forget PMI. And of course, the closing costs.
They get you when you buy the home and they get you when you sell the home.
The estimates are that closing costs will run you somewhere between 3-6% of the purchase price. Let’s be conservative and assume you’ll get stuck with the higher number.
This means that to close on a house, you want to be able to make a 20% down payment and cover closing costs of about 6%. In other words, to buy a house, you should have more than a quarter of the money up front.
Here’s a chart showing what that looks like for different purchase prices:
|Price||20% Down Payment||6% Closing Costs||Cash Needed|
“But Wait, There’s More”
What are you going to do in an emergency? What if the roof starts leaking or the plumbing bursts?
Better have an emergency fund.
By the way, it did happen to us that the roof started leaking within a year of buying the house. We got a great deal on the house, but we knew it needed a new roof soon. It turned out it needed it sooner than we thought.
We replaced the roof with a metal one that should last for a long time and had to pay someone a few hundred bucks to come patch the leak.
So how much should you have in an emergency fund before buying a house? That’s really up to you, but let’s just use $10,000. So here’s a chart that shows our previous 26% plus an additional $10k:
|Price||Cash to Close||+$10k Emergency Fund||Percent of Price|
I really don’t know what to tell you. Buying a house is expensive. It’s either expensive up front, or expensive as you go (or both).
How to Afford a Home
There are only two tricks in the book to be able to afford something you don’t have room for in the budget: Spend less or make more.
Usually when it comes to spending less, you have the flexibility of spending less on other things to be able to spend more on the thing you want.
But housing is probably your biggest expense. Usually it’s the thing that you can cut back on to spend more on other things. It’s the biggest big win in the arena of frugality.
There’s three ways that I can think of to spend less on housing.
The first one is just to buy a smaller, cheaper house than you want. I know this is about as appealing as telling you to eat nothing but steamed spinach for the next year. But the truth is that you get used to wherever you live. If you haven’t mastered your spirit, you’ll become just as discontent with an upgrade as you are in your current dwelling.
The second is to take your time shopping. Good deals always come around, but they aren’t always there right when you want them. I looked for almost a year before I found an acceptable house that we could actually afford on one income.
The third trick is a little more creative. It’s called house hacking and the idea is to buy a place where it’s possible to rent part of it out. You could view this as an “earn more” strategy, or you could view it as a creative way of lowering your housing costs.
And of course, if you really just have to have a house that’s outside your current price range, the only real solution is to figure out how to earn more.
Is it possible that you could ignore all my advice and be fine? Yes. Is it possible that despite being just 34 years old, I’m an old curmudgeon at heart hopelessly stuck in in an era that everyone else has left forever? Asolutely.
But it’s also true that most people have no idea how to manage their money. Most people buy more house than they can afford. Most people can’t retire comfortable at a reasonable age. So I would suggest that when it comes to your biggest expense, it’s wise to be more cautious than most people.
I know buying a house is tough. I remember the feeling that I would never find something I could afford. Don’t worry. You can do this.
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