For many people, owning a home brings a sense of pride and freedom that cannot be matched by renting. When you own your own home, you aren’t bound by a landlord’s rules, and your monthly payments are building equity. Although buying a home may be the first step you take toward building long-term wealth, it is important to understand the pros and cons of homeownership before taking the plunge.
The most obvious advantage of buying a home is that it’s yours. You can paint your walls whatever color you want, change the landscape, install a basketball hoop, or turn your unfinished basement into a movie theater. Provided you work within any building or zoning regulations, you can do almost anything you want with your home.
Another major benefit of owning a home is that some of your monthly mortgage payment comes back to you in the form of equity. When you pay rent, you will never see any of that money again. On the other hand, part of your mortgage payment will partially be applied to the loan principal, which builds equity.
You may be able to tap into the equity of the home while still living in it to make improvements or consolidate debt.
Since your home is an asset, you can make money if you sell it for more than you originally paid, and in some cases, this profit may even be tax-free. If you sell your main house, you may qualify to exclude up to $250,000 of the profit from your income, or up to $500,000 if you and your spouse file jointly. To qualify for the tax break, you must have owned and lived in the resident for two of the past five years before selling, and not used the tax break in the last two years.1
There may also be additional tax benefits from owning a home. In many cases, the mortgage interest and property taxes you pay are deductible, which means you will be lowering your overall tax burden.2
Cost of Owning
Even though there are many positive aspects to buying a home, let’s not overlook the potential drawbacks. If you’re renting and need repairs, you can generally call your front office or landlord, and they’ll fix or replace appliances at no cost to you. When you own your own home, there may be many unexpected repair and maintenance costs that you otherwise wouldn’t have if you were renting.
Another thing to consider is the potential to lose money on the house. Generally speaking, real estate has generally gone up in value, but there are times when the real estate market stays relatively flat or declines. Depending on the costs associated with the sale and amount you sell the house for, you could lose money.
Finally, buying a home is a long-term proposition. When you rent, you may only be bound to a month-to-month or annual lease, so picking up and moving can be done on relatively short notice. Once you buy a home, it isn’t as easy to pick up and move. You have a significant financial obligation, and the process of selling a home may take several months to complete.
Determine How Much Home You Can Afford
If you have decided that buying a home is right for you, the first step is to determine what you can afford. One of the common guidelines to use is the debt-to-income ratio. Most lenders suggest that your total debt-to-income ratio should not exceed 36%, and your mortgage debt alone should be less than 28% of your pre-tax monthly income.
To calculate your debt-to-income ratio, do the following:
- Add up your total monthly gross income
- Multiply your monthly gross income by 36%
- Add up your monthly debt
- Compare the figures from step 2 and step 3
Your monthly debt, including your mortgage, should be less than the figure calculated in step 2.
Next, add up all of your current monthly non-mortgage debt payments and subtract it from your monthly gross income. This number will give you an approximate maximum mortgage payment you can afford. Ideally, this amount should be 28% or less of your monthly income. Even with these guidelines, it is important to remember that your situation will ultimately dictate what you can truly afford, so consider all aspects of your situation.
Finding the Right Mortgage
After you have determined how much you can afford, it is time to shop for the right mortgage. Since you are likely to be financing a loan for hundreds of thousands of dollars, it is crucial that you make a smart decision. A bad mortgage can significantly affect your finances over time.
The good news is that there is a type of mortgage available for almost every situation; the bad news is that choosing the wrong one can cost you tens of thousands of dollars in interest over the loan term. The most common loans come in two styles: fixed and adjustable interest rate loans.
A fixed-interest loan will provide stability for you. The interest rate won’t change for the life of the loan, so your payments remain stable. One benefit with a fixed-rate loan is that if interest rates go up, you continue to pay your same lower rate. On the other hand, if rates go down, you may be paying more than the current rate, although it may be possible to refinance for a lower rate.
With an adjustable-rate loan, you sacrifice some of the stability in payments for the mortgage’s ability to adjust with prevailing interest rates. When interest rates are going down, this can be to your benefit, but when rates are increasing, you can find yourself with a higher monthly payment.
In addition to understanding what type of loan to look for, consider the down payment. In a traditional mortgage, you would provide a down payment of at least 20% of the home’s price because, for most lenders, this is the amount of equity they require to avoid paying private mortgage insurance (PMI).
When you are unable to put 20%, the lender generally requires that you also pay the PMI premium, which can be anywhere from $20 to a few hundred dollars each month. When shopping for a mortgage, consider this and ask if there are alternatives to paying PMI if you will be unable to come up with the full down payment.