Monday, May 18, 2015

Buying a House Part 1: Figure Out Your Budget

A few months ago I found myself very suddenly in the market for real estate. Having recently come out the other side, decompressing after buying a house, I find myself with an abundance of information for anyone interested in the process. In fact, it's is not nearly as frightening as you might think, so I hope I can demystify the process for you. I'm going to lay out the process in 8 steps:
  1. Figure out your budget
  2. Figure out what you want in a house
  3. Find an agent
  4. Check out houses
  5. Choosing a house (earnest money/early negotiation)
  6. The inspection period
  7. Negotiation and paperwork
  8. Closing
This first post will be entirely dedicated to that first step.


 Did you know you can buy a house for 3% down if you're a first time home buyer? This is technically true, though there's a lot of other things to consider. Regardless, when I began the process I kinda figured I'd be looking at 20% down like a regular loan (which would be way out of my budget), but that was simply not the case. If you've got the credit, the government is interested in helping you get a house. So, that 3% should be the first thing you think about when figuring out your budget.

Your budget, in this case, is how much you're willing to spend on a house. In other words, are you looking for a $100,000 house? $200k? 500k? You budget is going to be the first thing you'll want to know going into the process, so here's how you're going to want to figure that out.

First, I recommend checking out the MLS to get an idea of what houses cost in the area you want to live. The MLS is a very useful tool, free to use, and it provides all sorts of information that will help you figure out what kind of home you want in the first place. For our purposes right now, though, you should mostly be keeping an eye on the prices, figuring out an average price for the kind of homes that interest you.

From there, we'll do a bit of math. I'm going to operate here as if you found that houses were generally about $200,000, but you can just replace that number with whatever you've found.

First, let's check on that down payment: 3% of $200k is $6k, which sounds relatively easy to hit with a decent full time job and a year or so of saving up. However, there are more costs to factor into a house purchase than the down payment: inspection fees, assessments, taxes, and possibly even closing costs. To be safe, it might be a better idea to figure out 6% ($12k in this case), even though only 3% of that will go toward the purchase of the house. If you're lucky, you might be able to have the seller pay the closing costs, in which case you'll just have even more to put down on the house (which is very good, as I'll discuss soon), so I wouldn't recommend actually starting the process without 6% in-hand.

A couple of asides:

First, to define "closing costs." Closing costs are a general term for the various fees and such associated with buying a house: title fees, attorney fees, application fees, and all the other red tape you have to cut through in order to transfer ownership of real estate. If you're lucky, the seller will handle most of these fees, but that all comes down to the negotiation process.

Second, I should note that Laura and I were not able to purchase our house on our own. We required significant backing from our parents, otherwise it might have taken us a few years to afford it. We're both very fortunate to have parents who were willing and able to provide that assistance.

Anyway, your next step is to figure out if you can handle the monthly payments on a mortgage for a house at the price you're looking at. Currently, interest rates are awesome, but you don't want to count on them being that way forever. For now, let's just work with 6%, which is a bit higher than average at the moment. (We'll be doing a lot of rounding up here, since it's better to have pleasant surprises rather than nasty ones.)

First, subtract your 3% down payment from the total.

$200,000 - 6,000 = 194,000

Then figure out your yearly interest on the loan. (6%)

$194,000 * 0.06 = 11,640

Let's round that up to an easy number: $12,000. Next, we'll multiply that interest by the number of years on the loan. Most mortgages are for 30 years.

$12,000 * 30 = 360,000

Next, add the interest back to the principal amount (the amount you're borrowing).

$360,000 + 194,000 = 554,000.

That is your total payment over 30 years. Now, divide that by 30 to get your yearly payment:

554,000 / 30 = ~18,500

And divide that by 12 to get your monthly payment.

$18,500 / 12 = $1,550

So, you're monthly payment would be about $1,550. Ouch! In a place where a decent house might cost $200k, $1,550 per month would probably be pretty rough.

At this point, I should point out that my math is purely for estimation purposes. In reality, every time you make a payment to your principal your interest is calculated from your new balance, not from your total loan, so your monthly mortgage payment would actually be considerably lower.

That said, the amount above is still a relevant number since it will fairly accurately calculate your monthly payment including your mortgage payment, insurance, taxes, and utilities. Neat, huh?

So, if you can afford that monthly payment comfortably, congratulations! You've found a comfortable budget. If the amount is a little higher than you'd like or if the amount is a little too comfortable, adjust your budget accordingly until you've found a budget you're comfortable with. Remember, though, that this is to calculate your maximum budget, not the actual cost of your house. With some luck you'll find the perfect place for way less than your budget. That said, you definitely want to be honest with your budget and not undercut yourself since it would be a shame if your perfect home was just a little over a budget you set too low.

As a final note, we worked with a down payment of 3% in this exercise, but if you can pay more than that you definitely should. This is because people who get a mortgage with very little down have a few things to worry about:

1) Federal Housing Administration regulations. Basically, if you're getting a loan with minimal money down and less-than-stellar credit, the FHA is the government agency that will guarantee your loan so the banks won't immediately turn their noses up at you. Because they're taking a risk on you, though, they're going to have many more regulations and standards that your house is going to have to meet in order for them to agree to back your loan. In theory this is a very positive thing, since their standards are all intended to make sure the house is safe and livable. Unfortunately, some of those regulations can be very rigid, and the prospect of making a home meet those standards might scare away sellers. If you can bring your down payment to 5% or more and/or have a good credit score, you might qualify for a standard loan instead of an FHA loan, which could help a lot in the negotiation process.

2) Mortgage insurance. Whether you get an FHA loan or a standard loan, if you're putting down less than 20% of the total you're going to have to pay for a type of loan insurance--basically, an additional payment attached to your mortgage payment every month that applies to neither your interest nor your principal. This extra fee remains in effect until you hit that 20% mark, at which point it goes away. The less you put down the more that monthly fee will be, so it's best to put down as much as you can to reduce it. (My total from the exercise above kinda factors that fee into that monthly payment, by the way.)

3) Paying more in the long run. Simply put, the more you put down the less of a loan you're making, meaning there's less borrowed money for the banks to charge interest on. Every extra dollar you put down means less you owe, less interest, and smaller monthly payments, all of which adds up significantly in the long run.

If you have any notes to add, additional questions about budgets, or corrections you'd like me to make, please let me know in the comments. In the meantime, I'll plan on writing up Part 2 next weekend.

1 comment:

  1. I had a long thought out comment for you but when I tried posting it, Google prompted me to sign in and erased it all. I'm getting ready for bed and typing on my phone, so here's the quick version...

    Charlie, you rock.

    Jack's Dad Sayz: Small mortgages aren't all that bad. They leave you with more money that you'll be happy you have when life happens. Example: car breaks down, unexpected medical bills, etc. Also remember that your monthly mortgage is a minimum. You can always pay more. Paying off the mortgage early this way may very well mitigate the extra interest and loan insurance fees you mentioned earlier.

    All in all, love your post! I'll be referrIng to it more than once I'm sure! Now to copy all this text before I hit that post button.