Contributing to an emergency fund, saving for retirement and setting aside money for your children’s college are important financial aims to balance along with meeting your day-to-day living expenses. Adding a mortgage and other homeownership expenses shouldn't make you house poor and compromise your ability to balance all your financial priorities.
To understand how much you can afford to spend on a home, some financial professionals recommend using the “50/20/30” rule. This budgeting guideline divides your spending into three broad areas:
- Dedicate 50% of your income to fixed costs such as housing, car payments, insurance, utilities and so on.
- Put 20% into generally long-term financial goals such as retirement, an emergency fund and college savings.
- Spend the last 30% on fluctuating categories including dining out, hobbies and shopping.
If your money is all tied up in a house you can’t really afford, you won’t have any left over for these other goals, and it will be hard to build a financially comfortable future—let alone a secure life right now.
Know your budget
It’s easy to see how you might get in over your head with a home purchase. You fall in love with the perfect house that’s just outside your price range. When you make an offer, there’s a bidding war—and if you win, you find yourself spending more than you’d planned—sometimes as much as 10%–15% above the asking price (and above the amount you’d been preapproved to spend).
In this case, you entered homeownership with your heart instead of your head. Many homeowners, of course, learned an extremely painful lesson about overextending themselves during the housing crash and financial crisis of 2008. While the market has recovered since then, buying more home than you can truly afford remains a dangerous game.
How can you ensure that you see the full financial picture, and avoid getting in so deep with your dream home that you threaten your other financial goals? Read on.
Understand hidden costs
Remember, a mortgage is just the beginning when it comes to all the expenses you have as a homeowner. Depending on where you live, you may find it’s cheaper to rent than to own. This may mean you’re able to put more away for those other crucial financial goals—including saving up for a down payment for a future home purchase—by renting.
Other homeownership costs you may not have considered:
Property insurance: You’ll need enough coverage to be able to replace your home in case of a major disaster. Plus, mortgage lenders require you to carry it.
Property taxes: As states and cities try to close budget holes, property taxes are likely to increase.
Homeowners’ association fees: Many communities charge residents a fee to maintain common property areas.
Other closing costs: When you sign your mortgage, you might see a long list of other fees for related services, from appraisals to inspections to title insurance and more. All told, expect to pay 2% to 5% of the sale price when you close, according to Zillow.
Maintenance: Everyone’s situation is different, but the federal Consumer Financial Protection Bureau says you should budget at least 1% of your home’s purchase price for annual maintenance. On a $300,000 home, that means $3,000—every year.
Leave your options open
You never know when job opportunities, romance, family obligations or, well, pandemics might shape the location of your future residence. You might want to consider holding off on buying a home until you feel reasonably locked into some of your other life goals and responsibilities: career, love and family.
While you may be able to get a mortgage with only 10% down (or, in the case of Federal Housing Administration (FHA) loans Opens in new window, just 3.5% for borrowers with poor credit), a 20% down payment puts you on much stronger financial footing. (Indeed, in many cases putting down less than 20% means you’ll have to buy private mortgage insurance [PMI] until you make up the difference in equity, or how much of the home you own outright compared to its current value.)
Paying more upfront lowers your monthly mortgage cost, both because you’re borrowing less and because you might pay a lower interest rate when you have more equity in your home. It also eliminates the extra expense of PMI.
Take time to build up your down payment as you also work on other short- and long-term financial goals, so you have a better chance of getting a loan with the best rate and terms.