Should I Buy a Home?
Your guide to determining if home ownership is right for you
A home is one of the most expensive purchases most of us will ever make. It makes sense then to carefully consider if home ownership is the right choice before committing to that path.
In the rest of this guide, a number of topics will be discussed with information that can be used to help you answer the question, "should I buy a home?". If you’re a first-time home buyer, then I’d strongly recommend reading this guide in its entirety. If you’ve been through the process at least once before, then feel free to skip around. An outline is as follows:
- Am I Being Pressured into Buying?
- Are My Personal Finances in Order?
- Do I Plan on Staying for at Least Five Years?
- Have I Saved Enough for a Down Payment?
- Am I Prepared for the Closing Costs?
- Have I Considered Other Monthly Costs?
- Homeowner's Insurance
- Property Taxes
- Home Maintenance
- Renting - Am I throwing Money Away?
- Home Ownership Benefits
- So, Should I Buy a Home?
- What's Next?
Am I Being Pressured into Buying?
First and foremost in the list of considerations around the decision to buy is your underlying motivations for doing so. If you’re looking to do so for the space, privacy, financial aspects, and so on, then that’s great and you can probably skip the rest of this section.
On the other hand, and you should be honest with yourself, if your motivation is mostly coming from a source of pressure, then that can lay the foundation for future regret.
There are many possible sources of pressure like:
- Parents/guardians with an underlying expectation that home ownership should be in your immediate future.
- Friends and coworkers who have recently bought a home and are asking you when you plan to do the same.
- An advertisement that’s telling you that now is the time to buy.
- Those around you telling you that renting is the equivalent to throwing money away (more about that later on in this guide).
- A general feeling that it’s something that just comes with being an adult.
If you are feeling pressured, then it’s ok to take a step back. It’s ok to say that home ownership isn’t right for you at the moment. After all, a home is a big obligation and you’ll be the one at the end of the day who is responsible for it; not your coworkers, the advertiser, or anyone else in most cases.
Are My Personal Finances in Order?
Do you have credit card debt, auto loans, student loans, etc...? If any of these loans/debts have high interest rates, then it may make sense to attempt to pay some of them down before taking on additional debt.
Having a high existing debt load may make getting a home loan more difficult and lead to less desirable loan conditions like higher interest rates or higher up-front payments. This is especially true if your debt load is negatively impacting your credit score.
Another important consideration is future financial goals like retirement. Are you contributing to a company-provided 401K? If not and your company matches a percentage of the contributions, then you could be losing out on essentially free money.
Do you have an emergency fund? Having an emergency fund can provide some peace of mind to help manage the unexpected like a car breakdown, a potential job loss, a medical issue, and so on. Foregoing an emergency fund can make life's unexpected moments more stressful than they need to be.
Getting your personal finances in order can be challenging but you don’t have to approach it alone. A good move can be to work with a financial adviser to address your concerns and plot out your financial future before committing to a financial decision as big as buying a home.
Do I Plan on Staying for at Least Five Years?
You may have heard that a home is an investment. That can be true. But, like a traditional investment in the stock market, a home’s value can fluctuate year to year. That along with the costs associated with buying a home can lead to a substantial financial loss if you need to sell your home shortly after buying.
One of the more common reasons one is forced to sell is due to employment changes. This may be a move of the corporate headquarters, a layoff, a salary cut, and so on. If you feel that one of these events is likely to happen soon, then it may make sense to hold off on buying until there is some more stability.
Another reason one may need to sell quickly is because the home payments are too much of a financial burden. Being careful not to overbuy is a prudent move.
So why five years? Because staying for at least five years can give you a higher likelihood of your home’s value both increasing and increasing enough to cover some if not all of the closing costs associated with the purchase of the home: lender costs, title costs, home inspection, and so on.
Have I Saved Enough for a Down Payment?
Most lenders will require a certain percentage of a home's purchase price to be paid up front. This is what is known as a down payment.
The required amount of the down payment varies lender to lender. You can usually expect something in the range of 7%-20% where 20%, or more, is the ideal. A down payment of 20% will generally get you better loan terms and will eliminate the monthly PMI payment.
We’ll go into more depth on PMI a little later. For now, let’s put the down payment into real numbers. On a $300,000 home you’re looking at $21,000 (7%) at the low end to $60,000 (20%) at the higher end.
I know, this number can be a bit shocking and you may be asking how you could afford to save up that much. The answer to that is time and commitment. If you're looking to buy a home in the next few years, then commit to put away some money each month into a separate account (savings, money market, etc.) to reach this goal. Pretty soon you’ll be surprised at how much you’ve saved.
Am I Prepared for the Closing Costs?
When you apply for a home loan, you’ll receive an initial set of documents outlining the loan terms. If you agree to those terms, then a closing date will be set to finalize or “close” the loan.
A loan closing will generally be held at a title office. There, you’ll sign all the documents and provide a check to cover the down payment and other closing costs.
Some closing costs may include:
- Application fee: Fee paid to the lender for the submittal of the loan application.
- Origination fee: Fee paid to the lender to process the loan.
- Title fees: Group of fees paid to the title office for their title services like a title search, title insurance, and closings.
- Recording fee: Fee paid to the city or county to record the mortgage and/or deed.
- Appraisal fee: Fee paid to an appraiser for the home appraisal.
- Attorney fee: Fee paid to the attorney who helped prepare certain contracts and other documents related to the home purchase. An attorney may or may not be needed depending on the state you’re in.
- Home Inspection: Fee paid to the home inspector to inspect the home. This fee may or may not be paid separately from the other closing fees.
There are a number of other potential fees that could be included in the loan closing as well. The fees will vary based on local and state laws as well as by the individual lender, title agent, and some services you may select.
Closing costs average between 2% - 5% of the loan amount. For a $250,000 home, this means closing costs could be in the range of $5,000 to $12,500 dollars.
There are scenarios where closing costs could be significantly less. For example, some lenders offer no-fee loans. These loans aren’t truly fee free, but some of the closing costs could be paid by the lender with this type of loan.
The costs initially absorbed by the lender with a no-fee loan will normally be made up with a higher interest rate on the loan. As a borrower, you’ll in most cases end up paying more over the long run with this type of loan, but it could help you to get a loan that you would otherwise be unable to.
In any case, it’s wise to plan for closing costs in the 2% - 5% range when considering if a home purchase is right for you.
Aside from the closing costs, there are a number of other ongoing monthly costs that will need to be considered. These costs will be discussed next.
Have I Considered Other Monthly Costs?
The two costs that most immediately come to mind in a monthly home payment are principal (directly goes to paying down the loan) and interest (percentage of the loan amount that goes to the lender).
While these costs tend to make up the bulk of the monthly payment, there are other costs that need to be considered as well. Before we get into these costs in detail, let’s talk about an escrow account.
An escrow account is an account that your lender will typically open for you when you obtain a home loan. This account will be funded by you as part of your monthly mortgage payment. But what does it fund and why do most lenders require that you have this account?
Some standard costs that are paid for out of the escrow account include PMI, homeowner’s insurance, and property taxes. The lender requires this account as it’s a means by which the lender can ensure that you pay for the required services specified in the loan terms.
All the costs funded by the escrow account will be combined and then split up into monthly payments to be included in your monthly mortgage payment to the lender.
Not all costs associated with a home will be managed by the lender as part of the escrow account or monthly payment. The three big ones here being home maintenance, HOA fees, and utilities. You won’t want to forget about these costs as they can be significant.
Ok, so we quickly went over an escrow account, some of the costs paid from the escrow account, and the three separate costs that you’ll usually manage yourself: home maintenance, HOA, and utilities. What exactly are each of these items and how much do they cost? Let’s go over that next starting with PMI.
PMI stands for “private mortgage insurance” and is insurance that you pay for to protect the lender and only the lender in case you default on your loan.
PMI is generally required if your down payment is less than 20% of the loan amount. In some cases you could end up with less than a 20% down payment, but that will normally be offset by a higher interest rate.
PMI can add a non-trivial amount to your monthly mortgage payment. It tends to cost anywhere from 0.5% - 2% of the loan amount annually. For example, if you’re purchasing a $300,000 home, then the PMI payment could be $125 (0.5%) on the low end to $500 (2%) a month.
To be clear, PMI is of no benefit to you other than that it could make you eligible for a loan that you could not get otherwise. The good news is that once you’ve paid off 20% of the loan, PMI will usually be removed from the monthly home payment.
Unlike PMI, homeowner's insurance is for your benefit. It protects your home and your belongings from certain types of damage like fire, theft, wind, hail, vandalism, and a number of other things.
Homeowner’s insurance costs vary greatly. Live in a location that has frequent fires? Then you can expect to pay a lot more. Live in Tornado Alley? Again, you can expect to pay more.
You'll generally pay in the range of 0.5% up to 5% of the home’s value annually. For a $300,000 home this means that you can expect to pay $1,500 to $15,000 a year. Some insurance companies allow this amount to be split up monthly and others require it in an annual lump sum.
It’s very important to note that homeowner’s insurance does not cover every type of disaster. Earthquakes and floods and there two big ones and will require separate policies. Be sure to read your insurance documents carefully so that you know exactly what your policy does and does not cover.
It's also a good idea to talk with insurance companies about the area you’re looking at to see what they'll typically charge for a policy in that location. You may be in for a surprise if you don’t.
Property taxes rank at the bottom amongst the most liked taxes. But, they’re one of the major sources of tax income for many states and go to pay for a number of important things like schools, police, firefighters, roads, and so on.
How much you’ll pay varies state to state but it averages at 1.1%. This means that for a $300,000 home you’re looking at $3,300 annually or $275 monthly if incorporated into your mortgage payment.
This can be less though if your state has something known as a homeowner’s exemption. A homeowner’s exemption will allow the homeowner to take a certain amount off of the home’s value for property tax purposes if the home in question is the homeowner’s primary home.
This exemption can be significant. It can be a set amount (e.g. $100,000 exemption). Or, it could be a certain percentage (e.g. only required to pay taxes on 55% of the home’s value).
When considering the cost of a home, maintenance is generally something that most of us either don’t consider or push off as something that we’ll handle down the road. With the dizzying amount of paper work, home offers, lender shopping, and so on, it can be easy to do. But maintenance is not an insignificant cost and neglecting to consider it up front can lead to serious financial strain in the future.
How much should be planned for with maintenance? A common rule in the industry is the “1%” rule. This rule says that the average annual home maintenance cost is around 1% of the home price. For example, for a $300,000 home maintenance costs would average around $3,000 a year.
Of course, no rule is absolute. If your home is brand new, then your maintenance costs could average well under 1% a year for the first several years of home ownership. If you have an older home, then the average cost could climb up to something closer to 4% or even more. In either case, your budget should include something in the range of 1% - 4% for maintenance costs.
As mentioned, the 1% - 4% range is an average. There may be some years where you spend very little on maintenance. Or, you may have a year where something more major like a roof replacement needs to be done, which could cost several thousand dollars.
One good way to plan for maintenance is to set aside a certain amount of money per month into a separate savings account (standard savings, money market, etc.). For example, for a newer $300,000 home with a 1% average maintenance cost, the monthly amount would be $250 ($3,000 / 12 months).
Saving a certain amount of money per month will also help you to manage home emergencies. An emergency could be something like a wind storm that causes damage to your roof requiring repair or even replacement. Of course, homeowner’s insurance can help with a number of emergencies but not all. And even when it does, you’ll still be responsible for the deductible.
Without having money set aside you could be in trouble when a home emergency comes up and need to do something like take on credit card debt with a high interest rate. With money set aside, you’ll be in a much better situation.
In any case, it’s important when considering whether or not to buy a home that you plan for maintenance costs.
A HOA stands for Homeowner Association. A HOA is an organization that will set and enforce rules for the properties that fall under the HOA’s jurisdiction. These rules are generally specified in a “Declaration of Covenants, Conditions, and Restrictions" (CC&R) document. Some of the rules specified can include:
- Home style: This could include broader architectural style down to more specific items like home color.
- Parking: This could include where and how long vehicles can be parked.
- Pets: This could include the type of pets that are allowed in addition to attributes like pet size.
- Rent: This could specify if you are allowed to rent out your home and the rules for doing so if allowed. Pay close attention to this if you’re thinking you may want to rent out your home one day.
- Trash: This could include how long you can leave your trash can out on trash day and where you can keep the trash can on non-trash days.
- Noise: This could include quiet hours, hours to perform noisy activities, and so on.
A HOA has the ability to enforce the rules laid out. Noncompliance can result in fees or even a lien on your home.
A HOA may also perform certain activities like managing common grounds, handling property insurance (less common for individual separate dwellings), exterior home maintenance, and so on.
To cover the costs associated with the HOA, the HOA will levy a fee to the property owners. The costs for a HOA vary greatly. A HOA that manages restrictions only (trash, pets, parking, etc.) may not levy any fees. A HOA that manages common grounds, insurance, exterior maintenance, and so on can be hundreds to, in the case of larger more expensive properties, even thousands of dollars a month.
In any case, it’s important to take this cost into consideration for your monthly home budget.
Standard utilities include items such as water natural gas, trash, recycling, electricity, and internet. Utility costs vary greatly across the country with some of the factors impacting cost being:
Looking at a location with cold weather? If so, then you’ll want to plan for the additional electricity and/or natural gas costs for heating. Or, if you’re looking at a location with hot temperatures, then you’ll want to plan for the additional electricity required for air conditioning.
Some locations throughout the country experience frequent droughts. By the laws of supply and demand, you can generally expect to pay more for water in these areas.
Cost of Living
Utility workers in areas with high costs of living need to be paid more to live in those areas. This in turn leads to higher utility costs.
According the US Energy Information Administration, homes built in or after the year 2000 tend to be significantly more energy efficient than those built before. This will in turn impact heating and cooling costs.
The bigger the home the more you have to heat and cool.
It’s a good idea when determining whether or not to buy in a given area to look up the average utility costs in that area first. If looking at a specific home, you could ask for the last 12 months of utility bills as well. From there, you’ll want to factor this amount into your monthly home budget.
Renting - Am I throwing Money Away?
You may have heard that you’re essentially throwing money away by renting. Is this true? Let’s consider a hypothetical situation. Jamie is currently renting an apartment at $1,500 a month. Jamie is thinking about buying a $250,000 home. How would Jamie’s current monthly apartment rent compare to the monthly home costs?
Let’s say that Jamie is considering putting $10,000 down for a home loan that has an interest rate of 4%. In this scenario, the monthly costs for the home could break down into something like:
- Principal and interest amount: $1,145.80
- Property insurance: $104.17
- Property taxes: $250.00
- PMI: $200.00
- Maintenance: $208.33
- HOA: $100
- Utilities: Excluded as this is a cost you'll pay with renting as well.
- Total cost: $2,008.30
Let’s total the amount of the above costs that do not go directly to paying down the home loan for the first month of home ownership (all costs except principal): $800 interest (first month’s principal and interest is $1,145.80 = $800.00 interest + $345.80 principal) + $104.17 property insurance + $250.00 property taxes + $200.00 PMI + $208.22 maintenance + $100 HOA = $1,662.50. A chart of these monthly costs looks like:
As you can see, most of the total monthly cost is not going to paying down the home loan initially. Granted, this does get a bit better over time as less goes to interest and more to principal over the years in addition to PMI dropping off after 20% of the home loan has been paid off. Still, Jamie will end up spending a similar amount for costs not directly related to paying down the home loan in comparison to her current monthly apartment cost of $1,500 for the first several years of home ownership.
Continuing with the above, let’s say that Jamie’s job requires her to frequently fly across country meaning that she’s not at home a decent chunk of the year. Keeping up with mowing the lawn, painting the home, fixing a leaky faucet, and so on are not things she has much time for and something she's relied on the apartment manager to take care of with her current living arrangements.
Should Jamie still pursue buying the home? Well, that’s a bit of a subjective question. If Jamie plans on keeping the home for at least five years, has a plan in place for maintenance, and is comfortable with the associated costs, then it may be a good choice.
On the other hand, if Jamie may need to sell the home soon after buying, hasn’t saved up enough for a down payment, isn’t sure how maintenance will be handled, and so on, then it may be better if she holds off on buying a home for the moment.
So, back to the original question on if renting is throwing money away. The short answer is no. The long answer is that there are certain pros and cons to owning a home as well as pros and cons to renting. Which option to choose will depend on your individual circumstances.
Let’s move onto some of the benefits of home ownership.
Home Ownership Benefits
Owning a home does come with a number of benefits. Some of these benefits are listed below.
1. More consistent monthly payments
An apartment’s rental cost can fluctuate significantly over the years but will almost always move in an upwards direction. On the other hand, a home payment will be much more consistent as long as you choose a conventional fixed rate loan.
2. Cheaper Than Renting in The Long Run
You'll eventually pay off your home loan. You’ll never pay off a rented property though. So, initially a home will tend to be more expensive but at some point it will usually be cheaper.
3. A Place of Your Own
There’s nothing like a surprise visit from a landlord to make you realize just how much you really don’t own what you’re renting. Having a place of your own can be a source of pride and gives you certain freedoms that you’ll never have with renting.
Renters tend to come and go. Homeowners generally stick around for a bit longer. This can lead to a stronger community and potentially longer-term relationships with those around you.
5. Tax breaks
There’s the option to deduct monthly interest payments from your taxes. Since the first number of years of the monthly mortgage payment will be mostly interest, this can potentially lead to a significant tax break.
The final payment to the lender for a home loan can be exhilarating. Not only do you own your home with that payment, but you can also generally count on your home’s value going up over time. This can make a home a solid investment.
The above are just a handful of the benefits of owning a home. There are many other benefits as well.
So, Should I Buy a Home?
Ultimately, the only one who can answer this question is you. That said, if you have considered and are comfortable with the items above, then you’ll be ahead of the game and can be more confident in your decision.
If you'd like to review what you've learned, click the following to take a quick quiz:
Should I Buy a Home - Quiz
Decided that you want to buy? A good next step can be to determine how much you should spend on a home. Click the following to learn more:
How Much Should I Spend?