How to Know if You Can Really Afford That New Home

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High inflation often translates to high anxiety, which is why many Americans are scrambling to lock in the cost of one of their most basic and human needs: a home.

But with house prices already at high levels and mortgage rates soaring, many buyers may be tempted to jump in before they’re ready – or because they’re worried things will only get worse.

“There’s this psychological pressure of everything being uncertain,” said Simon Blanchard, an associate professor at Georgetown University’s McDonough School of Business who studies consumer financial decision-making. It can make a necessity like housing concrete, he said.

“It can feel comforting to focus on the present and lock in that part of the budget,” he said. “The danger is that you could create a vulnerability by leaving insufficient flexibility for later.”

The national median existing home price was $375,300 in March, up 15% from $326,300 a year earlier, according to the National Association of Realtors. Rates on 30-year fixed-rate mortgages were 5.10% for the week ending Thursday, down from 2.98% a year ago, according to Freddie Mac.

This has seriously eroded the amount potential buyers can afford: with a 10% down payment on the median home, the typical monthly mortgage payment is now $1,834, up 49% from $1,235 a year ago. a year, taking into account both prices and higher rates. Account. And that doesn’t include other non-negotiable items, like property taxes, homeowners insurance, and mortgage insurance, which are often required on down payments of less than 20%.

With inflation at a 40-year high and the cost of almost everything on the rise, it’s easy to get caught up in the irrationality that drives some shoppers to aggressively raise prices and skip basic precautions, like a home inspection.

“There’s a scarcity mindset right now,” said Jake Northrup, a financial planner for young families in Bristol, RI. He said he and his wife decided to wait a year and save more before buying their own house.

Some would-be buyers are doing the same – mortgage applications have slowed lately – but the market remains deeply competitive due to the country’s chronically low housing supply. This can lead to incorrect assumptions and poor judgment.

So before embarking on the open house circuit, it’s time to assess not only what you can spend but what you should spend – and potential costs down the road.

Before you start scanning lists, it helps to have a solid understanding of what you can afford – and how different price points would affect your ability to save and spend elsewhere.

Some financial experts suggest working backwards: assume a minimum savings rate — say 15 or 20 percent for retirement, college savings, and other goals — and tally up all other debt and recurring expenses on a spreadsheet . Then play around with different house prices to see how they would influence everything else.

“The right mortgage amount is not what you get pre-approved for, but what you can afford,” said Mr. Northrup, the financial planner. “The #1 mistake I see when people buy a home is not fully understanding how other areas of their financial life will be affected.”

What is affordable? The answer will obviously vary by household, income, family size and other factors.

Government housing authorities have long considered spending more than 30% of gross income on housing a burden – a figure that stemmed from “one week’s pay for one month’s rent”, which has become a rule of thumb in 1920s. This standard was later written into national housing policy as a limit – low-income households would pay no more than a quarter of their income for social housing, a ceiling which was raised to 30% in 1981.

Some financial planners may use a similar rough starting point: spend no more than 28% of your gross income on all of your housing expenses — mortgage payments, property taxes, insurance — and an additional 1-2% allocated for repairs and maintenance.

This won’t work for everyone, however, especially in high-cost metropolitan areas where it’s often difficult to find rentals within these limits.

“Take into account all your monthly expenses and really decide how much you want to spend on housing,” said Tom Blower, senior financial adviser at Fiduciary Financial Advisors. “I would never encourage a client to strictly follow a percentage of income to determine how much to spend each month. Rules of thumb are guidelines and something to consider, but simply not the end of it all.”

Rising interest rates mean that many people have had to limit their price ranges – by far. A family earning $125,000 who wanted to set aside 20% and spend no more than 28% of their gross income on housing — about $35,000 — could comfortably afford a $465,000 house when the rate of interest was 3%. At 5%, that figure drops to $405,000, according to Eric Roberge, financial planner and founder of Beyond Your Hammock in Boston. Its calculation takes into account property taxes, maintenance and insurance.

He generally suggests allocating a conservative share of household income – no more than around 23% – to housing, but acknowledged that this is difficult in many places. “Our affordability calculus doesn’t change,” Roberge said. “However, the big jump in fares changes what is actually affordable.”

There are other considerations. With many Americans moving from cities to larger spaces in the suburbs, you’ll also need to consider the added cost of running and furnishing that home, for example, or the extra amount you’ll need to spend on transportation.

Properties in less than ideal condition are attractive to those hoping to save money, but supply chain issues and other issues make that much more difficult, experts said.

“I have clients who have recently tried to partially circumvent the affordability problem by purchasing homes in need of major upgrades,” said Melissa Walsh, financial planner and founder of Clarity Financial Design in Sarasota, Florida. “Because contractors are hard to find and material prices have been rising at a rapid rate, these customers are finding that buying from a repairman may not be the bargain it was a few years ago.

She suggests setting aside a lot of money — she’s had two clients who spent more than double their original estimate on renovations this year.

Variable rate mortgages typically come with lower rates than fixed rate mortgages for a set term, often three or five years. After that, they reset at the prevailing rate and then change on a schedule, usually every year.

According to Freddie Mac, the average interest rate on a 5/1 variable rate mortgage – fixed for the first five years and changing every year thereafter – was 3.78% for the past week. finished Thursday. It was 2.64% last year.

More buyers are considering variable rate mortgages: They accounted for more than 9% of all mortgage applications for the week ending April 22, double the share three months ago and the highest level since 2019, the Mortgage Bankers Association said.

But they are certainly not for everyone. “The typical borrower is someone who doesn’t plan to stay in the property for long,” said Kevin Iverson, president of Reed Mortgage in Denver.

If you know you’re going to sell before your mortgage rate adjusts, this may be the right loan for you. But it’s unclear what rates will look like five years from now, and the sudden rise in rates pushed many borrowers to the brink during the 2008 financial crisis (although today’s ARMs are generally safer than products peddled at the time).

Be even more wary of so-called alternative financing – contract-for-deed agreements and “moveable” loans regularly used to buy manufactured homes – which often lack typical consumer protections.

The cost of just moving into a home can seem the most painful in the short term, but other expenses later can be just as tricky.

A recent paper by Fannie Mae economists analyzed the costs typically incurred over a seven-year ownership lifecycle and found that the major contributors include just about everything except the mortgage. Other ongoing expenses — utilities, property taxes and home improvements — together account for about half of a borrower’s costs, while transaction expenses were 20%, economists found.

They used 2020 loan data in which the average first-time home buyer was 36 with a monthly income of $7,453 and bought a home for $291,139 with an 11% down payment. The actual mortgage – excluding the repayment of the principal loan amount – contributes approximately 30% to the total costs over this seven year period.

Their conclusion: “Borrowing is a significant part of the cost of owning a home, but that cost is often overshadowed by utilities, property taxes, home repairs, and one-time fees paid to various parties to buy and sell. a house.”‘

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