A friend of mine recently realized her dream of home ownership, but for many Americans, the dream can quickly become a financial nightmare. The phrase “house poor” refers to someone who spends an unusually high percentage of their income on housing, whether it is their mortgage or rent, and thus may experience difficulty saving or meeting other financial obligations. Being house poor can also make your life miserable and stressful because you can never have any fun due to a limited discretionary income.
Although mortgage payments, property taxes, insurance, maintenance costs and utilities go toward paying off an appreciating asset, there are many expenses associated with home ownership that families do not consider, or do, but disregard and decide to stretch their income and get a larger mortgage than they can comfortably afford. In fact, a recent study explained that almost half of all Americans, roughly 130 million people, are “liquid-asset poor” and one financial crisis from hardship.
Being “liquid-asset poor” means that you make a decent living or salary, but do not have much in terms of wealth – cash, savings, emergency fund, investments, and assets. One financial emergency or hardship, such as a medical issue, job loss, divorce, rising living costs, or natural disaster, could leave you and your family living at or below the poverty line, along with nearly 50 million other Americans. Before you jump into the housing market, consider all the benefits and costs of owning your own home and try to stick with a price range you can afford if you get a 20 year instead of a 30 year mortgage.
What Is House Poor?
There are two ways to be house poor – one is having payments that are more than you can comfortably afford and the other is owing more on a house than the house’s market value (upside down mortgage). For homeowners with high mortgage payments and an upside down mortgage, getting out from under the debt can be difficult. It may be possible to arrange a short sale with the mortgage holder where they agree to release the lien for the approved selling price of the house. Short sales avoid foreclosure but can still damage credit.
How Much Can You Afford?
As a rule, the purchase price of a home should not exceed 3 times your annual income. If your combined annual income is $100,000, then your bank or lender will most likely loan you about $300,000, assuming you have a typical debt to income ratio. Although with a 20% down payment, you may be able to afford a house closer to $350,000, be safe and conservative, and stick to a selling price of about $300,000 to leave space for mortgage lending/broker fees, property taxes and insurance payments. This is especially important for homes in high property tax states like Texas, where residents pay approximately 3.25% on the appraised value of the property, whereas homeowners in California pay about 1.25% on the purchase price.
Your Down Payment
While FHA loans allow buyers to have as little as a 3% down payment on a home, most financial experts recommend that buyers have at least a 10% down payment. If you want to avoid paying PMI (private mortgage insurance), then you will need a 20% down payment. Private mortgage insurance protects the lender in case you default on your loan, and your mortgage payments will include PMI till you reach a minimum equity level of 20%.
However, families should not feel the need to put all their excess cash into their home. A home is an illiquid asset, which means that if you need fast cash tomorrow, you will not be able to sell your home or pull out equity through a line of credit at the bank in time. Having an emergency fund, or cash on hand in your bank account offers you a buffer against financial emergencies, and to deplete those funds to pay down your home would leave you vulnerable and unstable. Your best bet is to leave a minimum of 6 to 12 months worth of living expenses in your bank or investment accounts, and make a generous down payment you feel comfortable with.
Remember two very important factors when choosing the amount of your down payment:
- There are better long-term investments than a home, and any excess cash you don’t spend paying off your mortgage can be used to grow wealthier for retirement.
- If you experience financial hardship, miss a number of payments, and your home ends up in foreclosure, all your equity is gone, in addition to your clean credit history.
Research The Home
Once buyers decide that they want a house, they should consider potential problems. Just because a house is “new” to you doesn’t mean that serious maintenance issues will not arise in the near future. Get an appraisal and perform a professional home inspection. Check out other houses built by the same contractor, especially in subdivisions. Talk to neighbors that have lived in their houses for a year or two or twenty. If you are buying a house that is occupied, ask about problems and utility costs, but realize that sellers may have their own self-interest at heart. Realtors, builders and owners are not always honest, so it is essential to get a home inspection before buying.
Old houses that have been well-maintained are often a bargain, but buyers need to look closely for maintenance issues. My friend chose an older home, but the exterior, siding, roof and windows, had recently been redone with high grade, low-maintenance commercial materials. Balanced against that were the HVAC unit and water heater which will both probably have to be replaced within a year or two.
Before making an offer, consider what maintenance and repair issues might arise in the immediate future and negotiate to have the price-reduced. Never request that the seller oversee the repairs themselves – this person is leaving, do you think he/she really cares about the quality of work performed if he/she won’t be living there afterwards?
Additionally, you should always be willing to walk away from a deal if it no longer makes financial sense; however, don’t reneged on a good deal because of your emotions or the fact that you can’t get every single, little thing you want out of the purchase agreement. Just a little “Negotiating 101”, always include a few trivial concessions along with more elemental requests so you have something to bargain with and “concede” to the seller when going back and forth. This will make the seller “feel” like he isn’t giving in to everything you want.
Getting The Right Mortgage
The most common mortgage is a conventional, 30-year fixed rate loan, but to qualify, even with FHA, for this type of mortgage, you will need to have a minimum credit score of 620 and two years of continuous employment. Individuals who have more than a 20% down payment and cannot qualify for a 15 or 30 year fixed rate loan, may be offered an ARM (adjustable rate mortgage), whereby your interest rate is floating and attached to an index or market rate that is updated periodically. Buyers who opt for an ARM can be faced with increases in monthly payments and a balloon payment in two or three years. ARMs were largely responsible for the recent mortgage crisis when homeowners’ introductory rates were adjusted upwards to their “real” rates. Only consider an ARM if you know you can raise your credit score and meet minimum requirements for a fixed rate mortgage within two years so you can refinance.
Finding The Best Real Estate Deals
Many realtors will no longer show homes to buyers who have not been pre-approved for a mortgage. If you are pre-approved, make sure that your realtor does not push you towards the top end of your pre-approval amount by showing you the most expensive homes you can afford. When talking to realtors, set a maximum price below the pre-approved amount and advise the realtor that you do not want to look at houses above that range.
Furthermore, do your own research. Don’t rely on what your realtor or friends say is a good price – take a look at Zillow.com to get an idea of the general market value of homes in that neighborhood. Sometimes people get caught up in the excitement of buying their first home or really “fall in love” with a property, to the point that they overpay for it. Keep your emotions in check and realize there will always be other homes you will love and appreciate, and while infatuation comes and goes, your mortgage payment will be there for decades.
My friend, a value investor who recently purchased a home, offered less than the asking price and looked for homes that had been on the market for more than 90 days. Her home was an REO (foreclosure or “real estate owned” by the lender) that had been on the market for a year. She offered $10,000 less than the asking price, which was $20,000 less than the appraised value. The offer was accepted. This gave me $30,000 in equity before my down payment and a nice cushion in case I needed to pull out equity or flip it for a quick sale. Finding the best deal will require patience, but considering the fact that your home is a long-term investment and you may be stuck with it for at least 5 years, it is wise to wait for something you are happy living in and financially comfortable and confident owning.
Any Home Can Be A Dream Home
Buying a home that costs less than you think you can afford allows you to make improvements over time while building equity in the real estate. Buyers who overextend their finances can be faced with financial disaster if they lose a job, become ill or have unexpected expenses like car or home repairs. It is important to save at least 10% of your monthly income to provide a cushion for emergencies. If mortgage payments are more than 25% of monthly income, owners are too worried about paying the bills to enjoy living in their dream home.
Resources For Home Buyers
There are a number of PBS and cable television shows that educate potential home buyers in the pitfalls awaiting new homeowners. Holmes on Homes, This Old House and shows about flipping homes offer insight on how to approach the sales and negotiation process, how to inspect and renovate a home properly, and what can go wrong. On the show Property Brothers, one brother is a realtor and the other a contractor. They show viewers how to turn a less than ideal house into the perfect home. Buyers with a financial plan that understand the expected and unexpected expenses of home ownership can avoid becoming house poor by staying within their budget when purchasing a home, and leaving room in their finances to overcome potential problems, such as plumbing, electrical, roofing, or foundation issues.
Home prices are currently lower than they have been in decades, but that is not a good reason to jump into the housing market if you are not ready. Wait until you can make at least a 10% down payment and still have 6 months’ salary put aside for emergencies. Buyers who can do this and stay within their budget can build wealth and enjoy all the benefits of home ownership without sacrificing their happiness and comfortable lifestyle.