Buying a house is one of the most exciting (and expensive) purchases in life. Frankly, it can be pretty intimidating, too. There’s seemingly a lot to understand, several lengthy processes to follow, and endless terms or acronyms to remember—PITI, PMI, DTI, etc. Beyond that, and more importantly, how much should you spend, and what can you comfortably afford? Allow this article to serve as your guide as you consider buying your first home. To help explain the concepts, I’ll use real numbers from my first home purchase in 2020. Here’s what we’ll cover:
- The Basics: Down Payments and Mortgages
- Mortgages: How Do They Work?
- Supporting Concepts: HOA/Condo Fees, Mortgage Points, and More
- Closing Thoughts
The Basics: Down Payments and Mortgages
For most home buyers (and nearly all first-time home buyers), the prospect of buying the house in full, with cash, is out of the question. Thus, they opt to provide a down payment (money paid up-front, in cash, usually expressed as a percentage of the home’s purchase price) and take on a mortgage (a loan for the price of the home, less the down payment, paid monthly).
Generally, the rule of thumb is to try to put down at least 20% of the home’s purchase price as a down payment (e.g., $50K down on a $250K house), but this is not a requirement. Realistically, many first-time home buyers tend to put down anywhere from about 3% to 10%, which is totally acceptable. In my case, I purchased a home for $414,930 and I put down roughly 10% ($41,500), meaning my loan (mortgage) was for $373,430.
The impact is, the lesser your down payment, the greater your monthly mortgage payment. Additionally, in many cases, if you put down less than 20% of the home’s purchase price, your lender may require you to pay for private mortgage insurance (PMI) until you’ve built up 20% equity (ownership) in your home through the principal (equity) portion of your monthly mortgage payments. PMI, which is an additional monthly cost, helps reduce the lender’s potential losses in the event that you stop paying your mortgage (but it doesn’t get you anything extra!). In my case, even though I only put down 10%, I ended up not having to pay PMI each month because I opted to put additional cash down at closing (through what they call “points”) for what’s known as “lender-paid PMI.” More on this later.
Mortgages: How Do They Work?
Building on the example from before, let’s say that you plan to put $50K down on a $250K house (20%). This means that you’d ultimately be requesting a loan for $200K from a lender; this is your mortgage. This mortgage amount is broken into monthly mortgage payments, the amount of which depends upon several factors surrounding the terms of your loan (interest rate, length in years, etc.) In my case, I opted for a 30-year, fixed-rate conventional mortgage with a 3.5% interest rate (APR; annual percentage rate), which worked out to monthly payments of $2,109.
Mortgage Payments (PITI)
There are four components of a monthly mortgage payment: principal, interest, taxes, and insurance (commonly referred to as “PITI”). In short, principal represents the portion of your payment that goes directly towards your outstanding mortgage balance and contributes to your equity (ownership) value in the home. Interest is the portion of your payment that covers the cost of borrowing the money for your mortgage loan from the bank. Taxes in this case are for property taxes, which vary depending upon your state and county. Insurance in this case means home insurance, which, again, varies depending upon several other factors.
The relative proportions of each of these payment categories can change over time, depending on a few factors. In general, you will pay more towards interest than principal early in the life of your mortgage, until you reach what is called the “tipping point.” For my loan, my monthly payments originally only put $572 towards principal, but a whopping $1,098 towards interest. The remaining $439 of the total $2,109 payment went to property taxes and home insurance. Also, note that, contrary to popular belief, your mortgage payment can change over time, based on your home’s assessed property value (which affects your annual property tax requirements) and home insurance rate.
How Much Can I Afford?
To know whether a particular mortgage amount for a home purchase is reasonable (i.e., whether you’d likely be approved and can comfortably afford it), there are several quantitative items to consider here: your credit score, your debt-to-income (DTI) ratio, the interest rate (APR), and the term (number of years). Qualitatively, and, perhaps more importantly, you also need to consider your stage in life, your job (income) security, any other planned major purchases, and your overall financial situation. Each of these factors is discussed in the following sections.
Two of the most important factors considered in mortgage approvals are your credit score and DTI ratio. With regards to your credit score, obviously higher is better, but anything above 700 is generally safe. At this level, you appear to be a reliable borrower, and you’ll generally receive excellent rates and loan terms. With regards to your DTI ratio, lenders sometimes approve up to 43% (meaning the entire monthly mortgage payment could be as much as 43% of your gross monthly income), but note that this is on the extreme end AND this includes any other debt obligations (car payments, student loans, credit-card debt, etc.) To be safer, I’d stay below 30%, if feasible, in coordination with your monthly budget.
In my case, when I bought my house in February 2020, I had a credit score of around 780 and a monthly income of $9,433. Also, I had no other debt (e.g., credit card balance, car loans, student loans, etc.), so my DTI ratio for the $2,109 monthly mortgage payment on a $9,433 monthly income was only 22%. In hindsight, this was a really good spot to be in, especially considering I purchased it right before COVID struck and took many people out of work. It’s always good to play things conservatively for this reason.
To determine how a particular home loan would affect your DTI, you’ll need to know the interest rate and the length of the loan. In today’s market, where rates are historically low, home loans tend to go for anywhere from about 2% to 4% interest, but these fluctuate constantly. Fixed, however, are the options for the length of your loan. Most people opt for a 30-year mortgage (meaning you’d make 360 monthly payments over a total of 30 years before fully paying off the loan for your house), but 15-year mortgages are relatively common, too. Beyond those, there are other less-common types, such as 10-year, 20-year, etc., too. Most of these mortgages have fixed interest rates, but, in some cases, the interest rate changes, such as with the infamous 5/1 ARM (adjustable-rate mortgage) loan, meaning that the rate is initially fixed for five years, but then changes every year thereafter. Frankly, often times–especially with how low interest rates are in general these days–you’re better off with a fixed-rate 15-year or 30-year loan. Note that, the shorter the term of the loan, the greater your monthly payment, but you’ll pay less in interest over the life of the loan.
Adding to our ongoing scenario, if you were to opt for a 30-year mortgage at 3% interest (APR) for a $250K house with $50K (20%) down, just the principal and interest portions (i.e., not including the taxes or insurance portions) of your mortgage payment due each month would be about $843. In my case, recall that my monthly payments for a 30-year loan at a 3.5% APR for $373,430 worked out to $2,109. Breaking this down into the four PITI components (which change slightly each month), at this early stage in the loan’s life, I’m paying roughly $600 in principal; $1,000 in interest; $400 in property taxes, and $100 for home insurance. As the loan matures, the monthly interest amount will decrease, meaning the amount of equity I’m building through the principal portion of the payments will increase each month.
Quality-of-Life Considerations
Before all of the quantitative components discussed above, you need to consider your prospective purchase from a qualitative standpoint. By that, I mean, consider how likely it is that you could lose your job (and, if that were to happen, how easily and quickly you could find a replacement making comparable money). Additionally, consider how much you have saved up in an emergency fund, which you’d need to access in the event of job loss to make sure that you wouldn’t default on or miss any mortgage payments. Next, what other sources of debt do you have, and when will those go away? Do you have any other big purchases coming up, such as a car, more schooling, etc.? Finally, what feels comfortable? For me, I like to err on the side of caution, so I felt comfortable with the 22% DTI ratio my initial home purchase brought. However, I also knew at the time that the purchase was extra safe because my job wasn’t going anywhere, and, in fact, a substantial raise was imminent (bringing my monthly income to $12,500 and my DTI to 17%). Looking back, I’m both happy with the house I bought and the terms of my payments; I strongly recommend you do not overextend yourself!
Supporting Concepts: HOA/Condo Fees, Mortgage Points, and More
I realize we’ve covered A LOT in this particularly lengthy article, but I wanted to leave you with a few notes about other things to be aware of as you continue your learning and search processes for buying your first home. Specifically, HOA/condo fees, mortgage points, closing costs, buyer incentives, and maintenance expectations.
HOA/Condo Fees
In many cases, on top of your mortgage payments, you’ll also be required to pay an HOA or condo fee. These cover various things, such as neighborhood amenities, landscaping, roadwork, etc. In my case, my townhouse community has a $210 monthly condo fee, which gets us neighborhood-wide extensive landscape work, exterior maintenance, and snow removal services. Condo fees tend to exceed HOA fees (condo fees are usually for condos and some townhomes, while HOA fees are usually for single-family homes and other townhomes).
Mortgage Points
When you close the deal on your home purchase, you’ll likely have the opportunity to put down additional cash (beyond your down payment and any other closing costs/fees) towards mortgage points (correlating to percentages of your loan amount), which yield more preferable terms. In my case, I put down 1.07 points (i.e., an additional 1.07% of my $373,430 loan, or $3,995) to reduce the interest rate (APR) from 4.0% to 3.5% and remove the $68 monthly PMI payments through “lender-paid” PMI. Whether these make sense in your case will really depend upon the circumstances, but you can always crunch the numbers and figure out after how many years you’re better off having put down the points versus saving the money up front. In my case, it only took 2 years for these points to have paid for themselves, so to speak, so it was a no-brainer for me.
Closing Costs
Further still, and, unfortunately, there are even more costs when you initially buy your home than the down payment and optional mortgage points. Specifically, these include closing costs, which account for items such as administrative or processing fees, title fees, broker commissions, etc. In my case, I paid $15,628 in closing costs, which included my 1.07 points, 1% agent commission, prepaid escrow (i.e., taxes and insurance), and tons of required processing fees. As a buyer, prepare to spend about 3% of the home’s purchase price on closing costs.
Buyer Incentives
Depending upon the circumstances of your purchase (new construction, sellers’ market, etc.), you may have the opportunity to take advantage of one or more buyer incentives, ultimately reducing your closing costs, monthly payments, etc. In my case, my townhome purchase was for a new-construction home, so the builder’s company (Stanley Martin) had an established partnership with a lender. Essentially, if I chose to have the partner lender provide my loan, I’d be given $10,000 in closing-cost credits by the builder’s company. In these cases, I highly recommend doing your due diligence and seeing whether competing firms’ rates or terms are significantly better than the partner company’s. In my case, they weren’t, so it made sense for me to leverage the partner company and save the additional $10,000 up front.
Maintenance Expectations
Something to consider above and beyond the purchase price, loan terms, and monthly payments for your home are the expected maintenance and utility costs. Specifically, realize that larger homes naturally and generally tend to cost more to maintain (due to more space to care for, heat, upkeep, etc.). Additionally, you should factor in the age of the home. In my case, my new-construction home requires far less in maintenance costs than an aging home without warranties and the latest building technologies integrated, so that was certainly a benefit of my particular purchase. A general rule of thumb is to expect to pay up to 1% of the home’s price in maintenance costs per year. For my home, this estimate works out to about $4,150/year.
Closing Thoughts
This is undoubtedly among my longest and most in-depth articles, so there’s a lot to unpack here. It’s worth noting that this whole process is not as nearly as difficult as it may seem on paper. Ultimately, the takeaways are as follows: don’t financially overextend yourself; consider the stability and trajectory of your financial situation; and account for costs above and beyond the monthly mortgage payments (HOA/condo fees, maintenance, etc.) when assessing affordability.
Wealth Explorers, have you purchased a home already? If so, what do you wish you had known when you were going through your first purchase? If not, what do you still feel unsure about with your potential first purchase? Share below!
