Can You Afford to Buy a House?

If you're convinced that you want to buy a house, you need to consider whether you can afford it. You don't want to find yourself without a penny to spare for anything else. And you don't want to overextend yourself to the point where you can't keep up with your mortgage payments and risk losing the house.

a. Analyzing Your Current Expenses

Many new homeowners find that when they add up their total housing costs (the monthly mortgage payment; the cost of moving, settling in, and making immediate repairs; and the ongoing costs of taxes, insurance, and property maintenance), these costs are higher than the amount they previously paid for rent. If you think this might be true for you, can you afford to pay more for housing? Do you usually have some money left at the end of each pay period? If not, you may need to change some of your spending habits before you can consider buying a house.

Notice that some of your expenses are fixed, such as your car payment, taxes, and day care; others are discretionary-that is, you have considerable flexibility in deciding how much or how little to spend in these areas (for example, clothing and entertainment).

To some extent, you must simply decide how important it is to own your own home. Are you willing to put off some purchases or spend less for a time? You can try out the cost of homeownership by putting aside extra funds each month or from each paycheck. If you find you can do this, you may indeed be ready for homeownership.

You should not consider buying a house until you can handle the mortgage payment and other housing-related costs. If you do not repay your mortgage as promised in the mortgage documents you sign, you may lose your home!

b. The Costs of Purchasing a Home

Let's look at the main costs involved in purchasing a home. These include the upfront costs and the ongoing costs.

Up-front costs

Your up-front costs will include the down payment, closing (or settlement) costs, and the expense of moving and settling into your new home. It can also include "earnest money" or a deposit that the homebuyer puts down on the home to impress the seller that the buyer "earnestly" intends to purchase the home.

Down payment. Virtually all homebuyers rely on a loan (or mortgage) from a financial institution. And most mortgage products require that you contribute some portion of your own funds (the down payment). Lenders feel more secure if you have money invested in the house; that way you are not likely to walk away from it if your finances take a turn for the worse.

In the past, lenders expected buyers to make a down payment of at least 20 percent of the purchase price. This meant that buyers needed a down payment of $30,000 to buy a $150,000 house. Today, buyers can pay as little as zero to 5 percent down provided they purchase private mortgage insurance (or PMI), which helps protect the lender in case the borrower fails to repay the loan. A 5 percent down payment on that $150,000 home comes to $7,500. However, PMI might add another $100 to the monthly payment.

Closing costs. Besides the down payment, homebuyers must be prepared to pay a number of additional up-front costs incurred in buying a home. Collectively called "closing costs", these expenses range from 3 percent to 6 percent of the mortgage. (In some areas of the country, closing costs may be even higher than 6 percent.) If you were to buy a $150,000 house with a 5 percent down payment ($7,500), you could expect to pay $4,275 to $8,550 in closing costs on your $142,500 mortgage. Your local NFCC housing counseling agency can help you find down payment assistance programs for first-time and low-income buyers.

Settling-in costs. You also will need to consider what it will cost to move and settle into a new home. If you buy a house needing immediate repairs, you will need money after buying the house. You also may need to purchase major appliances such as a stove and refrigerator. You do not want to spend all of your money on buying the house.

Ongoing costs. As a renter, your primary housing cost is the amount of your monthly rent payment. As a homeowner, your housing costs will include your monthly mortgage payment, property taxes, homeowner's insurance, mortgage insurance (if required by the lender), utilities, and maintenance. Owners of condominiums or cooperatives also pay a monthly maintenance fee, often called a "homeowners' association fee" or "carrying charge."

Monthly mortgage payment. Since most homebuyers are accustomed to paying rent monthly, they are usually prepared to make monthly mortgage payments. Each mortgage payment includes both the repayment of a portion of the principal (the amount you actually borrowed) and the interest (a fee for using the lender's funds). Lenders refer to payments of principal and interest as "P&I." The amount of your monthly payment depends on the amount you borrow, the interest rate, the repayment period (or term), and whether you have a fixed- or adjustable-rate mortgage.

The bigger the loan amount and the higher the interest rate, the larger the borrower's monthly payment. You may wonder how these monthly payments are calculated. Most mortgages are fully "amortized." This means that at the end of the repayment period (after 30 years of making the same monthly principal and interest payment), you will have paid the entire amount of principal and all the interest charged by the lender. The house is then yours, free and clear.

Taxes and insurance (T&I). In many cases, a homebuyer's monthly mortgage payments include not only the amount required to repay a portion of the principal and accrued interest (P&I) but also property taxes, homeowner's insurance, and private mortgage insurance. The lender holds these additional amounts in a separate "escrow" account and then pays the tax and insurance bills. In this way, the lender ensures that these annual expenses get paid on time. If taxes and insurance are not escrowed each month, the homeowner must be prepared to pay these bills when they are due.

Because taxes and insurance are an essential part of a homeowner's housing costs, lenders often refer to the components of a mortgage payment as PITI, or principal, interest, taxes, and insurance. Condominium and cooperative fees belong in this category as well.

Other costs. Other ongoing costs include utilities (oil, gas, electricity, and water) and maintenance costs. First-time homebuyers often are surprised by the high cost of basic upkeep. The cost of utilities may vary greatly (increasing during the heating season, for example), but repairs often are an unexpected expense. For these reasons, homeowners always must have a cash reserve.

But the news is not all bad: Homeowners receive significant federal income tax benefits.

We've looked at both the importance of budgeting and the expenses of homeownership. Before you begin house hunting, you need to know what you can afford.

©2007 National Foundation for Credit Counseling