About 10 minutes
 
 
A white picket fence, a beautiful green lawn, and a frightening mortgage.
 
Ahh, owning a home. It’s the dreamiest of American dreams. Signifying a certain level of success, owning a home is simply a right of passage as we mature into financial adulthood. It’s a no-brainer goal we should all be striving towards. Or…is it? Let’s dig in.
 

Here’s what we cover in this guide

Renting versus buying
Your home; an asset and a liability
The power of leverage
Your home as an investment
How much can you afford
Saving for the down payment
Getting pre-approved for a mortgage
Be careful with adjustable rates
Starting your search
 

Rent vs. buy, the age old debate

Despite the obvious allure of owning a home, for many of us, renting simply makes more sense.
 
When we’re young, our lives are often in flux – new jobs in different cities, new neighborhoods to explore, roommates coming and going, changing relationships – and realistically most of us simply won’t have enough money for the down payment to buy a home. 
 
Even as we get older, renting offers more lifestyle flexibility which can be attractive, or even necessary, to many people. And let’s face it, there’s something nice about the simplicity of sending a check once a month and knowing that your responsibility ends there.
 

Long story short, don’t feel compelled to buy a home just because you see other people doing it.

 
That’s generally not a good reason to do anything, especially when it comes to your finances. For a lot of us, renting is actually a smart choice.
 
And yet, no matter what we say, you probably still want to buy. And that’s okay too. For many of us, buying a home at the right time and for the right reasons can be a great decision. But there are some important things to consider first.
 

Your home; an asset and a liability

As we mentioned in Setting Goals, when you own your home, it has characteristics of both an asset and a liability, or living expense.
 
On the one hand, your home can serve as a place to store wealth. And home prices tend to increase over time (although they can go down), making it seem like an asset.
 
On the other hand, owning a home has associated costs, like interest payments on your mortgage, maintenance expenses, and property taxes. Generally speaking, these costs will increase with a more expensive home. Additionally, if you buy more home than you can comfortably afford and home prices do go down, you can end up in serious financial trouble, because of leverage…
 

The power of leverage

When you borrow money to buy your home (as most of us do), you are said to be investing with leverage. This is because your return, and also your risk, will be magnified by the debt.
 
For example, let’s say you buy a home for $200,000, putting in $50,000 of your own money as the down payment and borrowing the remaining $150,000 with a mortgage, which is a loan that’s backed, or secured, by your home.
 
Let’s suppose that after a while the value of your home increases to $300,000.
 
Your initial investment of $50,000 has now increased to $150,000 (that’s $300,000 minus the mortgage of $150,000). Your return has been magnified, which is why this is called leverage (the debt acts as a lever on your investment).
 
What could be better than that? Well, let’s say instead of your home increasing in value, it dropped from $200,000 to $150,000. The value of your home would now equal the value of your mortgage. And your original $50,000 contribution would be wiped out entirely. In other words, if you needed to sell your home, you would have just enough to pay off the mortgage with nothing left over for you. Your investment would be lost.
 
If the price dropped even more, you could end up underwater, or owing more than the value of your home. This would put you in a serious bind if you needed to sell your home.
 

Are home prices really likely to drop?

Well, it’s hard to predict. During the later part of 20th century, home prices in the US steadily increased. And as a result, many people came to view buying a home as a guaranteed way to make money. This belief that was proven painfully wrong during the Great Recession and resulted in serious financial problems for millions of households.
 
From 2007 to 2011, home prices in the U.S. declined significantly. It was estimated that roughly 30% of American homeowners were underwater on their mortgages by 2012.
 
And the numbers were even worse for certain areas of the country. While this was a fairly extreme event, it shows that owning a home is not without risk. It’s simply a bad idea to assume home prices will always go up over any given period of time.
 

But isn’t a home an investment?

Yes and no. A common argument in support of home ownership goes like this. When you rent, you’re throwing money away each month, but when you buy, you’ll be building equity. Your home effectively becomes an investment that grows with each monthly mortgage payment.
 
While there’s some truth to this, the whole story is a little more complicated.
 
For one thing, during the first few years of a typical mortgage, most of the money you pay will be covering the interest portion of the payment. Very little will actually contribute to paying down the principal on your loan. So you won’t really be building much equity early on. It has to do with how mortgage payments are structured.
 
Also, if long-term investing is your main goal, then you could probably find higher return investments elsewhere.
 
Based on research by Nobel prize-winning economist and housing expert, Robert Shiller, home prices barely outpaced inflation throughout much of the twentieth century and were not even close to keeping up with stocks as an investment. In other words, you probably would have been financially better off renting and investing your savings in the stock market.
 
That being said, it’s also important to be realistic about our behavior as living, breathing humans. Yes, you could in theory invest in higher return investments, but you need to make sure you do it. And sometimes that’s easier said than done.
 
If making the regularly scheduled payments of a mortgage forces you to be more committed to your finances, it could make owning a home a better investment than it might be otherwise. And of course there are also the intangible benefits of owning your home.
 
Overall, if you approach buying a home responsibly, it can be a sensible long-term investment. But make sure you buy for the right reasons, don’t over-extend yourself with debt, and have realistic expectations for how the value will grow and what costs you’ll face.
 

Figuring out how much you can afford

This is one of the big, burning questions of homeownership. How much home can you really afford? And it’s not always an easy one to answer.
 

An often referenced rule of thumb is to spend no more than 30% of your income on annual housing costs.

 
However, rents and home prices have significantly outpaced incomes in recent years. So many people are now exceeding this amount. Again, just because other people do something doesn’t necessarily make it a good idea. But we also have to face the reality that life can get expensive. And we can’t always boil financial decisions down to one single number.
 
As you think about how much you can afford, you’ll want to take into account your other living expenses as well as your financial goals. Then try to figure out how much you can realistically spend on housing.
 
Be sure to consider specific costs like your monthly mortgage payments, homeowner insurance, ongoing maintenance, and property taxes, which vary state by state. You’ll also want to prepare for unexpected repairs, which are sure to occur and can add up to real money.
 
We have home buying calculator if you want to crunch some numbers.
 

Saving for the down payment

As you probably know, one of the biggest steps (likely THE biggest) to home ownership is saving up for the down payment.
 
The traditional down payment amount is 20% of the price of the home. For most people, 20% represents a lot of money and can be hard to save up. But the closer you can get the better. If you put down less than 20%, you’ll be required to buy Private Mortgage Insurance (PMI), which will add to your overall costs. So it’s better if you can avoid it.
 
In general, the more you can put down, the less you’ll have to borrow and the lower your monthly mortgage payments. You may even be able to negotiate a lower interest rate when you make a larger down payment. So start saving for a down payment well in advance of when you want to buy. It will take some time.
 

Getting pre-approved

Even before you find a home to buy, you’ll probably want to get pre-approved for a mortgage.
 
Not only will this get the mortgage process underway, but it will also give you a better idea of how much you’ll be able to borrow (and afford) and will let brokers know you are a legitimate buyer.
 
The first step in the pre-approval process involves talking to lenders and providing your information over the phone, after which the lender can give you a non-binding estimate.
 
Next, you’ll have to send supporting documentation to be reviewed by the lender’s underwriters before the true pre-approval is given. This might take a week or so from the time you send in your information. A few things to have ready when you talk to lenders;
 
• Social Security number

• Employment information

• Current income and net worth

• Down payment

• Where you’re looking to buy
 
The more you can line up in advance, the smoother the process will be.
 

Shopping around for a mortgage

And don’t be afraid to shop around for a mortgage and talk to multiple lenders either. They’re trying to make money from fees and interest, so why not make them compete for your business.
 
Yes, it might feel a little intimidating to reach out to several lenders. But it will be well worth the effort if you’re able to negotiate a better deal on your loan.
 
You’ll also want to make sure your credit is in good shape before you apply for a mortgage. As we mentioned in Demystifying Credit, your credit score can have a big impact on what interest rate you can get on your loan.
 
According to FICO, the difference between strong and weak credit can be as high as 1.5%. For a $200,000 loan, this would roughly equate to a difference of $200 a month or over $75,000 over the course of a 30-year mortgage. And for larger mortgages, this number would obviously go up.
 

Be careful with adjustable rates

When you do take out a mortgage, you’ll typically have several options for the length, or term, of the loan, with 15-year and 30-year mortgages being the most common.
 
Usually, the longer a mortgage, the higher the rate. So a 30-year mortgage would likely charge a higher interest rate than a 15-year mortgage (but keep in mind your monthly payments would still be higher with the 15-year because you’ll be paying off the loan in half the time).
 
Which is better for you? That will depend on your situation and how much you can afford to put towards mortgage payments.
 
You’ll also have a choice between entering into a fixed rate mortgage or an adjustable rate mortgage (sometimes called a variable rate mortgage or floating rate mortgage).
 
With a fixed rate mortgage, as the name implies, the interest rate will remain constant for the life of the loan. So you’ll know exactly how much you’ll owe on your monthly payments.
 
With an adjustable rate mortgage, you’ll lock in an interest rate for an initial period, after which, the rate is free to fluctuate. This means your future payments will be uncertain.
 
While adjustable rate mortgages might offer attractive initial rates, your interest payments can (and likely will) increase when your rate resets, sometimes by a lot. This was was a major contributing factor in the housing crisis. Long story short, you need to be really careful if you enter into an adjustable rate mortgage and understand how your payments could change over time.
 

Searching for a home

Searching for the right home can take some time, so it’s important to plan ahead and to start getting a feel for your particular housing market well in advance of buying. Location matters, and different towns and cities vary considerably with respect to home prices.
 
One thing to pay attention to is the median home price for any given area. This tells you the halfway point for home prices in the area – half are more expensive than the median and half are less expensive. Basically it will give you a rough idea of where you can afford to live. But of course it’s just the median value, and the price of any given home in that area will depend on other specifics, like the size, condition of the home, local school system, and various other factors.
 
You’ll also want to think about what type of home you’re looking for – house, condo, townhouse…cowboy ranch? Spend some time understanding the pros and cons of each, like maintenance, privacy, and how much control you’ll have over your property. And try to remember, every home is going to be unique, and charming, and frustrating in its own way.
 
There are a lot of online sources to help you search, and at some point you’ll probably want to work with an agent as your search narrows. Don’t be afraid to talk to multiple agents before signing with one. You’ll want to find someone you feel comfortable working with.
 
We’ve really only hit the tip of the home buying iceberg here. But hopefully we’ve given you some ideas to get going and a solid foundation to build on (pun intended).
 
 

Key Take-Aways

1) Buying a home can be a good decision, but make sure you’re buying for the right reasons and not buying more than you can afford.

2) When you borrow money to buy a home, you’re taking on financial leverage, which exposes you to risk if home prices decline.

3) If you decide to buy a home, try to contribute at least 20% as a down payment.

4) Figure out how much you can afford in advance and consider getting pre-approved for a mortgage. Don’t be afraid to shop around with mortgage providers.

5) Adjustable rate mortgages may look tempting but they carry additional risk because your interest rate can increase in the future.