How Will Purchasing a New Home Impact Your Long-Term Financial Plan?
By Aimee Calderon, CFP®
Homeownership is part of the American dream, but in Orange County, California, is the dream actually attainable?
The median home price in Orange County is nearly three-quarters of a million dollars. With the median income around $85,000, the disparity between income and home prices makes homeownership seem like a pipe dream for many. However, the homeownership rate in Orange County is over 57%, so somehow most people have been able to attain the dream, albeit by deciding to fork over quite a bit of their personal finances.
The First Step: How Much Are You Going to Pay?
With discipline, patience, and wise choices, you can make purchasing a home part of your future. When deciding to buy a home, you first need to figure out how you are going to pay for it.
Most first-time buyers don’t have the cash available to purchase it outright and will need to obtain a loan. It is generally accepted that putting down 20% on a home is a wise choice. By doing this, you will avoid paying private mortgage insurance (PMI) and should qualify for a lower interest rate than you would with only a 5% or 10% down payment.
Saving up for the down payment is where discipline and patience come into play. The following tips can help with the savings process:
Pay yourself first. Set up automatic transfers from your checking account once or twice a month to a savings account designated for your down payment. This should help put a priority on saving for a house and help keep your other discretionary expenses down.
Be conservative. Money that is being set aside for short-term financial goals should be kept conservatively. While the stock market has had good long-term performance, it is not a wise choice for short-term money. You don’t want to get caught in a bad year and lose some of the money you worked so hard to save. A money market, CD, or ultra-short-term bond fund are all possibilities. You should be able to earn at least 2% annually on your account in today’s interest rate market.
Be patient. It is tempting to jump into the housing market before you are financially ready. You might find a dream home that you love, or you might be afraid that mortgage rates or housing prices will rise. Don’t let fear guide your financial decisions. Seek wise counsel from a trusted mortgage broker and financial advisor to see if you are financially ready to purchase a home.
Mortgage brokers can provide guidance for your savings goal and let you know what you can expect to qualify for. Your income, down payment, and credit score will all affect the amount you can borrow and the interest rate you are offered.
A broker will tell you that your monthly housing expense should be somewhere around 33% of your gross monthly income. In addition to the mortgage payment, you need to consider property taxes, homeowners’ insurance, and a possible homeowners’ association (HOA) fee.
To break down the numbers, let’s assume you are buying a house for $750,000. A 20% down payment would be $150,000, which would leave a $600,000 mortgage. We will assume you get a 30-year fixed mortgage at 4%, and the property tax rate is 1.25%. Your monthly housing expense would be as follows:
Mortgage payment (principal and interest) $2,864
Property taxes 781
Homeowners’ insurance 100
HOA fee 100
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Total monthly housing expense $3,845
Based on this example, you would need to have a gross monthly income of $11,652 or an annual income of about $140,000 to meet the 33% housing expense rule.
The Impact on Your Long-Term Plan
Now, what does this do to your long-term financial plan? Along with the high housing price tag in Southern California comes the opportunity for higher-than-average appreciation over the long term.
However, we don’t believe that you should buy a home based on market expectations. You should buy a home that you want to live in and enjoy. Over the long term, your home should appreciate, but it shouldn’t be thought of as primarily an investment.
Obviously, any money allocated to a mortgage or the associated expenses cannot be saved for retirement. But you need to live somewhere, and if buying costs you near the same amount to renting, it may make sense to invest in real estate. If you want to know the nitty-gritty details, a financial advisor can run projections for you to show you the effects of renting versus buying.
The tax implications of buying a house can also affect your decision. With our new tax law, the deductions available are not as beneficial as they once were. Under the new law, you can deduct the interest on a mortgage with a balance up to only $750,000. In the scenario above, the interest would be deductible and would total about $24,000 in the first year.
In addition, property taxes are deductible; however, there is now a $10,000 limit on the total of state income tax and property tax. With California having high state income taxes, it is very possible that you will not get any extra tax deduction from paying property tax.
We often advise our clients to try to pay off their mortgage by the time they retire. This requires discipline in either the form of extra payments or resisting the urge to take a home equity line to use for other expenses. The main benefit of paying off the mortgage is that our clients reduce the amount they need to live on in retirement. The home is also now a large source of equity that can be tapped if needed.
Buying a home can be an exciting but overwhelming experience. With the objective assistance of a fee-only financial planner, you can sort through the questions of buying a home and its long-term impact on your financial plan to make an informed decision about your home purchase.
Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.