Unlike the many thrill seeking adults and teenagers who invest all their funds in the next trendy cryptocurrency or fad stock only to lose the majority of their principal months later, the decision around purchasing a home involves a tad more permanence. Deciding to buy a home is a major life milestone, and is one that requires careful consideration and planning. Whether you're a first-time homebuyer or a seasoned real estate investor, there are five key factors that should weigh heavily in your decision-making process. From down payments to mortgage rates, and from long-term affordability to ownership duration, understanding these elements will empower you to make informed and financially sound choices. Let's dive into each of these factors.
1. Percentage Down Payment
The down payment is the initial lump sum you pay upfront when purchasing a home. While it's common to put down 20% of the home's purchase price, the actual percentage can vary based on individual circumstances and loan options. As talked about in more detail in Lesson 54, a higher down payment often leads to a lower monthly mortgage payment and can help you secure a more favorable interest rate. However, it's crucial to strike a balance between a sizable down payment and maintaining a healthy financial cushion. Consider your current savings, financial goals, and the impact a larger down payment might have on your overall financial stability. This is especially important in today’s higher interest rate environment. Renting for a period of time while investing your savings may put you in a better financial position than maintaining a 7% mortgage rate.
2. Affordability Long Term
Buying a home is not just about the initial cost; it's about ensuring you can comfortably afford the ongoing expenses associated with homeownership. These include mortgage payments, property taxes, homeowners insurance, utilities, maintenance, and repairs. Create a comprehensive budget that factors in these costs and reflects your financial goals. Aim for a monthly housing expense that doesn't strain your budget, allowing room for other essential expenses and savings. Remember, your financial situation may change over time, so it's essential to plan for both short-term and long-term affordability. The good old “rule of thumb” is that your mortgage payment shouldn’t exceed 30% of your gross revenue on a monthly basis. Use that as a starting metric when measuring your long term affordability to own a home.
3. Fixed vs. Variable Mortgage Interest Rate
One of the most critical decisions when getting a mortgage is choosing between a fixed interest rate and a variable (adjustable) interest rate. Fixed-rate mortgages offer stability with consistent monthly payments over the life of the loan, making them suitable for risk-averse individuals. On the other hand, variable-rate mortgages offer initial lower rates but come with the risk of rates increasing over time, potentially leading to higher payments. So keep that in mind that you will pay a premium (i.e. slightly higher interest rate) when you select a fixed rate compared to a variable rate because of that stability and embedded risk aversity. Your decision should align with your risk tolerance, financial goals, and your outlook on interest rate trends. Over the long term, variable rate has been typically better, albeit this is over the last 40 years in which interest rates have been on the steady decline. With rates having gone through a rapid incline over the past 2 years, homeowners have a tricky decision as to whether interest rates will remain elevated over the long term, and how to best structure the mortgage rate policy coupled with mortgage term duration. In my opinion, there are a few scenarios to consider in which the following mortgage structures are recommended:
Scenario 1: Rising interest rates
Mortgage Structure Recommendation: Fixed rate, longer duration
Scenario 2: Steady interest rates
Mortgage Structure Recommendation: Variable rate, short to medium duration
Scenario 3: Falling interest rates
Mortgage Structure: Variable rate, short to medium duration
Here are these 3 scenarios summarized in tabular form, with a check mark indicating the recommended mortgage structure:
Table 1: Recommended Mortgage Structures for Various Interest Rate Environments
4. Loan Duration
The loan duration, often referred to as the loan term, is the length of time you have to repay the mortgage. Common options include 15-year and 30-year terms. Shorter terms typically come with higher monthly payments but lower total interest costs, while longer terms offer lower monthly payments but higher overall interest payments. Choose a term that aligns with your financial goals and capacity to make higher monthly payments. Consider your long-term plans, such as retirement, to ensure your mortgage timeline complements your broader financial strategy.
5. Length of Ownership or Stay in Home
Your anticipated length of stay in the home plays a significant role in determining the financial viability of your purchase. As discussed in length in Lesson 38, if you plan to stay for a relatively short time, the transaction costs associated with buying and selling (such as closing costs and real estate agent fees) may outweigh any potential appreciation in the home's value. On the other hand, if you plan to stay for a more extended period, you have a better chance of benefiting from price appreciation and recouping those initial costs. Consider your personal and professional plans when gauging how long you intend to stay in the home.
Choosing a place to buy or live involves a complex web of financial considerations that extend far beyond the price tag. From the down payment to the loan duration, every decision impacts your financial well-being in the short and long term. By carefully evaluating each factor and aligning your choices with your financial goals, risk tolerance, and lifestyle plans, you can make a confident and informed decision that supports your overall financial health.
Remember, a home is not only a place to live but also a significant investment that can shape your financial future. Educate yourself, seek professional guidance if needed, and approach the process with a clear understanding of your financial priorities. Your dream home can be a reality, provided you approach it with prudence and foresight, and provided you haven’t lost all your money by throwing the kitchen sink at crypto currency and fad stock “investments”.