Buying a house became an integral part of the American dream in the wake of World War II when the middle class expanded due to the prosperity of the 1940s and ’50s. Owning your own piece of land and the roof over your head is a huge source of pride and satisfaction for many Americans, symbolizing success and security.
But in the years after the Great Recession, getting to the point where home ownership is a viable possibility has become more difficult for many — millennials especially. For a generation saddled with outrageous amounts of student debt and an understandable distrust of the housing market, many are not in a position to buy. Some have even decided to be lifelong renters.
Though it may not seem like it, there are many benefits to home ownership. The most obvious of those is the ability to build wealth over time, build equity, and get several tax deductions. However, these are benefits you can only realize if you buy a home you can actually afford.
How do you determine how much money you need to buy a house? There are several things to take into account. The most obvious is the down payment, but there are also other factors to consider, such as closing costs, property tax, and insurance. Let’s take each one of these into consideration to determine how much cash you’ll need to realize your American dream of a new home.
1. Before You Look
Before you even begin to seriously consider buying a home, you’ll need to do two important things:
- Ensure you have enough in emergency savings (before the down payment and other expenses we’ll discuss below) to get you through at least three months of living expenses, although six months’ worth is recommended.
- Improve your credit score. This will ensure that when you go to get pre-approved for a mortgage, you’ll get a lower interest rate. In the end, even a decrease of a few tenths of a percentage on mortgage rates could save you thousands over the course of your home loan.
2. Calculate How Much House You Can Afford
Traditional wisdom recommends you spend 30% or less of your total income on housing expenses. For instance, if your gross monthly income is $3,000, you should be spending $1,000 or less on rent or mortgage payments.
This is a good rule of thumb, especially when buying a home, as lenders typically prefer that you have a total debt to income ratio of less than 36%, and a housing debt to income ratio no greater than 28%. In other words, if you make $3,000 a month, a lender would prefer that you owe less than $1,080 in total monthly debt payments, and less than $840 for housing.
However, if you want to be especially financially savvy, most financial experts would recommend a debt to income ratio of less than 30%, and a housing debt to income ratio of less than 25%.
How do you determine what a healthy housing to income ratio would be for you?
[Monthly Income before Tax] * 0.25 = Reasonable Monthly Mortgage Payment
Once you know how much you can afford to pay monthly, you can work backwards to figure out how much house you can actually afford.
3. Determine How Much Cash You Can Put Down
The down payment on a new home is generally expressed as a percentage of the home’s purchase price. For instance, a 10% down payment on a $200,000 house would amount to $20,000.
How much you decide to put down on your home will vary based on your financial situation. However, the suggested minimum down payment is generally about 20% of the home’s price.
If a 20% down payment seems impossible, there is hope. For first-time home buyers taking advantage of FHA loans — or mortgage loans insured by the Federal Housing Administration — the down payment can be as little as 3.5% if you have a credit score of 580 or above.
Returning to the example of a $200,000 home, if you decide to put down only 3.5%, that becomes a much more manageable $7,000. While you might be wondering why everyone isn’t buying a house yesterday when you can get away with such a low down payment, there are drawbacks to such low up-front costs.
In most cases, if you put down less than 20% of the home’s value, you will have to pay Private Mortgage Insurance, or PMI. PMI generally ranges from 0.5% to 5% of the total loan amount each year. On a $200,000 loan, if you decide to put only 3.5% down and have to pay PMI of 2%, that would be an extra $3,800. Over the course of five years, that adds up to about $20,000.
To really understand the cost versus the benefit of PMI, you’ll need to think through the opportunity cost of investing that extra cash (if you have it) in the market. You can take a look at this Cost of PMI Calculator. If you don’t have the cash, you’ll also have to evaluate how quickly the market in your area is appreciating, and whether you’ll get left behind if you don’t jump into the housing market now.
4. Save for Closing Costs
The down payment is usually the first — if not the only — factor that many new home buyers think about when evaluating how much cash they’ll need to have on hand to purchase a home. But don’t make the rookie mistake of forgetting about closing costs as part of the home buying process.
Closing costs are usually between 2% and 3% of the total loan amount. That means, if you take out a loan for $200,000, you’ll need to have between $4,000 and $6,000 for closing costs alone.
There are ways to reduce the cost of closing. For instance, during home purchase negotiations, some sellers will agree to pay the closing costs themselves, On the other hand, you can also negotiate premium pricing with your lender — meaning you’ll pay a higher interest rate on your mortgage in return for the lender paying the closing costs.
5. Factor in Prepaid Expenses
You’re probably thinking, “What?! There are more expenses after closing costs?”
Unfortunately, the answer is yes. Prepaid expenses are things like real estate taxes and homeowners insurance that can amount to up to 2% the loan amount — or another $4,000 on a $200,000 loan.
Real Estate Taxes
Property taxes are a major consideration when you purchase a home. Depending on where you live, you could pay anywhere from 0.27% to 2.40% on the value of your home annually.
When you purchase a home, you essentially have to pay the lender those taxes in advance to ensure they will have the funds to pay taxes when they are due next. Depending on the real estate tax collection schedule of your state, you may have to provide anywhere from 2 to 12 months of real estate taxes up front.
A fancier way of saying this is that the lender will put your money in escrow. That means if the taxes on the home are $200 per month with a six-month required escrow, you will be required to provide $1,200 upon closing.
The same principle holds true for home insurance. Mortgage lenders typically require you to prepay a homeowner’s insurance policy of at least one year on the home you purchase.
6. Don’t Forget Utility Adjustments
One more thing you’ll want to save up for are utility adjustments. Often, homeowners will pay for utilities such as water, sewer, and trash removal in advance. When you buy the house from them, you’ll have to essentially pay them back for the services they’ve already purchased, and which you will now enjoy as the new homeowner.
Homeowners association (HOA) fees also fall under this category. Often, in these types of communities, residents pay their HOA fee on an annual basis. For instance, if you buy the house from them in March, you would need to pay them back the fees they put up for April through December, or nine months’ worth of fees.
The good news? Utility adjustments usually only amount to a few hundred dollars.
7. Finish With Cash Reserve Requirements
Finally, we’ve made it to the last consideration in our list: cash reserves.
Many first-time home buyers may not be aware that lenders typically require borrowers to have at least two months of mortgage payments in an easily accessible account, such as a checking account, savings account, or brokerage account. This is to ensure you don’t default early on the loan due to unforeseen circumstances, such as the loss of a job, a medical emergency, or even unexpected home maintenance issues.
Now, if you’ve already built up your emergency fund — as we advise you do before you even start thinking about buying a home — you’ll be in excellent shape to complete the home buying process.
Bringing It All Together
Let’s finish walking through that example above. On a $200,000 home where you put 3.5% down, you’ll need about $19,000 in cash to close based on the items above.
If you want to determine how much you will need based on your own situation, take a look at this How Much Cash Do You Need to Buy a Home Calculator. Click “File” then “Make a copy” to input your own numbers.
Make Your Move
There are many expenses to take into account when you purchase a home. The down payment is just one piece of the puzzle.
Evaluating other expenses associated with your home purchase, such as closing costs, real estate taxes, and home insurance, will help you gain a better understanding of the amount of cash you’ll need to save before you buy your first home.
With a clear idea of how much you truly need to buy a house, you can go into the home buying process with confidence and peace of mind.