Mom or Dad were good at saying vague things like “Don’t bite off more than you can chew,” or “Your eyes are bigger than your stomach.” Or specific things like, “Double cheese fries and 64 ounces of Mountain Dew … really?”
But it turns out they not only meant well, they were cluing you in on the secret to buying an affordable first house and building a good life. It’s the big data version of “Don’t bite off more than you can chew.”
Here’s a summary of those secrets:
How Much Home Can You Really Afford?
The first secret home buyers should know is a little rule known as the “debt-to-income measure.”
Stay with me, it’s pretty simple: For your first house purchase, it means for every $1 you, or you and your partner, have in income, you spend 25 cents on your mortgage. Not a cent more. That’s it. Take this advice to the bank.
This is a big deal so it’s important to repeat: DON’T spend more than a quarter for every dollar of income when you sign that loan agreement for your first house.
It’s like an insurance policy against the very worst real estate news — you can’t make your mortgage payments. If that happens, the sheriff stamps FORECLOSURE on a sickly-looking piece of paper that goes in the courthouse records for a thousand years. Your neighbors can’t look you in the eye and your partner isn’t too happy with you, either. You lose your house, you’re out on the street.
Be Wary of the Salesperson’s Motives
This little secret of building a good life from the ground up is part of another pretty sound parental rule: “Don’t trust a salesman.” Or a saleswoman.
The salespeople in this case are your realtor and your mortgage banker. Nice people, very helpful, smile a lot. But when you borrow LESS and pay LESS for a home, they make LESS money. So they’ll try to get you to break the secret rule.
They say official-sounding things like, “You can spend a third of your income on housing costs,” or “the bank won’t let you spend more than 30% of your income on your house.”
You can’t believe them. But you can believe an expert like Kristoph Kleiner, assistant professor of finance at Indiana University’s Kelley School of Business.
“A simple rule is that a quarter of your income should go towards housing each month,” Professor Kleiner said in an interview with Debt.org.
But, Kleiner cautions, “the calculation is not always so simple.
“Do you have other large debt payments like student loans, car payments, medical bills?” he said. “Do you have kids or older relatives that depend on your income? A simple calculation can only take you so far. … In other words, you need to know whether that other 75% of your income can cover all your other expenses and savings needs.”
Real estate is like anything in life: When you “start out on the right foot”(another useful thing Mom said) more good things seem to fall into place, instead of bad things falling on your head.
You’ll Gain Self-Respect and a Competitive Advantage
When you save 75 cents on the dollar for expenses other than a roof over your head, your realtor and mortgage banker and your partner will treat you with new respect, realizing you really do know something, as opposed to nothing.
You’ll enjoy your new affordable house knowing that most Americans aren’t as smart as you are. According to the Bureau of Labor Statistics, Americans spend on average about 37% of their take-home pay on housing, by far their biggest expense.
They choke on debt. They become house poor. Many people pay even more, and renters have it worse.
You Can Qualify for a Lower-Interest Mortgage.
Before you talk to a lender, it’s important to learn your credit score. You can get a free credit score from several online sources. If you think it’s a little low, get a free copy of your credit report at annualcreditreport.com and make sure all the information is accurate. Your credit score is based on information obtained from your credit report.
And a good credit score will help put you in line for a lower-interest loan. But here’s that little secret again: Keeping your mortgage at no more than 25% of your income will go a long way to keeping down your overall debt-to-income ratio (DTI), a vital number that’s not part of your credit score but can persuade your lender to say “yes,” or, in many cases, “no.”
The formula for DTI is simple: take all your monthly debt payments (rent/house payment, student or auto loan, credit card payment and monthly alimony or child support payments), and divide by your gross monthly income.
Here’s an example of how to calculate it. Let’s say your monthly gross income is $5,000. Your debts are $2,250 (estimated new mortgage payment, $1,300, which I can see you have already noted violates the secret 25% rule; credit card payment of $400, car payment, $300, student loan $250).
Your DTI is 45%, too high in most cases. It’s better to take a smaller mortgage, and more good things will happen.
According to the Consumer Financial Protection Bureau, mortgage bankers frown on DTIs higher than 43% (though Fannie Mae has raised its standard to 50% to “help” some home buyers. We’re not sure more debt is really helpful).
Ideally, your DTI would be under 30%, though anything close to that is acceptable. A survey by the Federal Reserve said that 23.4% of rejected loan applications happen because home buyers failed the debt-to-income ratio test. It was the No. 1 reason for denial.
You Won’t Be House Poor
If you can’t afford a nice ribeye to put on that Weber grill in your spectacular gated backyard, if you can’t have friends over for dinner because you don’t have a dining room table in that grand paneled dining room, you’re house poor.
It makes a lot more sense when you’re starting out in life to go for “less house” and more financial security.
Build a good life slowly and sensibly. Get the $100,000, two-bedroom bungalow that you can comfortably afford, and not the $150,000 3-bedroom ranch that has you up at night fretting about the payment. You can afford the bigger house later.
Keep at least a six-month strategic cash reserve after the down payment. Think of it as money under the mattress to replace the air-conditioning unit or spruce up the landscaping or replace the roof.
“Realize that unforeseen events will always crop up, so don’t stretch yourself too thin,” Professor Kleiner says. “Not everyone has a yacht or plane or dream house. Be honest about what you need, and what can wait.”
You’ll sleep a lot better in that nice, new, appropriately-sized master bedroom.
You’ll See Your House as An Individual
Buying a house isn’t like buying stock. It’s not a standard commodity. It’s got personality. It’s got character. “I can’t just look up the trading price for a specific house,” Professor Kleiner says. “That is because each house is unique, and the value depends on many different factors.”
Seeing your house as an individual, with its special charm, warts and all, will help you negotiate a good deal. Check on Zillow or another real estate website to find out what your unique house sold for in the past. Find out its flaws with a housing inspector and negotiate money to fix them.
You’ll Live Comfortably for a Good Long Time in a House You Can Afford
Don’t get greedy and flip your first house in a year like a Wall Street trader on uppers. Think like a Hobbit. Plant a garden. Build a wine cellar in that small extra room. Get a dog. Make some friends.
Live a natural good life. Grow into your modest first house. Have a kid, or not. Let your house grow around you as you and your relationships grow richer over time. It makes good financial sense.
“The transaction costs associated with buying – things like paying a realtor, title fees, taxes, etc. – can add up,” Professor Kleiner says. “As a result, it likely only makes sense to buy if you are planning to own the house for a minimum of five years.”
Do Another Smart Thing Most People Overlook
Take an online homebuyer education course to prepare you for the first-house purchase. You’ll throw around financial terms like a real estate investor and impress your mother-in-law.
Many banks and lenders require you to take online courses with federally certified nonprofits. The courses typically cost $75 to $100. It’s a bargain.
“For most Americans, the house purchase is by far the largest the purchase you will ever make,” Professor Kleiner says. “Yet, we leave much of the process up to our realtors, mortgage brokers, and house inspectors. Classes that teach you the basics of real estate finance and mortgages will prepare you to find those great deals and make the best decisions for the future.”
You’ll Learn How to Be a Winning Team
Everyone has seen the young baseball team with promise that keeps losing. They have to “learn how to win.” Then by some mysterious process they start winning and reach their potential.
It’s not really a mystery. They learn how to do the right things at the right time.
Start by imposing the rule on yourself that just because you CAN qualify for a big first mortgage, doesn’t mean you SHOULD accept the largest amount of debt you can legally swallow.
Decide to be prudent with this first major expense in your life. Give yourself some breathing room.
You’ll be someone who knows who they are and what they want and how to get it. You’ll be comfortable in your own skin.
You won’t be the clown in a trailer with a beamer in his yard, or the mansion owner with a Yugo in the driveway. You’ll enjoy new levels of respect and, yes, self-respect, which leads to still more good things.
Appropriate will shine through everything in your life. Take time off for double cheese fries and gallons of Mountain Dew as necessary.
Cole, Lauren Lyons. (2017, Aug. 24). Forget coffee and avocado toast — most people blow nearly 40% of their money in the same place. Retrieved from http://www.businessinsider.com/how-to-save-more-money-2017-8
NA. (2017, March 3). What is a debt-to-income ratio? Why is the 43% debt-to-income ratio important? Retrieved from https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/
Harney, K. (2016, December 14) For every eight applicants who seek a mortgage, one is rejected. Retrieved from https://www.washingtonpost.com/realestate/for-every-eight-applicants-who-seek-a-mortgage-one-is-rejected/2016/12/12/263d426c-c09a-11e6-897f-918837dae0ae_story.html?utm_term=.ccf3e35feae9