Financial Considerations for First-Time Homebuyers
In light of the credit crisis, the calculus that goes into buying one’s first home as changed. The old logic of bigger is better no longer applies. The new rules emphasize careful planning, conservative forecasting, and frugality.
First of all, no longer can/should you assume that your home will appreciate indefinitely, if at all. This erroneous assumption is one of the biggest factors in the current wave of foreclosures, as mortgagers took out mortgages that were larger and riskier than otherwise advisable because they believed that they would be able to ultimately sell the house for profit.
In hindsight, the opposite proved to be true, and millions of homeowners now find themselves with underwater mortgages. In short, don’t think of your home as a conventional investment that will yield a return when it’s ultimately disposed of. A home has utility (which includes intangible value), and this should be the biggest factor in the purchase. Along the same lines, you need to consider that if your home does appreciate (or even maintain its value) it will require substantial upkeep, perhaps to the tune of 4% a year. While maintenance will provide an emotion return in the form of increased comfort/satisfaction, it will likely negate most, if not all of the financial return that will earn from owning your home.
Second, don’t make overly optimistic assumptions about future earnings, which could potentially leave you with a crushing debt burden in the even that your income doesn’t grow as planned. DINKs (Double Income No Kids) might think of themselves as the exception to this rule, because they are best in position to gamble. At the same time, this is somewhat irresponsible, since such individuals are most likely to witness their costs (kids….) increase faster than their income. This rule is especially important in the current economic environment, with income growth projected to be flat, on average, for the next few years.
The third piece of advice is to think small. When in doubt, go with the smaller home/mortgage. If your financial situation changes for the worse, you will be glad that you did. If, on the other hand, your financial situation improves, you can always upgrade to a larger home. In this case, a viable option is to simply expand your home, which will probably prove less costly, inconvenient than moving.
Along the same lines, you may want to consider taking out a “conservative” mortgage. Generally, this means going with a 30-year fixed rate mortgage. It could mean higher rates in the short-term, but there won’t be any surprises over the long-term. You will know from Day 1 exactly how much you will need to pay each month, regardless of whether home prices or interest rates change. In addition, bear in mind that a down-payment of more than 20% of the value of the home is least likely to lead to an underwater mortgage down the road. Hewing closely to your lender’s recommended income and asset ratios also makes it less likely that you will overextend yourself.
Finally, remember that there is an advantage to being a first-time homebuyer right now, in the form of a government tax credit. Ideally, you should consider the affordability of your mortgage irrespective of the credit, in which case your financial position will be especially robust. Still, human nature being what it is, I suppose you can’t be faulted for factoring in the government’s contribution to your down-payment. For some borrowers, the government’s 10% (maximum $8,000 contribution) could even eliminate the need to make a down-payment altogether. Bear in mind that time is running out on this program; while the federal government is mulling an extension, it is currently scheduled to expire on December 1. With potentially only two more month left, now’s the time to start filing the paperwork!