Home-buying hopefuls have until April 30 to write a contract on a house if they want to qualify for the $8,000 tax credit for first time home buyers or the $6,500 credit for current homeowners who are trading up. So it seems like a good time to share what I call "The 4 Walls of Home Ownership."
This is the four-part plan I developed for choosing a home you can truly afford, maintaining it properly and paying it off early to SAVE BIG. During the bubble years, people were buying homes they simply couldn't afford and the continuing foreclosure crisis is proof. "The Four Walls of Home Ownership" is my antidote. Here goes.
Houses need four walls to stand, right? Your financial foundation for home ownership needs to be strong too. When you have all four of these walls in place, they will be a sound financial structure for the sturdy house you hope to buy.
Wall #1: Down Payment = 20 Percent or More
For the first wall, you save up a substantial down payment of 20 percent or more in a savings account that you open for this purpose and this purpose only. Stretch and strain for this sizable down payment, because it's the key to everything. During the bubble years, people were routinely putting just three to five percent -- even zero -- down. That's wrong. Why? Saving up a down payment is one way you prove to yourself that you are financially ready for home ownership. More importantly, the bigger your down payment is, the smaller your monthly payment will be and that will be a comfort in tight times. Furthermore, if you put down less than 20 percent these days, you will have to pay private mortgage insurance, which is a huge waste of money.
Wall #2: Rent Amount = Mortgage Amount
The next wall is making your mortgage payment equal your rent payment. That mortgage payment must include principal, interest, taxes, homeowner's insurance and condo fees, if applicable. I know it sounds crazy, but in most markets it is absolutely possible to buy a home at a price point that gives you a mortgage payment equal to your current rent payment. (If you live somewhere with stratospheric real estate costs, the solution is to save a larger down payment.) As long as you can currently afford your rent, this is one way to know for sure that you can afford your home. I don't like the vague, theoretical formulas real estate agents and mortgage brokers use to figure out what you can afford because everybody's personal financial situation is different. I created a nifty one-of-a-kind calculator that shows you what price home you can afford based on your current rent payment. It's a great conversation starter! (Note that the calculator automatically assumes a 20 percent down payment. If you can afford to put even more down, then you can afford a more expensive house than the calculator will reflect.) Try it here.
Wall #3: House Savings Account = Maintenance Account
Wall number three is converting the special house savings account you started earlier into a house maintenance account to pay for repairs. You're already accustomed to saving this money and you've made your mortgage equal your rent, so your monthly outlay remains the same, making this a painless transition. You will now use that pot of money to pay for maintenance. Everybody always preaches about the importance of having a home maintenance fund. They're right. The most common rule of thumb is that each year you should save one percent of your home's purchase price for maintenance. On a $250,000 house that would be $2,500.
Wall #4: Tax Deduction = Mortgage Prepayment Fund
The final wall of your sound financial structure is using the "free money" you get from your mortgage interest tax deduction to prepay your mortgage. The IRS allows you to deduct the interest you pay on your mortgage from your federal income taxes. Many people use this windfall to stretch for a more expensive house. Instead, I want you to use it to pay your mortgage off early. What you do is direct your lender that the extra money you send in is to be put toward your principal. By paying down your principal at an accelerated rate, there is less principal for the bank to charge you interest on. You will save tens of thousands of dollars. (Just make sure there is no prepayment penalty on the mortgage you choose.) For example, if you have a $200,000 mortgage at seven percent and you send in about $250 extra each month. You will save $114,578 over the life of the loan. Even if you send in just $50 extra a month, you will save $36,427 in interest over the years.
Owning a home is the biggest of all the BIG savings, because housing is your highest expense. You have to live somewhere and you might as well make that housing payment serve two purposes -- nest and nest egg. The key is to do it the right way. Buy below your means, set aside money to maintain the house properly and pay it off early to save even more.