SMART HOME BUYING GUIDE
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Buying A Home
Buying a house will likely be the single largest purchase you may make in your lifetime. Although many people buy a home for purely emotional reasons, its also critical that you evaluate a home purchase from a financial standpoint as well.
A good safe neighborhood with a highly rated school system, a nice yard for the kids to play in and enough space are some of the most important factors many people look for when buying a house.
But what about some of the finances? How much house should you actually be buying? How do you know if you’re getting a good deal? Are you overpaying?
Making poor financial decisions when it comes to buying a house can quickly erode the good feelings you might have had initially when you bought the house. When the house payment becomes too much of a burden or when you want to sell and you cant seem to get the money you have invested into your home back out.
Here are 2 Rules to Help Keep Your Home From Breaking Your Budget
Rule #1: Always Put Down At Least 20%
My primary rule for financing your home is to always put down at least 20%. Having a down payment of at least 20% will keep you from having to pay Private Mortgage Insurance (PMI) which can cost you an additional monthly fee of between .5% to 1% of the total loan per year.
The rate you receive for your private mortgage insurance will depend on your credit score, the amount of money you have for your down payment, and insurer. But typically the premiums for private mortgage insurance can range from $30-70 per month for every $100,000 borrowed.
So you should be looking for a home priced where you can comfortably put down at least 20%. For example, on a $200,000 home you should be able to comfortably have $40,000 on hand to use as your down payment.
If you don’t have 20% to put down, you will likely have to pay private mortgage insurance or if you qualify use an FHA loan.
PMI Example
Lets say you have found the home of your dreams and its priced at $350,000, but you only have 10% available to use as a down Payment. Your lender tells you no problem, you can just put 10% down and finance $315,000.
After working out the details of the loan he comes up with a 15 year loan for $315,000 at 4% interest. Your Monthly Payment for principal and interest would be $2,330.02. However you will also have a PMI fee of .75% per year of the original principal balance of your loan. This will cost you an extra $197 per month. By the way many lenders wont break this out separately for you, they will just include it in your payment. Adding PMI brings your total monthly payment up to $2,527.02 per month.
As I said, many lenders will try to downplay the cost of PMI, as will many realtors. Its only .75%, right?
Yes. But because you didn’t put down a full 20% its .75% on your entire loan. If you had put down an extra 10% or $35,000 you wouldn’t have PMI. So in effect the PMI cost is really just the cost of borrowing that additional $35,000.
Borrowing the additional $35,000 at 4% interest over a 15 year mortgage raises your monthly payment by $259 per month. However, when you add in the cost of the PMI, $197, that brings your monthly payment up to $456 per month. When you factor all of that in together the cost of borrowing the extra $35,000 ends up being 13.57%.
Amazing how a .75% fee ends up really costing you 13.57%!
Remember that this for illustrative purposes only. Your loan amount and financing terms will vary and therefore your results may be different.
FHA Loans
Typically FHA loans can be even more costly! Intended to help lower income families find affordable housing, these loans end up costing them even more.
An FHA loan allows a borrower to buy a house with as little as 3.5% down. And thats about where the benefits end.
In addition to paying an ongoing fee similar to PMI, FHA borrowers are also required to pay an upfront mortgage premium equal to 1.75% of the home loan.
On a $200,000 home this would cost an additional $3,500 or about half of the down payment. This fee can be paid upfront or rolled into their mortgage as part of the settlement costs which will raise their payment even more.
The monthly expense is called mortgage insurance premium, which works pretty similarly to PMI.
Monthly Mortgage Insurance Premiums
On a 30 year loan less than $625,000 with over 95% LTV MIP = .85%
On a 15 year loan less than $625,000 with less than 90% LTV MIP = .7%
Here’s an example of using FHA to buy a new home
Buying a $350,000 home would require a $12,250 down payment (3.5% of purchase price) the remaining $337,750 would be financed.
At 4% Interest on a 15 year loan the Monthly Payment would be $2,498.
However adding in the MIP cost of $197 (.7 x $337,750) plus the upfront MIP rolled into the mortgage, brings the monthly payment up to $2,739 per month. (This does not include any other closing costs)
In this example the borrower put down only $12,250, instead of the $70,000 that would be the normal 20% downpayment.
So the true borrowing cost of the additional $57,750 that would have been needed to avoid the FHA loan would go as follows.
$57,750 (additional down payment to avoid FHA)
+ $5910 Upfront MIP Payment 1.75% x $337,750=$5,910 (rolled into mortgage)
= $63,660
The monthly payment for financing the additional $63,660 is $470/mo.
Adding in the Monthly MIP of $197, brings the total payment up to $667 per month. Which makes the additional borrowing cost 11.29% interest per year!
Remember that this for illustrative purposes only. Your loan amount and financing terms will vary and therefore your results may be different.
This may only appear to be not as bad as regular PMI because of the lower down payment required on FHA loans. In reality, when you add up all of the expenses, FHA costs a lot more money than PMI. These rates are more typical of what you would expect to see on a credit card, not on a mortgage for someones primary residence!
Rule #2: Have An Affordable Monthly Payment
A standard Rule for lenders is that your monthly housing payment including taxes and insurance should be no more than 28% of your income before taxes.
My personal rule is that it should be between 20-25% of your gross income.
Be careful factoring in bonuses, commissions and overtime
If you have bonuses, commissions or overtime, I would generally recommend not including that portion of your income in your mortgage affordability calculation. If it represents a significant amount of your total income, decide on a percentage of that income you will use in your total. Do not use 100% of this income! Be realistic. If you have been with your current employer during a recession or slow down in their business, what was the overtime, bonus or commission situation at that time? If you weren’t around during the last downturn, talk to some co-workers and ask them what the income was like. The last thing you want to do is take on a mortgage that you can only afford as long as your getting that extra money.
Because housing is usually such a large percentage of most household budgets, buying too much house can be one of the quickest ways to mess up your budget. This can create stress and force you into eliminating regular savings or racking up debt in other areas.
Remember your down payment and monthly mortgage payment is only a part of the total expenses you may experience as a homeowner.
Don’t forget to budget for utilities, routine maintenance, and also set aside funds for unexpected repairs.
Many people stretch themselves to get their new house and end up using all of their savings just to cover the downpayment. When you move in, especially if you’ve never been a homeowner before, you find yourself buying all kinds of things you didn’t realize you needed.
List of “Unexpected” Things you didn’t know you needed when you Buy a House
- Trash cans
- Rakes, shovels
- Lawn Mower, weed trimer etc.
- Hose
- Decorations/Rugs/Lamps etc.
- Indoor and Outdoor Furniture
- Grill
- Landscaping
- Sprinklers
Hopefully now you have a better idea of how much you should be spending on a new house. Remember the two rules. Make sure you can put down at least 20% down, and find out how much house payment you can truly afford. Making sure your payment is no more than 25% of your gross income.
After some basic calculations you should have an idea as to a price range of homes that you will be searching for.
Your next step is to begin narrowing your search down to some neighborhoods that fit your price range and have the features that you’re generally looking for, such as number of bedrooms, overall square footage, yard, schools and proximity to work and entertainment.
How To Conduct Home Buying Research Like A Pro
Buying a home can be a very emotional buying process, however, I always prefer cold hard facts to emotion. Don’t worry, you will still find a great house, but it will also be at a great price.
Once you have decided on an area that you want to buy in, learn everything you can about both the houses that are currently on the market as well as any homes that have sold in the last 6 months. This should be a very specific list including only homes in the exact neighborhood where you are considering buying. If possible, have your realtor provide you with the listing sheet for all of the homes. If the list is too big you might need to get more specific with your search or you can try shortening the time frame from 6 months to 3 months.
Determine Price Per Sq. Foot For The Area
The first thing to do with this list is to try to get an idea of what the price per square foot is for the area. To do this you will only evaluate the homes that have actually sold. Do not include houses that are currently own the market. Again, this should be a very specific area, don’t include homes that are not in the same subdivision or neighborhood. If you are looking in more than one area do this exercise for each of the neighborhoods you are truly considering.
After reviewing the recent sales you should come up with a high and a low range for the homes on a price per square foot basis. Next, drive by all of the homes that have sold recently. What do the houses look like that sold near the upper range of the price per square foot. What do the houses look like that sold at the lower end of price per square foot?
Also, talk with your realtor, ask them about the houses on the list. Have they been inside any of them? Were they updated? How nice?
You also want to separate this list by style. Are there ranches as well as 2 story homes? 3 stories? Basement/No Basement?
Separate the house into lists based on their common features.
- Ranch with basement
- Ranch with no basement
- 2 Story with basement
- 2 Story with no basement
You should focus primarily on the home style you are most likely considering, but it’s good to know how different features like having a basement affect the sale price and price per square foot.
Newer neighborhoods where all of the houses are all less than 10 years old will tend to have a tight range of price per square foot, whereas older neighborhoods can have a much bigger range in price per square foot because you could have a house that hasn’t had anything done to it in 30 years, right next to a house that has been remodeled from top to bottom.
Its in these older neighborhoods that can have the biggest opportunity to find a good deal.
As you review the listings for the neighborhood your looking at, pay particular attention to the price per square foot for each of the homes. You best opportunity usually lies in the homes that are at the biggest discount to the average or upper end of the price per square foot for the area. But not always.
Going through this exercise should give you a pretty good idea of the price ranges for the homes in the area you’re looking at and the price per square foot. Now when you look at houses, you should have a very good idea as to how good of a deal they may be.
Schedule Showings For Homes Currently On The Market
Schedule showings for the houses in the neighborhood still on the market. This is just research for now. Don’t get too excited about any of the homes you are looking at. Some of them could even be outside your price range, but its important to understand the entire market.
Take notes on the houses you’re looking at. Are the houses at the upper range of price per square foot completely renovated? How nice are the fixtures? Are the home systems like roof, plumbing air conditioner and furnace new? Feel free to take your own pictures so you can reference them later.
What you are looking for are homes that are at a discount to the high end of the price per square foot. Make some notes as to how much you think it will take to renovate the home or replace the roof, furnace or whatever else you think might need to be done to the house. This will take some work at the beginning, because you may not have any idea how much this stuff costs, or even what may need to be replaced. Your realtor may also be able to give you some ideas as to how much stuff costs.
A winner is a house where the purchase price plus the costs to renovate are still substantially less than the house would be worth after its totally fixed up.
Making An Offer
If you think you have a winner, go ahead and put in your offer. Remember, just because they are asking for a certain number, doesn’t mean thats what you have to pay. Lots of things can motivate a seller to agreeing to an offer for less than the house is worth. If its a house you want, don’t be afraid to put in a low offer. The only thing they can say is no, or they may present you with a counter offer.
Make sure your offer to purchase has been reviewed by a qualified real estate attorney and has a contingency period that can allow you out of the contract within a certain period of time for any reason whatsoever, and also allows you access to the home to do an inspection.
Due Diligence
Congratulations! Your offer has been accepted. The first thing you will want to do is schedule a full house inspection. Ask around to find someone good and reputable in your area. When scheduling the inspection ask how long they think it will take. If he he says about an hour, find someone else.
On the day of the inspection plan on spending at least 2-3 hours, and you should definitely be there to ask questions and take notes. Follow him around the house. If something needs to be replaced or fixed, ask him if he knows how much it may cost. Ask how much remaining life is in all of the major home systems. It should be in his report, but ask anyway, that ay you’re getting a running commentary.
You don’t have to follow him here, but make sure he gets up on the roof, crawls under the house if theres a crawl space and gets up into the attic.
After the inspection you should receive a detailed report explaining all of the findings of the inspection. Use this report to begin compiling estimates for everything that needs to be updated or fixed.
Schedule another day to get access. Tell them you would like to bring in a couple of contractors to get some estimates on things you want to have done to the house. In reality you are going to line up 2-3 contractors for everything that you want done. The house needs a new roof, bring out 3 roofing companies and get a written estimate from each. New furnace and air conditioner, get 3 estimates. If you need major renovation, you could also bring in a general contractor, but this will add significant cost because they will be adding a percent to the top to manage the project. It just depends on how much work you want to do.
After the inspection and getting estimates for the work that needs to be done. Add up the best estimates and add that to your accepted offer price. Divide that total by the square footage of the house. Does it still come in less than the price per square foot for the area. That difference is your potential gain. If its not a big enough margin you could go back a re-negotiate your offer. Especially if the inspection turned up anything that wasn’t completely obvious when you made your offer. Remember to
If the margin is small and you cant re-negotiate a better price, you may be better off buying a house thats already been remodeled.
Keep in mind budgets can get out of hand quickly, especially with older homes.
Going through this process is certainly a lot of work. Many people don’t do it. It takes work to do the research, it takes work to do the due diligence and if you choose a house with some projects it will take work to manage that. In the end, you will likely find a home that you can be confident that you’re not over paying for. Real estate can go up and down, but if real estate does go down a person who overpaid for their house will certainly lose more than a person who bought their house at a good value.
Average Life Expectnacy and Cost Of Major Home Systems
Years | Avg. Cost to Replace | |
Water System | 20 | $1,629 |
Plumbing | 100+ | $6/square foot of home |
Roof | Varies | $5/square foot |
Furnace | 15-25 | $7,500 |
Air Conditioning | 10 | $6000 |
Windows | 20 | $800/per installation |
Kitchen Upgrade | 20 | $20,301 |
Bathrooms | 20 | $9,313 |
Hot Water | 10-11 | $900 |
Electrical | 15 | $800-$3,000 |
Paint (Exterior & Interior) | 15 | $2,581 |
Light Fixtures | 10+ | $95-$250 |
Flooring (Hardwood) | 100+ | $8/square foot |
Flooring (Carpet) | 8-10 | $5/square foot |
Driveway (Asphalt) | 15-20 | $13/square foot |
Landscaping | — | $3,500 |
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- 21 E Long Lake Rd #104, Bloomfield Hills, MI 48304
Contact Us
- bill@lethemonfinancial.com
- (248) 731-7829
