Making Smart Decisions Around Purchasing a House

• Can commit to a location for at least 3 years — You may have a growing family and want a more permanent residence for a particular neighborhood and school district. Three years provides enough time to amortize some of the buying/selling costs and makes the buy versus rent equation usually move in the direction of the buyer.
• Ability to renovate or modify the home to exactly what you want — While you may be limited to current inventory in the market you are searching in, you have more freedom to make improvements or renovations to a residence.

2. Understanding how much home you can afford to purchase (and continue to pay for).

With the different types of mortgages out there and choices of lenders, there are varying options that figure into how much you will pay up front (down payment) and monthly over time (mortgage payment). Your personal financial situation can dictate these two levers. Consulting with your financial advisor to help understand which paths make the most sense for your situation would be prudent before you go ahead and sign on the dotted line.

Consider saving for a down payment that is at least 20% of the home purchase price. Putting down anything less than 20% will require you to pay for private mortgage insurance (PMI), which increases the cost of your mortgage. PMI protects the lender of your mortgage on the chance you default on your loan. The cost of PMI will be added to your monthly mortgage amount, to the closing costs when you finalize your purchase, or in the form of a higher interest rate on your loan. PMI expenses will remain in place until you have paid down your loan to 75%–80% of the loan’s value to your purchase price or reappraised home price.

Note that there are first-time homebuyer loans, physician loans, and veteran loans, which avoid PMI for below 20% down payments.

To figure out how much mortgage you are probably going to qualify for, you should understand the 28/36 rule. The reality is that you will probably qualify for more mortgage than you actually want to carry long term, so we discuss affordability in the next section.

28% — Mortgage payment/pre-tax income

Your monthly mortgage payment (principal, interest, property taxes, and insurance) should equate to no more than 28% of your monthly pre-tax or gross income. Your gross income should be your reliable monthly income before taxes and payroll deductions. For example, if your household’s income/base salary is $150,000 ($12,500/month), then approximately $3,500 of monthly mortgage payments is the top end of your affordability.

36% — Total debt payments/pre-tax income

Your monthly mortgage payment used above plus all other debt payments you have outstanding on a routine basis (auto loans, student loans, credit card balances if not paid in full each month) should equate to no more than 36% of your monthly pre-tax or gross income.

Working with hundreds of clients, we’ve developed a rule of thumb for house purchases. Generally, purchases of 3x pre-tax income or below allow households to save effectively and not have many budgetary constraints. While 4x pre-tax income is doable, it does require some sacrifice to savings and budget in many situations. We’ve had a few clients go up to 5x pre-tax income. This is not advisable as in many of these situations there is very little financial flexibility left over. Many of these individuals have to stay at their job (or at least their income level) and their savings ability becomes marginal at best with very little flexibility for 10–15 years.

Let’s look at a quick example: If a family has $150,000 of pre-tax income, we would advise targeting $450,000–$600,000 as the house purchase price (3x–4x pre-tax income). At or below $450,000 would be very affordable, and above $600,000 the family would start sacrificing financial flexibility and longer-term savings and wealth growth.

We often advise clients to compare 2 types of mortgages: 30-year fixed and ARMs (generally 7/1 or 10/1 ARMS), or adjustable-rate mortgages. Generally, 30-year fixed mortgages are easy to understand — you effectively pay the same interest + principal payment for 30 years to pay off the mortgage. A 10/1 ARM starts out the same as a 30-year fixed, with 10 years of set interest and principal payments. At the end of that 10 years, the principal payment schedule doesn’t change but the interest resets to a floating rate, usually the SOFR (Secured Overnight Financing Rate) + a spread. As a general rule, you do not want the mortgage to ever reach the floating-rate stage as those rates can be substantially higher, so getting a 10/1 ARM usually involves an unstated commitment to refinance or sell within 10 years.

How do you make a decision between the two? In situations where there is a chance you will sell your home in the next decade or two, we typically recommend an ARM over the 30-year fixed. For example, if you are offered 4.50% for a 30-year fixed and 4.00% for a 10/1 ARM on a $1MM mortgage, you save $5,000/year or $50,000 over 10 years on interest payments over the next 10 years by taking the ARM. However, you then have to deal with having to refinance within the next 10 years to avoid hitting floating rates at whatever future interest rates might be at the time, so you need to ensure you are getting paid enough for taking that risk.

For people confident their purchase is a “forever home” or at least their home for the next 20+ years, then a 30-year fixed mortgage may be better, as it locks in the low interest rates we have today over that entire period. However, one element to note is that “locking-in” the last decade or so of a 30-year mortgage has a reduced impact since the outstanding loan balance during those years becomes much lower, unless you cash-out refinance to take equity out.

The obvious question is why we didn’t recommend a 15-year mortgage. A 15-year mortgage means that the principal is fully paid over 15 years versus over 30 years on a 30-year fixed mortgage. This seems reasonable, but the problem is that when you make principal payments, you are earning the mortgage rate on a pre-tax basis (and something less after the interest deduction is accounted for). So, $1 paid toward a 4% 15-year mortgage is earning 4% pre-tax and less on an after-tax basis. This $1 could probably earn a higher return in a moderate or aggressive portfolio long term (6%–7% expected return yearly) so from wealth maximization perspective, lowering the principal payments by going to a 30-year amortization schedule drives a higher wealth expectation (as long as you take the $1 you would have used for principal and invest it). Obviously, portfolio returns are not guaranteed, but the chances an investor comes out ahead over 10 years is over 80%.

In many states, interest-only (IO) mortgages are available. These mortgages tend to not require any principal payments for the first 10 years, and then the principal is amortized over the last 20 years. Again, like with ARMs, IO mortgages usually involve an unstated commitment to refinance or sell within 10 years because individuals don’t want to deal with the higher payment after Year 10.

For the same reason that a 30-year mortgage is preferable to a 15-year mortgage in terms of wealth maximization, IO mortgages can be more attractive than mortgages that require principal paydown. This is because you can take the money that would have been required for principal paydown and invest it at a higher expected rate of return.

3. You should not dip into your emergency fund savings during or following a home purchase.

The last thing you want to have happen is to dip into your emergency fund savings for monthly home-related expenses you forgot about or did not consider in the first few years of homeownership. As general rule of thumb and reminder, you should have at least 3–6 months of your monthly expenses in liquid cash saved in an accessible emergency fund for unexpected expenses. Following a home purchase or during closing, it is important to consider the below (aside from a down payment and monthly mortgage):

• Closing costs for the purchase — anywhere from 2%–7% of the purchase price
• Moving expenses
• Repairs and maintenance costs that you do not expect to fix yourself
• Monthly utility expenses
• Potential increases in property taxes annually
• Furnishings

Our recommendation is to set aside 5% of the purchase price in addition to setting aside the estimated closing costs and major repairs/renovations. Note that this could amount to making 50% of the down payment available for these costs, which might suggest a client would need to set aside 30% of the purchase price, so that 10% can go toward these additional expenses. On a $1MM house purchase, this would mean $200,000 for down payment and $100,000 for these additional expenses.

4. Having a contingency plan when life events happen.

What if you or your spouse lose your job? What if a major medical event happened in your family’s life? What if you or your spouse passed away unexpectedly or became disabled and unable to work?

Life happens, and before any major change in lifestyle expenses, you should make sure you have a plan in place for what savings you would draw down first in the event of emergencies, and what insurance you need to make sure you and/or your family have necessary protection to ensure your mortgage and other fixed expenses can be covered while tackling a personal or financial hardship.

If you are thinking of making your first home purchase, looking to move to upsize/downsize your current living situation, or thinking of a second home/vacation property, talk to your financial advisor about your home purchase endeavor and review your overall financial plan along with insurance coverages to make sure everything is up to date.