The lure of the ‘dream home’ is powerful and seductive. Every couple or family yearns to have a beautiful home in the perfect neighborhood. A source of personal satisfaction, comfort and pride.
Those who work in real estate or mortgage financing, are aware of this seductive pull. While most agents and lenders want to make their clients happy, very few are encouraging buyers to borrow less, buy less and settle for less. That just sounds bad.
I had a conversation about this issue with Denise Downey, a fee-only financial advisor in Spokane, Washington.
Denise has experienced the world of finance from a number of different angles. In June, she started her own business, motivated by the need to spend more time with her young family and by her desire to help people.
“I like financial planning, not sales,” she says. She believes that her new role allows her to spend more time advising her clients on all the gritty details of their financial decisions, whereas in her old life, she did not get paid for this kind of advice because her compensation was directly tied to the sale of financial products.
Mortgage brokers and realtors make money by helping people buy and sell homes, and so that is what they promote. But Denise offers a new perspective on this. Contrary to the trend of moving frequently to chase that dream home, Denise says that it’s best to stay in a home for at least 5-10 years, to allow for market fluctuations. And that’s for starters. The longer you stay in your home the better, financially speaking.
Regarding mortgages, she begins by advising clients to make a list of all their debts and equities and then find their “debt-to-equity ratio.” This is the same formula that banks use to determine whether a buyer can afford a home loan. No more than 36% of your income should be going towards a fixed debt. With a mortgage, she advises an even more conservative approach. “28% is really the high end of the spectrum,” she says. Preferably, it should be no more than 20%. This is much less than the 33% which banks typically allow. A 20% debt-to-income ratio leaves room in case of unexpected events, such as the birth of children or the loss of an income if one person has to leave the workforce.
I also asked her about down payments. FHA loans typically will allow a down payment of just 3.5% in order to get families into a home quickly. But Denise points out that a 3,5% down payment can easily leave you “upside down” if the market value goes down. Besides, it won’t give you much equity, a critical asset to make sure you’re prepared for emergencies. She advises a down payment of 20-50%. Each person’s circumstances will differ; for example, retirees are better off not using a mortgage at all, and should if possible, pay in cash.
But a 20-50% down payment is a lot! Here in California, even a modest home costs $200,000-$300,000. That’s a lot of saving. What about a young couple who just doesn’t have much saved up right now?
Her advice is to hold off. Wait. As seductive as the prospect of moving immediately into your first home may be, you have to make sure that you’re on a firm foundation before taking this step. There are many unexpected costs (repairs, etc.) that go into owning a home. Make sure you’re ready.
She describes the process she goes through to begin helping people in this situation. “I start by asking how much they want to save, and how quickly,” she says. “Then we look at their budget.” Denise helps her clients determine where they can cut money out of their budgets in order to save the necessary amount for their down payment. Sometimes they decide to move to a smaller apartment, cut out cable, or rein in expensive hobbies.
She adds that lots of people don’t even have a budget, and maybe not everyone needs one. “But it is handy when you’re saving for a goal.” Retirement would be one of many goals that a person should keep in mind when creating a budget.
“I cringe a little when I even mention credit cards,” Denise remarks. “But - as long as you pay them off every month - they’re good for tracking where your money is going.” She also suggests Mint.com or a user-friendly app called YNAB (“You Need a Budget”). These apps can be used directly from your Smartphone.
I asked her about her own personal experience in the process of buying and selling homes. She described to me how she determined what to spend on their house in Spokane. “I knew I’d be leaving the workforce and that we’d be going from a dual to a single income. So we looked at we what we could afford, and bought half that. Or at least, significantly lower.”
She said that “comparison shopping” added a layer of stress to their home buying experience, as her realtor sometimes showed them houses that were outside their price range. This is a practice that can put buyers in a difficult situation. “The house looks good, because it’s outside the budget. But I will be stressed out every month paying the bills.” She adds that many features of pricier homes are “nice to have” but not essential, such as a nearby park or a scenic view from picture window.
Banks are in the business of lending money. For this reason, the loan amount they are willing to offer is not a reliable indicator of what you can afford. Banks only look at your current situation, which could change depending on your circumstance. It’s important for buyers to be “forward thinking,” since banks are not.
“You really have to look out for yourself,” she says. That’s great advice for anyone.