Home Purchase Considerations

This article discusses five questions to consider before purchasing a home.


Should I purchase a home at all?

Compare the total housing costs of renting versus purchasing a home.  If the cost of rent and renter's insurance is substantially less than a mortgage, homeowner's insurance, property taxes, home maintenance fees, and possibly homeowner's association fees, you may decide to keep renting even if you can afford to buy a home.

The current interest rate environment can affect this comparison substantially, with home purchases much less attractive during high interest rate environments (because of higher mortgage payments) and much more attractive during low interest rate environments (because of lower mortgage payments), all else equal.

In the event buying a home would be comparable to or less expensive than renting in terms of total annual housing costs, it's still probably better to avoid purchasing a home if you'll end up needing to sell it within the next few years.  The closing costs of buying or selling a home can be expensive, often thousands or tens of thousands of dollars.

An analogy is having an extremely large bid-ask spread when transacting in investments.  If that's the case, you would rather buy-and-hold for a substantial amount of time rather than take part in many transactions, to minimize these high transaction costs.

Once you're through your education and training phases and have a stable employment situation for a few years, if you plan to remain in the area for the long-term, buying a home appears much more attractive.


What sized home should I buy?

It depends on the size of your family, or the size of the family you plan to have in the near future.  Based on that, you should be able to figure out how many bedrooms in the home you'll need now or in the future.

And don't forget, two kids can share a bedroom with a bunk bed!  Having the option to finish a basement also gives you some flexibility for more space in the future if your family size grows.

Try to avoid purchasing a home larger than you currently need or ever plan to need, even if you can afford it.  Having a much bigger home than you need is more expensive in terms of property taxes, homeowner's insurance, utilities, cleaning and maintaining it, and so on, without much if any benefit.

Right-sizing your home can limit your total housing costs and allow you to direct more of your after-tax earned income toward your other financial goals such as becoming financially independent sooner.


What's the most I can afford to spend on a home?

Keep your Housing Ratio 1 (HR1) less than or equal to 28%, which is your housing costs divided by your gross pay, where housing costs are the sum of your mortgage payment, property taxes, and homeowner's insurance (where both the numerator and denominator are in terms of either monthly or annual amounts so the units match).

Keep your Housing Ratio 2 (HR2) less than or equal to 36%, which is your housing costs and all of your other debt payments divided by your gross pay.

For example, if your pre-tax earned income (gross pay) is $400,000/year, your gross pay per month would be $400,000/12 months = $33,333/month.  To stay within the HR1 guideline, your monthly mortgage payment, property taxes, and homeowner's insurance payments should not exceed ($33,333/month)(0.28) = $9,333/month.

To stay within the HR2 guideline, your monthly mortgage payment, property taxes, homeowner's insurance, and all other debt payments (e.g., student loan payments, auto loan payments, credit card interest payments, etc.) should not exceed ($33,333/month)(0.36) = $12,000/month.

As an even more conservative measure, and to free up more cash flow each month for other purposes, consider using your monthly after-tax earned income instead of your monthly pre-tax earned income, when calculating your HR1 and HR2 ratios.  This calculation adjustment is more important for high income earners who have a high effective tax rate.

For example, if your pre-tax earned income is $400,000/year but you pay $80,000/year in taxes, your after-tax earned income is $320,000/year, or $26,667/month.

Based on this, to stay within the HR1 guideline (using after-tax earned income in the denominator), your monthly mortgage payment, property taxes, and homeowner's insurance payments should not exceed ($26,667/month)(0.28) = $7,467/month, instead of the $9,333/month calculated above using pre-tax earned income.

Once you've done the calculations (using either pre-tax or after-tax earned income in the denominators), avoid considering any housing options which would put you over either the HR1 or HR2 guidelines.


How large of a downpayment should I have when buying a home?

Plan to have a downpayment of at least 20% on a conventional home loan to avoid private mortgage insurance (PMI) and lower your mortgage interest rate.

Having a larger downpayment makes you less risky from the lender's perspective.  Because of this, the lender will offer you more favorable terms, including offering you lower mortgage interest rates and not requiring you to pay PMI premiums.

Keep renting until you've saved up enough for at least a 20% downpayment in cash.


What's the difference between fixed rate mortgages and adjustable-rate mortgages (ARMs), and which one should I choose?

Let's take the example of a 5/1 ARM on a 30-year mortgage.  The interest rate is fixed for the first five years, and after that, the interest rate adjusts up or down every year based on current market conditions.

Although the initial 5-year interest rate on this 5/1 ARM on a 30-year mortgage is going to be lower than a 30-year fixed rate mortgage, the lender is transferring interest rate risk onto you as the borrower via the ARM.

Specifically, the lender is transferring the risk to you that after the initial 5-year period, market interest rates will rise considerably and remain high for many years, and accordingly, your ARM interest rate will rise and remain high for many years, which would be bad for you and good for the lender.  And to entice you to take on this interest rate risk after the initial 5-year period, the lender will offer you a very low interest rate for the first five years of a 5/1 ARM.

Assuming you plan to take all 30 years to pay off your 30-year mortgage, you may rather have a 30-year fixed-rate mortgage instead of a 5/1 ARM on a 30-year mortgage, where the lender, not you as the borrower, is the only party facing interest rate risk.

Specifically, under the circumstance of a 30-year fixed-rate mortgage, the lender faces the risk of interest rates falling (below your 30-year fixed interest rate), and you as the borrower refinancing your mortgage to a lower rate (and locking in this new, lower, fixed interest rate for the remainder of your mortgage), which would be good for you and bad for the lender.

However, if instead you're planning to pay off the mortgage within five years, you'd be better off taking the 5/1 ARM over a fixed rate mortgage, since you'd be at a lower initial interest rate via the 5/1 ARM compared to the fixed-rate mortgage and wouldn't be facing any interest rate risk during those first five years under either option.


If you are a prospective client and would like to learn more about hiring us for a financial consultation, where, among other things, we would help you plan for financial goals such as home purchases, please visit our Schedule Meeting page.



Mike McErlane, DO, MBA, CFP^®, CFA^®, RICP^®, EA, MCEP^®

Mike McErlane is the owner and founder of Comprehensive Financial Planning for Doctors, LLC based in Frisco, Texas.

Comprehensive Financial Planning for Doctors, LLC (CFPFD) is an Investment Adviser registered with the Texas State Securities Board.  Registration of an Investment Adviser does not imply any specific level of skill or training.  CFPFD only transacts business in states or jurisdictions in which it is registered or exempt from registration.  A copy of CFPFD's current disclosure brochure is available through the Securities and Exchange Commission's Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.

The opinions and analyses described are subject to change at any time without notice.  Any information is considered general and is not intended to provide any specific advice or recommendations.  Your use of the information is at your sole risk.  You should consult with your financial advisor, attorney, tax advisor, insurance agent, or other professional advisor before taking action on any information or implementing any strategy.