In the late Fall of 2021, the 30-year fixed-rate mortgage at below 3% offered cheap financing for borrowers looking to purchase, or refinance, a home. However, while the cheap financing seemed like a blessing, the acceleration in home prices was the devil in disguise. Fast forward just a few months, and we see 30-year fixed-rate mortgages at approximately 5.2% and above.
While rates are not at an all-time high from a historical perspective, the rate of change in such a brief period has higher rates in a head-on collision with elevated home prices. With rates and numbers on the rise, here are a few essential principles to keep in mind if you embark on a home search.
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Raise Cash for Unexpected Expenses
A lesson first-time homebuyers quickly learn is that homeownership expenses go beyond the monthly mortgage payment. Costs related to insurance, property taxes, general maintenance (particularly with older homes), yard maintenance, etc., can cause severe strain on your budget. Guard against this strain with a cash reserve amounting to at least six months of your monthly income before purchasing a home. Without a cash reserve, homeowners risk accumulating debt on lines of credit, credit cards, etc., to pay for these expenses. This is something to avoid in a rising interest rate environment.
Savings Come First
Do NOT sacrifice your long-term savings plans when purchasing a home. While there are certain scenarios where a step back in retirement savings makes sense, be sure that a home purchase outside your budget is not one of them. Unfortunately, a common mistake I see young homeowners make is spending too much too soon on a home and subsequently inhibiting their ability to save.
Recommendation: Saving early and often is key to long-term wealth creation! Make retirement savings a top priority and have an emergency savings account for medical expenses, etc. Also, be willing to delay your home purchase, or purchase a less expensive home, to stay on track for a successful retirement. Specifically for retirement, if your company offers a company match, take advantage of this as it is a 100% guaranteed return on your investment. Ideally, try to save at least 10% of your gross income annually.
Limit the Monthly Mortgage Payment
A general rule of thumb is to limit your mortgage payment to no more than 28% of gross income. I would even take this a step further by limiting your mortgage payment to no more than 28% of gross income AFTER retirement savings. So, for example, if gross income is $100,000, and annual savings to a company 401k is 10%, or $10,000, then one should limit their monthly mortgage payment, including insurance and property taxes, to no more than $2,100 per month.
Recommendation: When looking to purchase a home, know your monthly mortgage limit before you start looking at houses. DO NOT exceed this limit, and remember: Just because a bank will lend you money DOES NOT mean you should borrow it!! If you need help finding the right home for you with your budget, seek assistance from a financial advisor. Remember keeping your budget in check is key to success.
In next week’s part two of the series, we’ll look at the other side: When Renting Makes Sense.
Marshall Clay CFP, J.D., is a Partner and Senior Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Marshall is a graduate of the United States Military Academy in West Point, New York, the Cumberland School of Law in Birmingham, Alabama, and is a CERTIFIED FINANCIAL PLANNER™. In addition, Marshall is a frequent guest on local television stations as an expert on various financial planning matters.
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