Why your first home shouldn't be your dream home

It may pay to settle for less when purchasing your first home.

Since 2000, homeownership rates in the U.S. have hovered around 66% to 67% of the population. In 1900, fewer than half of Americans owned their own home. The biggest surge in homebuying came after World War II, when many young families were encouraged to buy a "starter home."

Attitudes about how to buy a home have fluctuated as much as interest rates during the decades since World War II. Eventually, many first-time homebuyers were encouraged to buy big, in order to stretch their budgets as much as possible and buy the home they wanted to live in forever.

Given the high level of foreclosures and the loss of value in many homes, today's buyers are more wary of taking on a home they cannot afford, but many are still tempted to make their first home purchase a dream home rather than a starter home.

A recent Coldwell Banker Real Estate Brokerage survey of its brokers revealed that while affordability was the No. 1 concern of first-time homebuyers, 81% of those buyers consider move-in conditions very important when buying a home. Only 7% were considering buying a fixer-upper.

Jim Gillespie, president and CEO of Coldwell Banker, was quoted as part of the survey, saying, "In the past, first-time homebuyers were willing to purchase older, more basic houses in an effort to save money and break into homeownership. It is important for first-time homebuyers to remember that by considering a fixer-upper for their first home purchase, they can build equity over time and later move up and into their second-stage home that better reflects their expectations."

The economy and your home
Personal-finance writer Liz Pulliam Weston describes four economic changes that should discourage buyers from overspending on their house payment:

  1.  Inflation: Rising prices, while hard on the household budget, usually came along with substantial annual raises. These days, homebuyers cannot count on a significant raise to make their housing payments easier to handle.
  2. Two-income couples: Weston says that when more families had a single wage-earner, the other spouse could work to pay for the house if they were in financial trouble. Today, most households have two workers, and that double income is needed to make the mortgage payment. Consider trying to base your budget on one income or perhaps 1.5 incomes to make sure your housing payment will still be affordable if one spouse stops working.
  3. Lenders: Thirty years ago, it was difficult to qualify for a loan for more than was easily affordable. But as lending practices changed, mortgage qualifications became looser. Standards have tightened today, but lenders will always give borrowers the maximum amount for which they qualify — not necessarily what they should spend.
  4. Retirement: Thirty years ago, most people had their retirement covered by a pension and could count on Social Security. Today, retirement savings are more typically funded individually in 401(k)s and individual retirement accounts that come directly from your budget.

Each of these changes suggests that today's homebuyers should be shrinking their housing budget rather than expanding it, making sure that they can comfortably keep up with their payments, pay down their principal and build equity in their property.

Calculating your housing budget
Lenders will qualify you for a loan based on your credit score, debt-to-income ratio, income and assets, and employment history. But all potential buyers should do their own calculations to determine their comfort level with a budget. While lenders these days generally prefer to limit housing expenses (principal, interest, taxes and homeowners insurance) to 28% of the borrowers' monthly gross income, you should think about your individual spending habits.

A lot depends on your other debts and expected income and expenses. Most lenders prefer to keep total debt to income — including all the minimum payments on revolving debt or other loans, such as auto or student loans — to less than 36% of your gross income, although in some circumstances, this can increase to 40% or even 45%.

Make sure to budget about 1% to 3% of the home value for future repairs and maintenance. Those costs can quickly derail your budget.

Most homeowners should plan to stay in their home for five to seven years, so consider what may change in those years. If you plan to have children and may want to have one parent work less, your income could drop. If you enjoy golf, travel or skiing, you must factor that into your budget or decide if you are willing to reduce your spending in that area. If you work on commission or as a freelancer, or if you depend on overtime earnings, make sure you base your budget on a low-earning year rather than a high-earning year in case your income drops.

On the other hand, you can consider increasing your housing spending if your retirement is fully funded, you are debt-free and you expect a guaranteed increase in income.

The bottom line
Although no one can predict with accuracy whether or by how much home values will increase, purchasing a home you can afford and building equity by paying down the principal are the surest ways to get started climbing the property ladder.

By Michele Lerner of Investopedia

Patrick Kennedy

Patrick Kennedy

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