First Time Homeowners: Have You Thought of Everything?

My wife and I purchased our first home seven years ago, which was not nearly as fun as an episode of HGTV’s House Hunters makes it out to be. After actively searching for months and putting offers in and losing out on six different houses, we finally succeeded in acquiring our new home amidst fierce competition. We managed to outbid seven competing offers after spending only 20 minutes at an open house on the first day it hit the market. The experience was undeniably stressful, but we ultimately secured a wonderful home that has served our growing family well over the years (we now share our house with our three beautiful daughters). Interestingly, the current conditions in the real estate market seem eerily reminiscent of those we faced years ago.

Throughout the process, though, one thing I realized I had control over was our mortgage application. And going through the process myself made me realize how bewildering it can be. There are numerous factors to consider when obtaining financing for your home, some of which I’ve outlined here.

What determines how much you can spend on your new home?

Congrats! You (and perhaps a significant other) have decided that you want to purchase a home. Perhaps you’ve already figured out which general location, neighborhood, school district, or other factors are on your list of ‘must haves’, but if you’re like most, you probably cannot afford to outright purchase a home with just cash and will have to take out a mortgage. Your borrowing capacity will generally depend on four main factors:

1. Your Down Payment

Your down payment refers to the money you’ve already saved to buy your new house, typically ranging from 5-20% of the home’s purchase price. If you are obtaining a conforming loan1 and putting less than 20% down, you may be required to obtain private mortgage insurance (PMI) to protect the lender in case of default. On average, you will also need an additional 2-5% of the purchase price to cover closing costs and other expenses like attorney’s fees, appraisal fees, mortgage recording fees, transfer taxes, and title insurance premiums.

2. Your Credit Score and Credit History

Your credit score, or FICO score, is derived from the information found on your credit report as reported by the three major credit bureaus (TransUnion, Equifax, and Experian). Each bureau generates a separate FICO score ranging from 350 to 850, and it is important to review each one before applying for a mortgage so you can correct any errors. Your credit report includes:

  • Payment history (Have you made payments consistently and on time?)
  • Debt utilization percentage (What percentage of your available credit are you currently using?)
  • Length of credit history (How many years have you been borrowing?)
  • Types of credit (Do you have a mix of credit cards, student loans, car loans?)
  • Applications for new credit (Have you applied for new lines of credit in the recent past?)
  • Negative comments (Do you have any outstanding judgments, liens, or recent bankruptcies?)

You can expect to obtain competitive mortgage interest rates if your score is 720 or above, which may enable you to borrow more than you otherwise would have.

3. Debt-to-Income Ratio

Your debt-to-income ratio (DTI) is expressed as a percentage and is calculated by taking your monthly debt and dividing it by your gross monthly income. For example, if you have a student loan payment of $750 per month, a car payment of $325 per month, a minimum credit card payment of $120 per month, and a gross income of $12,500 per month, your DTI (before your mortgage) would be 9.56% [($750+$325+$120)/$12,500]. A DTI of less than 36% can qualify for most mortgages – the lower your DTI, the more you can potentially borrow for your new home. In the above example, with a maximum DTI of 36%, you could add a monthly mortgage obligation of approximately $3,300. However, it is generally inadvisable to obtain a mortgage that consumes your maximum monthly obligation, as it severely limits your ability to save towards other financial goals.

4. Monthly Maintenance Expenses

Your monthly maintenance fees are comprised of all the expenses that go along with homeownership that are not factored into your monthly principal and interest payment. Some items, like your property taxes or homeowner’s insurance, may be escrowed2 by your mortgage provider. Other costs, like utilities, association dues, and other upkeep, may fluctuate from month to month but should be considered as part of the overall cost of your home.

All these factors will impact the interest rate offered by your lender and the size of your monthly payment. It is crucial for your monthly payment to align with your overall cash flow so that you don’t feel financially constrained by your new home. As the saying goes, “house rich + cash poor = house poor”.

What else should you consider as a first-time home buyer?

Beyond the four major factors discussed above that would determine what type of home you could purchase, it’s important to think about your bigger financial picture. Make sure to consider these key components as well.

Income Taxes

Another important factor is the deductibility of mortgage interest on your income taxes. For a “qualified home,” the IRS allows an individual to deduct the interest charged on up to $750,000 of home acquisition debt (debt used to buy, build, or improve a home is considered acquisition debt). Mortgage interest is considered an itemized deduction, meaning all your itemized deductions (including State and Local Taxes “SALT” up to $10,000, charitable contributions, and qualified mortgage interest) must exceed your standard deduction for itemizing to make sense. In 2023, the standard deductions are:

  • Married Filing Jointly – $27,700
  • Single/Married Filing Separately – $13,850
  • Head of Household – $20,800

As an example, let’s take a look at a married couple who files their taxes jointly, lives in New York City, and has a combined income of $300,000. They decide to purchase a $1,062,500 home with a 20% down payment, financing the remaining $850,000 through a mortgage. Assuming they obtain a 30-year fixed mortgage at 6%, their first-year interest payments would amount to approximately $50,700. However, due to the home acquisition debt limitation, only $45,000 of that interest would be deductible on their 2023 income tax return. If the couple also maximizes the SALT deduction at $10,000 and donates $5,000 to charity annually, their total itemized deductions will reach around $60,000. This exceeds the standard deduction by approximately $32,300.

These itemized deductions reduce the couple’s effective tax rate from approximately 32% (combining Federal/State/Local taxes) to around 27%, resulting in a total tax reduction of approximately $15,000. Remember, the mortgage interest tax deduction helps lower your income tax burden when you file your tax return, but you still need sufficient cash flow to meet your total monthly payments throughout the year.

Types of Mortgages

Once you have a purchase price in mind, the next decision is the type of mortgage product to obtain. There are various types of mortgages, but they generally fall into two main categories:

  • Fixed-rate mortgages, where the interest rate remains constant throughout the loan’s life.
  • Adjustable-rate mortgages (ARM), which adjust based on the rate of an underlying index following a fixed-rate period (typically 3-10 years). Typically, ARM interest rates are lower than those of fixed-rate mortgages because the lender assumes less interest rate risk.

Ideally, you should choose the fixed rate period of your loan based on how long you expect to stay in your home. Remember that you cannot take your mortgage with you when you sell your home. So, if you anticipate moving within the next 5-7 years, why pay more for a 30-year fixed rate? On the other hand, if you’re considering a “forever home,” a 30-year fixed-rate mortgage may make the most sense.

Another option to consider, especially for those with family members who are willing and able to assist, is an intra-family mortgage. This arrangement involves borrowing funds from a family member to finance your home purchase. With an intra-family mortgage, you can negotiate terms and conditions that may be more favorable than traditional loans. For example, you may have the flexibility to set a lower interest rate, more relaxed repayment terms, or even bypass the need for a credit check. However, it is essential to approach intra-family mortgages with clear communication, legal documentation, and a mutual understanding of expectations.

While an intra-family mortgage can be advantageous for both parties involved, it should be treated as a formal financial transaction in order to maintain family relationships and ensure transparency. Additionally, to qualify for the mortgage interest deduction, the loan must be structured as a bona fide debt secured by the home – meaning a mortgage must be formally filed against the property being purchased. Additionally, the borrower may need to provide the lender with a Form 1098, which reports the mortgage interest paid during the year, and abide by other IRS regulations.

Refinancing Options

Depending on the type of loan you obtained and your loan servicer, refinancing your mortgage may be a viable option to consider in the future. Refinancing can be particularly beneficial if mortgage interest rates decline from their current levels. By refinancing, you have the opportunity to secure a new loan with improved terms, such as a lower interest rate or adjusted repayment schedule, which can result in significant savings over the life of the loan.

However, before considering refinancing, it is important to carefully evaluate your financial situation, long-term goals, and consult with a financial advisor. Additionally, as you build equity in your home (the increase in value relative to the purchase price), you may have the option to access some of that equity for renovations or other expenses. This can be achieved through a “cash-out refinance,” where the new mortgage exceeds the amount of the existing mortgage, effectively converting the equity in your home into liquid funds you can use.

Conclusion

The decision to buy a home should not be taken lightly. It is a significant decision with far-reaching consequences. However, with careful planning, expert guidance, and a positive outlook, you too can achieve your dream of homeownership.

Footnotes:

1 A conforming loan is a loan that meets all the requirements set out by Fannie Mae and Freddie Mac. Fannie and Freddie are organizations that were created by Congress to create stability in the mortgage market by acting as mortgage buyers. This provides mortgage originators, banks and credit unions, the liquidity they need to issue mortgages. Generally, if you borrow $726,000 or less (this can increase to over $1,000,000 in some high-priced markets) your loan will be considered a conforming mortgage.

2 An account set up by your lender to collect payments of property taxes and homeowner’s insurance premiums that will be collected on a monthly basis and then paid on your behalf, typically annually or bi-annually. The costs of these items are part of your monthly mortgage payment.

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Eric Dostal

About Eric Dostal, J.D., CFP®

Eric is a wealth advisor in our New York City office.

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