In the mid-2000s, observers expected millennial homeowners to be few and far in between. This new generation faced stagnant wages, crippling debt issues, and an unfavorable market. Flash forward more than a decade later, and we see a different picture.
The Wall Street Journal notes, a wellspring of new buyers from the millennial market has carried the housing industry this year. Last year, this demographic represented more than half the new mortgages. By July 2019, they also made up 38% of homebuyers. Home ownership aspirations among millennials continue to grow even in 2020, thanks to low interest rates. The COVID-19 pandemic, however, also led to massive unemployment. Its impact on millennials’ finances will no doubt slow down demand from this market.
If you’ve a stable job and need a little more elbow room, now could be the best time to buy a home. But let’s not get ahead of ourselves. And even if you had to put your house-hunting aspirations on hold, don’t fret. The first steps often begin long before you even look at the listings.
The Advantages of Home Ownership
There is no real answer to the classic rent or own debate. What works best for your situation will depend on your finances and lifestyle. Some people prefer the mobility offered by renting. Others love the stability provided by an owned home. When it comes to price, it’s a different ball game.
The longer you live somewhere, the more it makes financial sense to own the property. Fixed-rate mortgage payments have one big advantage over rent. You pay the same amount for the entirety of the mortgage. Rents, meanwhile, can rise over time. If rents rise too high, it might be cheaper to buy a house!
As a general rule, you can compare the costs of renting vs. owning by multiplying your rent by 200. This is the equivalent of staying in place for 16 years and three months. For instance, let’s assume your rent costs $1,500 a month. In 200 months’ time, you could’ve paid for a modest home worth $300,000. And this is already assuming that your rent stays the same.
Complicating factors include the median home price in your neighborhood. Renting might be justified if the houses in your neighborhood are too pricey. If you have the option of moving, then a cheaper home somewhere else might be more practical.
Refining Your Budget
Whoa, there. Close that tab and stop looking at house listings. Before you fall down that rabbit hole, let’s examine your budget. This much-needed reality check can help you make the right financial decisions. The last thing you want is repeat the same mistakes people made two decades before.
Your budget will play a key role in deciding when you can buy a home. How much mortgage can you fit into your regular budget today? Will your budget have room for savings afterward? Examine the costs of home ownership and compare them to your current needs. In the meantime, focus on pressing financial matters like emergency funds and debts. You must make these considerations before deciding to buy a home. While you wait, set aside as much money as you can for a down payment.
Defining Your Down
The down payment is among the most important expenses you’ll make in the homebuying process. It lowers your starting loan-to-value (LTV) ratio. Your LTV is the percentage of the home paid for by the mortgage and thus owned by your lender. For instance, if you paid a 10 percent down payment, your LTV ratio is 90 percent. The remaining 10 percent is your home equity, the amount you do own. The greater your starting home equity, the smaller the sum you need to borrow.
A sizeable down payment cuts down your expenses in other ways. You’ll also avoid private mortgage insurance (PMI). This is an extraneous fee slapped onto your mortgage payment to protect lenders from the risks of default. It does nothing to help you build equity!
By law, PMI payments stop after your LTV ratio reaches 78 percent. But why waste your money until then? Instead, avoid paying PMI altogether by having a down payment worth at least 20 percent of your home’s price. You can save more money by removing that one unnecessary cost.
Remember, prices are not static. Real estate markets often follow an upward curve. Be aggressive when saving and adjust your down payment goals. If you expect real estate to climb by 3 percent each year, plan accordingly. If your savings goal is 5 years away, aim to make 16 percent more than your target amount.
Analyzing Your Home Needs
It’s easy to get carried away with a dream home. But don’t buy into it easily. Choose a home based on meeting your immediate and anticipated needs.
The ideal home will vary from person to person. If you like to keep things simple and manageable, then a small home might be right for you. A standard, four-bedroom family home is good for the average nuclear family with two kids. Even if you don’t expect another child, the extra bedroom could serve a variety of purposes. It can be a guest bedroom, a room for your parents, or a home office. If you have or expect a big family, a bigger home is in order. If you love the countryside, a rural property might be the thing you’re looking for.
Home offices in particular have become important considerations for homebuyers. Thanks to the advent of telecommuting, millennials needn’t live close to the city center to work. Companies, including tech giants like Twitter, now recognize the advantages of remote work. This trend grew further in the wake of COVID-19 and may likely continue into the future. A home office keeps your professional and personal lives distinct when telecommuting.
While you can always go to cheaper suburban or rural areas to buy a bigger home, this isn’t always advisable. A long stressful commute to work can have adverse effects on both your health and your daily budget. And don’t think having “more house for your money” is a bargain. One UCLA study has found that most rooms in a standard American house were underused.
How much and how long you must pay for a house will vary. It’s natural for you to veer toward the smallest monthly payment option. You want a mortgage that fits snugly into your budget. But this choice comes with its own drawbacks. Loans calculate interest fees from the money you borrowed based on the rate and the term. The longer the term and the higher the rate, the greater the interest costs.
According to Freddie Mac, the most popular mortgage option has been the 30-year fixed-rate mortgage. These have low, regular payments that are easy to fit into the regular budget. It has been around for nearly a century. But is the 30-year fixed mortgage all that it’s cracked up to be? Critics have claimed that this loan product has failed as a wealth building tool for working-class Americans. This is because the interest costs of a 30-year mortgage will always be high. Besides their long terms, they often have steeper rates.
Thus, aim for as short a term as you can afford. Although pricier each month, a 15-year mortgage can help you save more money in the long run.
Let’s look at one example. Suppose you bought a house worth $300,000 and are willing to pay a 20 percent ($60,000) down payment. You have two options for your $240,000 mortgage. One mortgage offered a 15-year term and 2.5 percent annual percentage rate (APR). The other offers a 30-year term but comes with 3.3 percent APR. The examples below do not include escrow payments like taxes and home insurance.Mortgage DetailsMortgage 1Mortgage 2Term15 Years30 YearsRate (APR)2.5%3.3%Monthly Principal & Interest$1,600.29$1,051.09Total Interest Paid$48,052.94$138,393.31
Although you saved $549.20 each month, you still spent $90,340.37 more on your mortgage’s interest.
Some low monthly payment options come with dire financial consequences. Adjustable-rate mortgages may have low minimum payments at first. But that payment does not reduce your mortgage’s principal. Because their rates change with the market, you’ll likely end up paying more in the future.
Other Ways to Save
There’s more than one way to save money on your mortgage. Because of the way mortgage interest is calculated, you can pay extra toward your principal to save money. This is an excellent and flexible way to reduce your lifetime interest costs if you cannot afford a higher monthly payment up front.
Here’s how it works. In the early days of a mortgage, most of your payments go toward paying interest. On your first payment, only a small part goes toward paying your principal balance. With each payment, your balance shrinks. This means less of your payment goes toward interest and more toward your principal. The cycle continues until your mortgage matures. Paying extra to your principal speeds up this process.
Let’s return to our 30-year example. Suppose, in the 3rd year, you begin paying an extra $100 per month. For this example, we used this extra payment calculator from MortgageCalculators.info.Mortgage DetailsOriginal PaymentExtra $100/ month on the 3rd yearMonthly Principal & Interest$1,051.09$1,151.09Pay-off Time30 years26 years 3 monthsTime Saved03 years 9 monthsTotal Interest$138,393.31$120,129.89Total Interest Savings0$18,263.42
In that span of time, you shaved off 3 years and 9 months from your loan term and saved about $18,263.42 in total interest charges. That’s money you can set aside for emergency funds, retirement, or other important expenses.
Another way you can save is through biweekly payments. This method takes advantage of a quirk in the calendar. There are about 52 weeks in a year and 26 biweekly periods. In effect, you’ve added an extra month to your payment plan. There are several ways to set up biweekly payments. You can discuss the matter with your lender or have a third party do it on your behalf. Both options come with pricey maintenance fees. The alternative is to pay the equivalent of one month’s payment at the end of the year.
Finally, you can refinance your mortgage. This involves paying down your existing mortgage balance with a new one that has more favorable payment terms. Refinancing to a shorter term or lower rate has the potential to save you even more money in the long run. CBS reports that U.S. homeowners can save $160 each month if they refinanced their mortgages. Indeed, many homeowners refinance when rates drop low enough.
Returning to our previous example, let’s look at how much you can save by refinancing. In this example, we’ll assume you’ve paid off 3 years’ worth of mortgage payments. From there, you refinanced to a 15-year term at the cost of $3,200. Your new APR is 2.7 percent. Here’s how much you can save:Mortgage DetailsCurrent PaymentRefinanced PaymentRemaining Mortgage Balance$225,221.50$225,221.50Rate/APR3.3%2.7%Monthly Principal and Interest$1,051.09$1,523.05Interest Due$115,332.99$48,927.27
By refinancing, you can save $63,205.16 in interest minus your closing costs. But to recoup the costs, you must stay in your current home for at least two years and two months. The up-front costs of refinancing make it an unwieldy option for many homeowners. Thus, refinancing is ideal for established homeowners who intend to stay in their homes long-term.
The Bottom Line
If you want to settle down, don’t wait until your rent goes up. While you save up for your down payment, it’s time to review your spending. Look for expenses you can remove to bolster your cash flow. Start by paying extra toward debt. Clearing your credit card bills and other debts serves a dual purpose. By paying extra toward your debts, you save money and increase your cash flow. Making regular, punctual debt payments also improves your credit rating. This will help you qualify for better interest rates when you look for a mortgage deal.
Look out for caveats like prepayment penalties in your mortgage contract. These punitive clauses punish home buyers for paying extra too early. If a prospective lender won’t remove these clauses, take your business elsewhere. If you’ve already signed on, don’t worry. Since 2014, prepayment penalties must only last three years by law.
As with all things worth doing, if you can afford to wait it out, do so. Great savings come to those who wait.