The Millennial Moola Guide to Buying Your First House

You’re in your first big professional job out of college. You’ve been renting for a couple years, but you’ve decided to finally make the big leap and purchase your first house. What should you look for? How much can you spend? Are you going to put 20% down or seek government financing? Should you buy a starter home with the thought that you’ll trade up later? There are a lot of choices to make when you’re buying your first house, and Millennial Moola is here to help.

Do Not Ask Your Realtor How Much You Can Afford

First of all, you should have a buyer’s agent because it does not cost you anything. The seller’s real estate agent usually gets a 6% commission for selling a house. If you have a buyer’s agent, the seller’s realtor has to split the commission with them. So the price you pay will not go up if you have professional representation as a buyer. This does not mean that there are not major conflicts of interest though.

If you go to a car dealer, will they steer you towards their cheaper models or, after discovering your high income occupation, will they attempt to place you in a newer vehicle? The answer is obvious. They will try to get you to buy the most expensive model that you can afford. However, if you give them a strict budget upfront, they will not waste your time by showing you cars outside of your range. The same is true in real estate. If you have no idea what your budget is coming into the housing search, your realtor will tell you the default answer. They will say that you can pay as much as 3.5 times of your total household income for a house. If you are a mid level engineer with a solid salary of $70,000, they will tell you that you can buy up to a $245,000 house. If you have a partner as well, they will include that income in the calculation. Say that engineer has a girlfriend who is a nurse practitioner making $80,000 a year. The buyer’s agent might try to convince you that you can afford up to a $525,000 house.

The conflict of interest comes from the way commission is paid to realtors. They do not get a fixed fee or even performance bonuses for a job well done. They get a percentage of the house price when you buy. It’s about the same amount of work to show a family a 2 bedroom 1 bath house as it is to show a 5 bedroom 3 bath house, and the two times higher price on the latter would mean two times higher commission income for the agent. He or she will get you in front of the right bankers who give you a mortgage that they immediately sell away to another investment group, thus pocketing hefty fees in the process. So even your bank has an incentive to say yes to a mortgage that is more than you should be taking out. The bigger the mortgage the bigger the fees.

A reasonable budget for buying a home is no more than 2.5 times your income as a single worker. That engineer could therefore afford a home up to $175,000. If you want to use your total household income to determine eligibility, then a reasonable budget for buying a home is no more than 2 times your income as a couple. That engineer and his girlfriend with total combined income of $150,000 could buy a house up to $300,000.

There are plenty of reasons for this limitation. If you limit your budget in this way, you will be on track for retirement in your 50s. Homes are extremely expensive. Unlike a renter, who can call a landlord to fix busted pipes or a leaky roof, you must pay for everything as a homeowner. These costs add up tremendously. Most people’s total housing costs take away between 33%-40% of pre-tax income. When you max out your personal finances like this, you leave no room for error. If your husband or wife gets sick and needs to go on disability, you will have to choose between food on the table or falling behind on credit card bills. If a new boss makes your work life a living nightmare, you might have no choice but to tough it out with a huge mortgage to pay.

More House Means Exponentially Higher Costs

When you buy at the top end of your budget, the mortgage is not the only thing you should worry about. A big house usually means more yard to mow, more stuff to buy to fill all the empty space, higher utility bills, higher property taxes, higher insurance costs, higher maintenance and repair costs, and the temptation to keep up with the Joneses in the more exclusive neighborhood you’re probably living in. These hidden costs that no one thinks about when signing a purchase agreement are the anvils that keep average middle class folks working into their late 60s.

There’s an old saying from Charles Dickens in his classic book David Copperfield that encapsulates how to be happy with money. “Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” When you buy less house than you are told you afford by society, you protect yourself from ever getting in a situation where you fall into financial trouble because of your high fixed monthly costs. It is very important to limit the overall purchase price for your house in the way that I suggested earlier. The two times your income rule will give you a lot of money left over to spend on other things in life too.

How To Finance Buying Your First House

You need to be very aggressive about asking for disclosure of all fees in your mortgage application. If you visit your local bank, or even credit union, expect a lot of random fees to get a mortgage. The bankers typically quote you a low interest rate on the mortgage but include a lot of upfront fees that you have to pay. They do this on purpose, because most people are confused by lots of math and cannot comparison shop with a bunch of different interest rates and fees. You should ask them for all these fees to be included in your APR, or interest rate you pay for the mortgage. That is the only way you will be able to comparison shop.

I think the best option when getting a mortgage is to either apply online or through a credit union. If you go the online route, I’d check out Quicken, Lending Tree, and SoFi just to get an idea of what you’d pay. Obviously, online lenders have no local brick and mortar expenses and thus can afford to give you lower rates. Another great option is to go with a credit union because they are not for profit institutions. The likelihood that they sell your mortgage to an outside party is lower than a bank. Also, based on my experience dealing with over a dozen different credit unions and banks, the credit unions had better customer service every single time. If I fell behind on my mortgage, I sure would not want to have to call Bank of America or Wells Fargo for help staying in my home.

The biggest decision you will need to make is if you want to do an FHA mortgage or go the traditional route. If you do not have a 20% down payment in the bank, no traditional lender will give you a loan in the post financial crisis world without any government insurance on the mortgage. An FHA mortgage will be what most millennials will use in the absence of a parental funded down payment. An FHA, or Federal Housing Administration, loan gives first time home buyers access to a 3.5% down mortgage. The main catch is you have to pay PMI, or Private Mortgage Insurance. This is an insurance premium in case you walk away from your mortgage obligation because you have such a low investment in the house. You can expect this insurance to add an additional 0.5% to 1% to your interest rate.

If you are set on buying a house and do not have the 20% down payment, then go ahead and get a 15 year FHA mortgage and pay the private mortgage insurance. Instead of holding bonds in your portfolio, hold all stocks because you can consider your mortgage to be a negative bond portfolio. When you buy your home, that debt you have is the opposite of investing in bonds. You owe someone else a fixed interest payment every month instead of the other way around. Instead of taking out a 30 year mortgage you’ll probably never pay off with a 20% down payment, you can probably get the 15 year 3.5% down mortgage for a similar interest rate. The higher payments you will make will ensure you are debt free well before the big liabilities of children’s college costs, retirement, and medical expenses team up on your bank account.

Another thought is to use your 30 year mortgage as a way to lock in an unbelievably low interest rate for a long period of time. Back in the 80s, mortgage rates were in the double digits. Imagine if a similar period ever returned and you had debt that only cost 4%. You would effectively be getting your house for free. If I were to buy a house, I would buy a very cheap one and take out a 30 year mortgage just to lock in the super low interest rates of today. However, I think most people would be better served psychologically just by getting a 15 year mortgage and paying it off aggressively. My parents have told me that nothing feels as good as living in a home without a mortgage. Your money feels like it goes much farther each month.

Your Home is Not an Investment, So Do Not Think of It As One

Every time I hear someone ask me “why are you throwing money away on renting?”, I want to laugh. How did throwing money away on rent work in 2000-2007? It saved you from a 50% or more collapse in real estate prices. Most people do not even realize how badly the values of their house fell because they were not forced into selling it. When you buy a house, you might pay 2% to 4% of the value in transaction fees. When you sell a house, you might pay between 6%-8% in transaction fees. Most of the mortgage payment for the first five years goes to interest, not principal. Add in the unpredictable nature of home prices that could stick you with a loss when you are trying to move for a new job opportunity, and you should only buy a house if you plan on living somewhere longer than five years. I have written on buying vs renting before, but in general your house will increase at approximately the rate of inflation over the long term. Anyone who suggests that you buy a larger, more expensive house for investment reasons has not run the numbers. Ask them for a net of fees, taxes, and expenses annual return calculation from a buy and hold investor of that house for the past 10 years. They probably will not be able to provide this number. That’s because most people who would throw around this kind of assertion so loosely are probably salespeople.

Pitching your primary home as an investment is often done by realtors with an incentive to sell you more home than you need. You should ignore this advice. A home is a very special place though. It could be where you raise your children, where they experience their first Christmas, or where you will grow old with the person who you love. It is clearly a unique dwelling that cannot be thought of in solely financial terms. Once you have a budget limit in place to guide your choices, you can decide what home you want on strictly non financial terms.

Some Final Thoughts on Home Buying

I had a really wise Bible Study leader who told me once that every couple he knew who tried to build their dream house together ended up divorced. A big house does not make you happy. Rich people living in big mansions have the same anxieties, hopes, dreams, and fears as the rest of us. You can have a movie theater in your house, or for $8 you can go down to a massive 30 foot tall screen and see the latest movie with your friends.

The biggest piece of advice I can ever give you is just limit the purchase price on your home. Give your realtor a strict number and do not let them show you houses above that level. If you buy a house less than 2 times your combined household income, you can buy whatever you want. That’s the beauty in it. Before you go to a showing for a house outside of your price range, think of how stressed out you might be with big monthly bills dominating every dollar you bring in. Consider living in a neighborhood where your house is one of the nicer ones on the block. That means your neighbors will be folks with modest incomes who will not resemble the Joneses so many people run themselves into the ground competing with.

When you buy a smaller house, you have more money to make the inside of it nicer and more livable. The exponentially lower costs you will incur from the more compact dwelling might even allow you to indulge in such luxuries as frequent restaurant visits, nicer vacations, and bathroom/kitchen remodeling down the line.

Consider taking out a shorter term mortgage and holding fewer bonds so you will achieve a no mortgage lifestyle as soon as possible. Once you own more than 20% of your home, you can get rid of the mortgage insurance. With a 15 year mortgage and extra payments when you can afford them, you will reach that point sooner than you think. Do not get into the mindset of buying a starter home from which you will trade up later. Look for a home that you can live in for a long time to come. You should be able to find one easily with the “two times your income rule” with two middle class earners in the household. All of this advice is for folks that are sure they want to buy a home. If you cannot afford the house you want after applying these guidelines, you should probably rent. Happy home shopping!