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If you’re in the market to buy your first home, you probably don’t have a clear sense about the costs of homeownership. Even people who presently own a home and are considering trading up often don’t have a great grasp on their current or likely future homeownership expenses. So we include this section to help you assess your likely homeownership costs.

Making your mortgage payments

A mortgage is a loan you take out to finance the purchase of a home. Mortgage loans are generally paid in monthly installments typically over either a 15- or 30-year time span. Chapter 4 provides greater detail about how mortgages work.

In the early years of repaying your mortgage, nearly all your mortgage payment goes toward paying interest on the money that you borrowed. Not until the later years of your mortgage term do you rapidly begin to pay down your loan balance (the principal).

As we say earlier in this chapter, all that mortgage lenders can do is tell you their own criteria for approving and denying mortgage applications and calculating the maximum that you’re eligible to borrow. A mortgage lender tallies up your monthly housing expense, the components of which the lender considers to be the mortgage payment, property taxes, and homeowners insurance.

Understanding lenders’ ratios

For a given property that you’re considering buying, a mortgage lender calculates the housing expense and normally requires that it not exceed 40 percent or so of your monthly before-tax (gross) income. So, for example, if your monthly gross income is $5,000, your lender may not allow your expected monthly housing expense to exceed $2,000. If you’re self-employed and complete IRS Form 1040, Schedule C, mortgage lenders use your after-expenses (net) income, from the bottom line of Schedule C (and, in fact, add back noncash expenses for items such as real estate and equipment depreciation, which increases a self-employed person’s net income for qualification purposes).

This housing expense ratio completely ignores almost all your other financial goals, needs, and obligations. It also ignores property maintenance and remodeling expenses, which can suck up a lot of a homeowner’s dough. Never assume that the amount a lender is willing to lend you is the amount you can truly afford.

In addition to your income, the only other financial considerations a lender takes into account are your debts or ongoing monthly obligations. Specifically, mortgage lenders examine the required monthly payments for other debts you may have, such as student loans, auto loans, and credit card bills. They also deduct for alimony, child support, or any other required payments. In addition to the percentage of your income that lenders allow for housing expenses, they typically allow an additional 5 percent of your monthly income to go toward other debt repayments.

Calculating your mortgage payment amount

After you know the amount you want to borrow, calculating the size of your mortgage payment is straightforward. The challenge is figuring out how much you can comfortably afford to borrow given your other financial goals. This chapter should assist you in this regard, especially the previous section on analyzing your spending and goals.

Suppose you work through your budget and determine that you can afford to spend $2,000 per month on housing. Determining the exact size of a mortgage that allows you to stay within this boundary may seem daunting, because your overall housing cost is comprised of several components: mortgage payments, property taxes, insurance, and maintenance (and association dues if the property is a condominium or has community assets like a swimming pool).

Using Appendix A, you can calculate the size of your mortgage payments based on the amount you want to borrow, the loan’s interest rate, and whether you want a 15- or 30-year mortgage. Alternatively, you can do the same calculations by using many of the best financial calculators available for less than $50 from companies like HP and Texas Instruments. (In Chapter 8, we discuss the ubiquitous online mortgage calculators, which are often highly simplistic.)

SO YOU THINK YOU CAN HANDLE EXCESS BORROWING?

Some people we know believe they can handle more mortgage debt than lenders allow using their handy-dandy ratios. Such borrowers may seek to borrow additional money from family, or they may fib about their income when filling out their mortgage applications.

Although some homeowners who stretch themselves financially do just fine, others end up in financial and emotional trouble. You should also know that because lenders usually cross-check the information on your mortgage application with IRS Form 4506T (the lender receives your actual tax return you filed, which certainly didn’t overstate your income), borrowers who fib on their mortgage applications are caught and their applications denied.

So although we say that the lender’s word isn’t the gospel as to how much home you can truly afford, telling the truth on your mortgage application is the only way to go. It may be painful to learn that you don’t qualify for the loan you need to purchase that home of your dreams, but you’re likely better off in the long run not overextending yourself with mortgage debt.

We should also note that telling the truth prevents you from committing perjury and fraud, troubles that catch even officials elected to high office. Bankers don’t want you to get in over your head financially and default on your loan, and we don’t want you to either.

Paying property taxes

As you’re already painfully aware if you’re a homeowner now, you must pay property taxes to your local government. The taxes are generally paid to a division typically called the County or Town Tax Collector.

Property taxes are typically based on the value of a property. Because property taxes vary from one locality to another, call the relevant local tax collector’s office to determine the exact rate in your area. (Check the government section of your local phone directory to find the phone number or search for the name of the municipality and “property tax” online.) In addition to inquiring about the property tax rate in the town where you’re contemplating buying a home, also ask what additional fees and assessments may apply. In California, many recently developed areas have special assessments (such as Mello-Roos districts), which are additional property taxes to pay for enhanced infrastructure and amenities, such as parks, police/fire stations, golf courses, and landscaped medians.

If you make a smaller down payment – less than 20 percent of the home’s purchase price – your lender is likely to require you to have an impound account (also called an escrow account or reserve account). Such an account requires you to pay a monthly pro-rata portion of your annual property taxes, and often your homeowners insurance, to the lender each month along with your mortgage payment. The lender is responsible for making the necessary property tax and insurance payments to the appropriate agencies on your behalf. An impound account keeps the homeowner from getting hit with a large annual property tax bill.

As you shop for a home, be aware that real estate listings frequently contain information regarding the amount the current property owner is currently paying in taxes. These taxes are often based on an outdated, much lower property valuation. If you purchase the home, your property taxes may be significantly higher based on the price that you pay for the property. Conversely, if you happen to buy a home that has decreased in value since it was purchased, you could find that your property taxes are actually lower.

Tracking your tax write-offs

Now is a good point to pause, recognize, and give thanks for the tax benefits of homeownership. The federal tax authorities at the Internal Revenue Service (IRS) and most state governments allow you to deduct, within certain limits, mortgage interest and property taxes when you file your annual income tax return.

You may deduct the interest on the first $1 million of mortgage debt as well as all the property taxes. (This mortgage interest deductibility covers debt on both your primary residence and a second residence.) The IRS also allows you to deduct the interest costs on additional borrowing known as home equity loans or home equity lines of credit (HELOCs, see Chapter 6) to a maximum of $100,000 borrowed.

To keep things simple and get a reliable estimate of the tax savings from your mortgage interest and property tax write-off, multiply your mortgage payment and property taxes by your federal income tax rate in Table 1-1. This approximation method works fine as long as you’re in the earlier years of paying off your mortgage, because the small portion of your mortgage payment that isn’t deductible (because it’s for the repayment of the principal amount of your loan) approximately offsets the overlooked state tax savings.

TABLE 1-1 2017 Federal Income Tax Brackets and Rates

Investing in insurance

When you own a home with a mortgage, your mortgage lender will insist as a condition of funding your loan that you have adequate homeowners insurance, which includes both casualty and liability coverage. The cost of your insurance policy is largely derived from the estimated cost of rebuilding your home. Although land has value, it doesn’t need to be insured, because it wouldn’t be destroyed in a fire. Buy the most comprehensive homeowners insurance coverage you can and take the highest deductible you can afford, to help minimize the cost.

As a homeowner, you’d also be wise to obtain insurance coverage against possible damage, destruction, or theft of personal property, such as clothing, furniture, kitchen appliances, audiovisual equipment, and your collection of vintage fire hydrants. Personal property goodies can cost big bucks to replace. Some prized possessions like jewelry, antiques, and collectibles are often excluded from your base policy and can require a special added coverage policy with limits that need to be set based on the replacement value of the items.

In years past, various lenders learned the hard way that some homeowners with little financial stake in the property and insufficient insurance coverage simply walked away from homes that were total losses and left the lender with the loss. Thus, in addition to sufficient casualty and liability insurance, lenders require you to purchase private mortgage insurance if you put down less than 20 percent of the purchase price when you buy. This is risk insurance that protects the lender by making the mortgage payments to the lender if you’re unable to. This could be because you have a loss of income whether from a job loss or an injury/illness.

Private mortgage insurance is an extra cost that will factor into the calculation for the amount of your loan and reduce your ability to borrow. You may be able to avoid paying private mortgage insurance by using 80-10-10 financing. We cover this technique in Chapter 6.

Budgeting for closing costs

As you budget for a given home purchase, don’t forget to budget for the inevitable laundry list of one-time closing costs. In a typical home purchase, closing costs amount to about 2 to 5 percent of the purchase price of the property. Thus, you shouldn’t ignore them when you figure the amount of money you need to close the deal. Having enough to pay the down payment on your loan just isn’t sufficient.

Some sellers may be willing to assist buyers by paying a portion of the closing costs. This is particularly true with new home subdivisions by major builders but is always negotiable with any seller. However, expect to pay a higher interest rate for a mortgage with few or no upfront fees.

Here are the major closing costs and our guidance as to how much to budget for each:

❯❯ Loan-origination fees and charges: Lenders generally levy fees for appraising the property, obtaining a copy of your credit report, preparing your loan documents, and processing your loan. They’ll also whack you 1 to 2 percent of the loan amount for a loan-origination fee. Another term for this prepaid interest charge, as we explain in Chapter 9, is points. If you’re strapped for cash, you can get a loan that has few or no fees; however, such loans have higher interest rates over their lifetimes. You may be able to negotiate having the seller pay these loan-closing costs. The total loan-origination fees and other charges may add up to as much as 3 percent of the mortgage amount.

❯❯ Escrow fees: These costs cover the preparation and transmission of all home-purchase-related documents and funds. Escrow fees range from several hundred to over a thousand dollars, based on the purchase price of your home.

❯❯ Homeowners insurance: Lenders generally require that you pay the first year’s premium on your homeowners insurance policy at the time of closing. Such insurance typically costs from several hundred to several thousand dollars, depending on the value of your home and the extent of coverage you desire.

❯❯ Title insurance: Title insurance protects you and the lender against the risk that the person selling you the home doesn’t legally own it. This insurance typically costs from several hundred to a few thousand dollars, depending on your home’s purchase price. Happily, the premium you pay at close of escrow is the only title insurance premium you’ll ever have to pay unless you subsequently decide to refinance your mortgage. Oddly, there are places like Northern California where the seller (not the buyer) pays for the “main” title policy. This is purely a matter of “local custom.” Ask your agent what the custom is where you are buying.

❯❯ Property taxes: At the closing of your home purchase, you may have to reimburse the sellers for property taxes that they paid in advance. Here’s how it works. Suppose you close on your home purchase on October 15, and the sellers have already paid their property taxes through December 31. You have to reimburse the sellers for property taxes they paid from October 15 through the end of the year. The prorated property taxes you end up paying in your actual transaction are based on the home’s taxes and the date that escrow actually closes and cost from several hundred to a couple of thousand dollars. In some parts of the country, if you paid more than the prior owner for the property, you may also receive a supplemental property tax bill from your tax collector, after you close escrow, seeking payment for the incremental increase in the property taxes for your prorated period of ownership.

❯❯ Attorney fees: In some eastern states, lawyers are involved (unfortunately from some participants’ perspectives) in real estate purchases. In most states, however, lawyers aren’t needed for home purchases as long as the real estate agents use standard, fill-in-the-blank contracts. If you do hire an attorney, expect to pay at least several hundred dollars.

❯❯ Property inspections: As advocated in Home Buying For Dummies (Wiley), you should always have a home professionally inspected before you buy it. Inspection fees usually cost at least several hundred dollars (larger homes cost more to inspect of course). Be sure to carefully review this report and ask for additional information or hire a specialized contractor to conduct further investigation for any noted item of concern. If you are able, accompany the inspector when he inspects the property.

❯❯ Private mortgage insurance (PMI): If you make a down payment of less than 20 percent of the purchase price of the home, mortgage lenders generally require that you take out private mortgage insurance that protects the lender in case you default on your mortgage. You may need to pay up to a year’s worth of premium for this coverage at closing, which can amount to as much as several hundred dollars. One terrific way to avoid this extra cost is to make a 20 percent down payment.

❯❯ Prepaid loan interest: At closing, the lender charges interest on your mortgage to cover the interest that accrues from the date your loan is funded – generally one business day before the closing – up to the day of your first scheduled loan payment. How much interest you actually have to pay depends on the timing of your first loan payment.

If you’re strapped for cash at closing, try the following tricks to minimize the prepaid loan interest you owe at closing:

● First, ask your lender which day of the month your payment will be due and schedule to close on the loan as few days in advance of that day as possible. (Payments are usually due on the first of the month, so closing on the last day of the month or a few days before is generally best.)

● Or ask whether your lender is willing to adjust your monthly due date closer to the date you desire to close on your loan.

● Also, never schedule a closing to occur on a Monday because the lender will generally have to put your mortgage funds into escrow the preceding Friday, causing you to pay interest for Friday, Saturday, and Sunday. (Some lenders may be able to accommodate a Monday closing by same-day wiring the funds for an afternoon closing.)

❯❯ Other fees: Recording fees (to record the deed and mortgage), courier and express mailing fees, notary fees – you name it. These extra expenses usually total about $200 to $300. Note: Ask your mortgage lender for a complete listing of all fees and charges.

Managing maintenance costs

In addition to costing you a monthly mortgage payment, homes also need flooring, window treatments, painting, plumbing, electrical and roof repairs, and other types of maintenance over time. Of course, some homeowners defer maintenance and even put their houses on the market for sale with lots of deferred maintenance (which, of course, will be reflected in a reduced sales price that is often much greater than the cost to have made those simple repairs).

For budgeting purposes, we suggest that you allocate about 1 percent of the purchase price of your home each year for normal maintenance expenses. So, for example, if you spend $240,000 on a home, you should budget about $2,400 per year (or about $200 per month) for maintenance.

With some types of housing, such as condominiums or planned unit developments (PUD), you pay monthly dues into a common interest development (often referred to as a homeowners association), which takes care of the maintenance for the community. In that case, you’re responsible for maintaining only the interior of your unit. Check with the association to see how much the dues are currently running, anticipated future monthly or quarterly dues increases or special assessments, what services are included, and how they’ve changed over the years.

Financing home improvements and such

In addition to necessary maintenance and furnishings, also be aware of how much you may spend on nonessential home improvements, such as adding a deck, remodeling your kitchen, and so on. Budget for these nonessentials unless you’re the rare person who is a super saver, can easily accomplish your savings goals, and have lots of slack in your budget.

The amount you expect to spend on improvements is just an estimate. It depends on how finished a home you buy and your personal tastes and desires. Consider your previous spending behavior and the types of projects you expect to do as you examine potential homes for purchase.