Many people think that being able to afford a home means to simply afford a loan payment. Home ownership, however, is much more than just a monthly loan payment. When deciding to buy a home, there are several different monthly expenses, besides just a loan payment, to account for as well as a few benefits that can help make home ownership more affordable.
The most important expense to be familiar with when buying a home is the mortgage payment. A mortgage payment typically consists of four components – Principal payment, Interest payment, Property Tax payment, and Insurance payment. These four components of a mortgage define what is referred to as PITI (Principal, Interest, Tax, and Insurance).
The principal and interest payment of your mortgage are the portions of your mortgage payment that are paid to your bank on a monthly basis to repay your loan. Principal is the portion of your monthly mortgage payment that goes towards paying down your home loan. This portion of your mortgage payment is what builds equity in your home while Interest is the portion of your monthly mortgage payment that is the fee that you pay to your bank for borrowing money. The amount of interest that you pay depends on your loan’s outstanding balance and interest rate.
Property tax and insurance payments are generally paid to the county and insurance companies separately. Although property tax and insurance payments are not due on a monthly basis, some banks set up an escrow account that collects 1/12th of your annual property tax and insurance premium on a monthly basis. When an escrow account is set up, your bank pays the county tax collector and your insurance company on your behalf with the funds in the escrow account when they become due. If your loan does not have an escrow account, you should make it a habit to put aside 1/12th of your annual property taxes and insurance premium each month so that the burden will not be excessive when the payments become due. When planning for a home purchase, you should contact the Count Tax Collector where you are searching for a home to find out the property tax rate of your neighborhood. Because property taxes can costs thousands of dollars a year, it is an expense that you can not ignore when planning for your purchase. Planning for an insurance payment is easier. The standard rule of thumb used by mortgage professionals to account for property insurance payments when pre-qualifying you for a home loan is to multiply the purchase price of the home you are considering by 0.3% (0.003). This provides a conservative estimate for your annual home insurance payment.
Private Mortgage Insurance, often referred to as PMI, is required by many banks when you buy a home with less than 20% down payment. Private Mortgage Insurance is an insurance policy that your bank buys from a third party to protect itself in the case that you cannot make your monthly payment and default on your loan. Even though this insurance policy protects the bank, you as the borrower are responsible to pay the monthly premium for the policy. The premium for this insurance policy varies depending on your down payment amount. Typically, the premium for this policy decreases as your down payment approaches 20% of your home purchase price.
There are many great mortgage calculators on the web that can help you estimate PITI payments. You can find a series of these mortgage calculators on the Resources page of many reputable real estate, lending, and non-profit housing agencies. There is more to home ownership finances, however, then PITI. In the rest of this article, we will look at the ‘big picture’ by building a cash flow analysis. This cash flow analysis will combine PITI with your monthly budget and a few homeownership benefits to help you understand if you can truly afford owning a home.
One of the most important pieces of preparation for a home purchase is to understand your monthly budget prior to purchasing a home. This monthly budget should consider typical monthly expenses such as groceries and gas but should also consider annual expenses. For instance, if you pay $1,200 per year for automobile insurance, you should divide this amount by 12 and include the resulting $100 as part of your monthly expenses. A monthly budget calculator can help you formulate a detailed budget that includes your income as well.
Home ownership is not all expenses but can also have a couple of financial benefits. The best financial benefits from home ownership are the Federal tax advantages that you can receive. Based on your home purchase price, your property tax rate, and your interest rate, you can receive thousands of dollars per year back from the Federal government that can offset the expenses of owning a home. Another great way to offset the expenses of owning your home is to consider renting out a portion of your home or purchasing a multi-residential property. A multi-residential property, such as a duplex, allows you to live in one unit while generating rental income from the other unit(s) to offset your monthly mortgage expenses.
The best way to determine if you can truly afford a home is to develop a cash flow analysis for each home that you are considering. To make a cash flow analysis, simply add up your monthly sources of income including the income you receive from work, any potential rental income, and tax benefits you will receive from purchasing a home. Next, subtract your monthly expenses including the PITI of the specific home you are interested in and the lifestyle expenses that you estimated in your budget. If your result is negative, then the home that you are considering can lead you into financial disaster. If, however, the result is positive and you will have money left over each month, you will have to decide if this is enough money to put away for a rainy day and to help you build your savings to prepare for the next big investment.