What to Consider Before Buying a Home

Owning a home brings a sense of pride and freedom that can't be matched by renting. You aren’t bound by a landlord’s rules when you own your own home. Your monthly payments build equity. Buying a home may be the first step you take toward building long-term wealth. But it's key to understand the pros and cons of homeownership before taking the plunge.

Key Takeaways

  • The benefits of owning a home include equity and tax breaks on capital gains when and if you sell.
  • Owning a home comes with more ongoing costs and commitment than renting.
  • Your debt-to-income ratio can help you determine how much you can afford to spend on a home.
  • Think about the loan terms and down payment size that work best for you when you know how much you can spend.

Equity Advantage

One big plus of buying a home is that it’s yours. You can paint your walls any color you like. You can change the landscape, install a basketball hoop, or turn your unfinished basement into a movie theater. You can do almost anything you want with your home as long as you work within any building or zoning rules.

Another major plus of owning a home is that some of your monthly mortgage payment will come back to you in the form of equity. You'll never see any of that money again when you pay rent, but part of your mortgage payment will be applied to your loan's principal when you buy. That builds your percentage of free-and-clear ownership.

You may be able to tap into the equity of your home while you're still living in it, to make upgrades or to consolidate debt.

Tax Breaks

Your home is an asset. You can make money if you sell it for more than you originally paid. This profit may even be tax-free in some cases.

You may be able to exclude up to $250,000 of the profit from capital gains tax, or up to $500,000 if you and your spouse file jointly, if you sell your main home. You must have owned and lived in the residence for two of the past five years before selling. You can't have used this same tax break in the last two years.

There may also be other tax benefits from owning a home. Mortgage interest and property taxes you pay are deductible in many cases. You'll be lowering your overall tax burden.

The Cost of Owning

There are many positive aspects to buying a home, but let’s not overlook the potential drawbacks. You can reach out to your landlord if you're renting and need repairs. They'll fix or replace the problem at no cost to you, but there may be many unexpected repair and maintenance costs that you otherwise wouldn’t have when you own your own home.

Another thing to think about is that you could lose money on a house. Real estate tends to go up in value, but there are times when the market stays flat or even declines. You could lose money in that case, depending on costs associated with the sale and how much you sell the house for.

It's a Commitment

You may only be bound to a month-to-month or annual lease when you rent, but buying a home is a long-term commitment. Picking up and moving can't be done on short notice when you own your home. You have a big financial obligation. The process of selling can take many months to complete.

How Much Home Can You Afford?

The first step is to figure out what you can afford if you decide that buying a home is right for you. One of the guidelines that lenders often begin with is your debt-to-income (DTI) ratio. Most lenders suggest that your total DTI ratio should not exceed 36%. Your mortgage debt alone should be less than 28% of your pre-tax monthly income.

First add up your total monthly gross (pre-tax) income to figure out your DTI ratio. Next multiply your monthly gross income by 36%. Add up your total monthly debt. Compare 36% of your monthly income to your monthly debt figures.

Now add up all your current monthly non-mortgage debt payments. Subtract this total from your monthly gross income. This number will give you an idea of the largest mortgage payment you can afford. It should be 28% or less of your monthly income.

Keep in mind that your personal situation will ultimately tell you what you can truly afford, so think about all aspects of your finances.

Finding the Right Mortgage

It's time to shop for the right mortgage after you've pinned down how much you can afford. You might be financing a loan for hundreds of thousands of dollars, so it's crucial that you make a smart decision. A bad mortgage can greatly affect your finances over time.

The good news is that there's a type of mortgage for almost every buyer. The bad news is that choosing the wrong one can cost you tens of thousands of dollars in interest over the loan term. The most common loans come in two forms, with either fixed or adjustable interest rates.

fixed interest loan will provide you with stability. The rate won’t change for the life of the loan. Your payments will always remain the same. You'll keep on paying your same lower rate even if interest rates go up. You may end up paying more than the current rate if rates go down, but you may be able to refinance for a lower rate.

You'll lose this stability in payments with an adjustable rate loan. The mortgage will adjust with the prevailing interest rates over time. That can be to your benefit when rates go down, but you can find yourself with a higher monthly payment when and if rates rise.

Your Down Payment

Think about your down payment, too. Plan on making one of at least 20% of the home's price if you take out a traditional mortgage. That is the amount of equity most lenders want to see in order for you to avoid paying private mortgage insurance (PMI).

Most lenders require that you pay a PMI premium if you can't put down 20%. It could be anywhere from $20 to a few hundred dollars each month. Ask whether there are any other options besides paying PMI if you won't be able to come up with the full down payment.

Article Sources

  1. IRS. "Topic No. 701 Sale of Your Home." Accessed Dec. 11, 2021.

  2. IRS. "Publication 936 (2019), Home Mortgage Interest Deduction." Accessed Dec. 11, 2021.

  3. Consumer Financial Protection Bureau. "What is a Private Mortgage Insurance?" Accessed Dec. 11, 2021.