The next thing to do, if you don’t already own a home, is to save for a down payment to buy a house. Houses are a great wealth building tool, and offer a source of security and stability for your family. Now instead of rent going to a landlord, your mortgage payments are going to an asset which you own. However, it’s important to not get overstretched with a house, so let’s discuss some parameters here.
The first thing to know is that you need to invest for retirement, following the principals I’ve outlined in the next few chapters. However, it’s fine to postpone that for up to a year, and no more, while you save up a good down payment for your house. My recommendation is this amount is at least 10% of the purchase price, although 20% would be great.
The reason you need a good strong down payment is to protect yourself against real estate prices going down when you need to sell. You never know when you’ll be forced to sell because of a new job, life change, or just because you want to leave a certain city or state. If you don’t have a cushion of equity, you’ll be stuck. You won’t be able to afford the realtor fees and closing costs, and your home will sit and get foreclosed upon. While it may be tempting to do those low money down loan deals, it’s really dangerous, and you should take the time to sock away some cash to put up a real strong down payment.
You’ll also get much better mortgage terms. When you have 20% down on a house, you don’t have to pay for mortgage insurance, which lowers your payment substantially. More of each payment you make will go towards paying down principal, which is a key component of building wealth through home equity.
How much home can you afford? Well, the more you spend on your home, the less will be available for other wealth building investments. So, you don’t want to spend too much. A good rule of thumb is to make sure you’re not spending more than ¼ of your take home pay on your mortgage. Any more than that, and you’re going to have a tough time stretching your paycheck to cover your bills while still investing in your future.
A lot of people make the mistake of treating their home as equal to their other investments. This is not the case. While a home does build wealth, in the form of equity, it will never provide any sort of income for you to live off. Quite the opposite, as you will constantly be throwing money into your home to fix the roof, replace the water heater, etc.
Your home is simply a place of stability and harmony for raising your family. While I want you to live in a great, safe neighborhood, with great people surrounding you, don’t do this at the expense of your future. While good schools are a plus, your child’s economic future will not be impacted much (if at all) by their school. It’s just not the case. Your child’s scholastic background (this is true even through college) has very little impact on their overall future. Don’t use that as an excuse to get roped into a more expensive home. It’s not worth it.
Your goal should be to pay down your house as fast as possible, because one of the tenets of retirement is that you need to be completely debt free and not burdened with a mortgage payment. That way, your investments don’t need to produce as big of an income in order to meet your needs.
Let’s walk this out. Pretend your income is $100,000, and you spend $25,000 per year on your home (25%) and another $24,000 (24%) on saving. Forget about raises and inflation in our example. The minute you retire, if your home is paid off, you only need to make $51,000 in order to keep your exact same lifestyle. That’s because you’ll no longer need to keep saving, because you’re retired, and you don’t have a house payment. If you retire with a mortgage, you’ll need to have your investments produce $75,000 of income for you. Big difference!
In sum, a lot of people make huge mistakes when buying their home. They buy it before they’re ready, without a good emergency fund to back themselves. Things will go wrong in your home, and you’ll need to have cash available to avoid credit cards. When you’re the renter, the landlord covers it. When you’re the owner, it’s on you. Make sure you’re ready to truly care for your home prior to purchase. Also, remember that if you buy more home than you can afford, you’ll be sorry later because you’re siphoning off money that could otherwise be used to invest in your future. A home is a wonderful thing, it’s part of the American dream, but please make sure you do it the right way!