Buying a home is a huge financial decision. If you’re thinking about buying in the near future, you need to know your financial situation. The last thing you need is to dive into purchasing a house you have no idea if you can afford. Brokers, agents and home sellers all want to get as much out of you as possible, so you need to know your limits.
The first thing you need to do is make a detailed list of your expenses. While you’re at it, make a second column and estimate what those expenses would be if you owned a home. Use monthly data, so you have an easy visible equivalency. What should you note down?
Your expected monthly income. This shouldn’t change between renting and buying
Your taxes, specifically what you pay in income tax for social security, federal income tax and state/local taxes
Your housing expenses. You won’t have a figure for rent for home ownership, but you will have both the home loan and property taxes to consider. You also need to note down your home insurance, gas and electric utilities, water, phone, television, Internet and other utilities. Remember that as a renter you may not have to cover garbage service or maintenance, which are projected expenses in home ownership. Likewise, you will need to furnish your new home
The cost of food is important. Shopping for food and eating out should both be considered
Transportation costs. Car loans, fares for public transit, vehicle registration fees, fuel costs, insurance and maintenance are all important. Remember to consider potential home locations when you figure the gas expense of a commute, maintenance costs and access to public transportation
Appearance items. You don’t necessarily buy clothing every month, but if you average out a year’s worth of records, you can come up with a monthly figure. Also include frequent expenses such as a haircuts and dry cleaning
Debts. Note your credit card debt, student, auto, and other loans.
Entertainment. Movie tickets and rentals cost money, vacations cost money, gifts cost money, hobbies cost money, pets cost money. Anything you spend money on that could be classified as entertainment should be added here. Most of this shouldn’t change with a new home, but if you think it might, note that down
Required health and finance expenses. If you have an investment broker, a financial advisor or an accountant, note the cost. The same goes for regular hospital and dental visits, ongoing prescription drugs and therapy
Insurance expenses. You’ll have noted some of these in other categories, so anything remaining should go here. This includes health insurance and life insurance
Education. This is important if you or your spouse are attending college, or if you’re starting a family and will need to fund a child’s education
Child expenses. Any parent has expenses for childcare, toys and other such expenses
Anything else you spend money on that doesn’t fit in one of the above categories. If you can, review bank records for the past year to determine everything you may have spent money on.
Aside: Slashing Your Spending
If you’ve never had a budget before, you might be realizing that you spend more than you realize on frivolities or expenses you can minimize. Slashing your expenses will help you save for a home — after all, every penny you put into savings or an investment will earn you that much more interest. Every personal financial situation is different, but here are some general ideas you can use to cut expenses.
Extinguish debts. Carrying a credit card balance, paying minimum for car loans and holding off student debts are costing you in the long term. Interest will continue to pile up. Paying more each month will cost you more in the short term, but your interest expenses will drop. It also helps minimize the risk of a missed payment or a debt entering collections, both of which will hurt your credit; causing penalties, fees & higher rates. If you have money saved, apply it! Your savings account probably has a lower interest rate than your credit card, so you’re losing money by carrying a balance.
Trim down frivolous purchases. Everyone has something they spend more on than they should. Maybe this is expensive designer clothing, rather than rugged utilitarian or out of season clothes. Maybe it’s non-essential luxury or a hobby you can cut back to save a little more. It might be as simple as a daily lunch at a fast food restaurant costing you $100 every month. Or it might mean replacing pre-made coffee with your own machine.
Buy food and other items in bulk. A membership to a store like Sam’s Club or Costco will cover its investment in the bulk savings on items you frequently purchase. Groceries are a huge expense for many people, so cutting back will help significantly. Buy off-brand items to save a few bucks and you’ll be surprised and how little impact it has on your life. Remember, marketers spend a lot of effort to convince you that off-brands and generics are somehow worse or harmful. Most of the time, the formulas and recipes are identical, but the price is slashed.
Don’t slash everything. It’s tempting to cut out every hobby, every bit of takeout and every luxury in the interest of saving money. This almost never works. The more you slash, the harder it is to stick to your budget. You’ll justify it by saying it’s only a one-time purchase, over and over, and suddenly you realize you’re spending just as much as you were. Leave yourself room in your budget for fun money, a bit each month for eating out, luxuries and entertainment. It’s not a bad thing to treat yourself, as long as you know you can handle the expense.
Maintain your budget. Even if you’re the type of person who saves as much as possible, a budget helps. In fact, a budget is one of the most essential pieces of information you have if you’re looking to buy a home. Budgets aren’t a tool for the over-spenders to limit themselves, like a diet. They’re a tool to build financial awareness.
Setting a savings goal is intimidating. When you’re putting together a budget, and you decide you want to save $200,000, realizing you can only put away $200 a month and figuring it would take 80 years to reach your goal is intimidating. Thankfully, it’s rarely as shocking and depressing as that example.
Set a goal. Most people should have two primary long-term goals: retirement and a home. It’s hard to choose figures for these goals, especially in your 20s and 30s. While you should probably consider buying a home eventually, think about retirement. If you think you might enjoy working even when you’re 70 or 80, you don’t necessarily need to save specifically for retirement — and even then, not an early retirement in your 50s and 60s
Establish a retirement account — or not. Retirement accounts like 401Ks are amazing tax breaks, if you can match your employer contribution. They also lock your money in place until a designated age is reached. You can cash out earlier, but you typically get hit with a significant fee.
Save an emergency fund. Now that you have a budget, you know how much it costs to maintain your lifestyle. Try to have at least three months worth of your expenses set aside. If you have a particularly at-risk job or a variable income, it might be better to shoot for six months or more. The idea is that, if you suddenly lose your job, you don’t have to stress out about affording surviving while you try to find new employment
Save for the future. Maybe you want to go back to college to further your career. Maybe you want to build a family and send children to college. Either way, you need to save for education. Some areas offer interesting educational savings accounts, so investigate local universities and financial institutions
Save for a business. This isn’t for everyone, but if you’ve ever thought you might want to start a business, you should save for the start up costs
Protecting the Future
Insurance is expensive. Insurance is also critically important. If you’re living without insurance, you’re taking an incredible personal and financial risk. Here are some cautionary examples.
Disability: What if you don’t have disability insurance and an accident costs you the use of your legs? Costly therapy, slashed work income and the potential legal fees all cut into your savings.
Home: What if you live in Kansas and lack storm coverage? Even if you don’t live in a particularly tornado-prone area, a freak storm can blow up at any time. A tornado tearing your house — or your whole neighborhood — apart will tear your savings apart just as easily.
Life: An unexpected illness, a freak infection, a bad accident. Anything can cause the loss of a loved one, and the lack of proper life insurance means you won’t be able to compensate for their lost income. You might be forced to sell a house at a loss just to move to somewhere you can afford.
As with any major purchase, shop around when you search for affordable insurance. Gathering quotes and balancing coverage is an art form all its own, so take your time and make sure you’re properly insured.