Monday, April 15, 2019
The Dangers of Overextending Yourself When Buying a Home
In Southern Ontario, we have seen the explosion of the values of homes. From Toronto to my town, London Ontario, it is apparent that the cost of a family home had reached its all-time high. While you would think that this circumstance would drive people from the market, it has in fact done the opposite. People are flocking to buy homes at record levels causing the prices to go even higher. A side effect of this sort of activity is the reality that some are overextending themselves to be a homeowner. The industry of home sales often will push people to their brink during the buying process. Today I want to speak about the dangers of overbuying when you purchase a home. Being house poor is real and has serious consequences, so take heed to the points of this post.
Pre-Approval isn’t everything
While I stress the importance of getting pre-approved before you go house shopping, I also stress that getting pre-approved is not everything. It is very common for lenders to overshoot what you are pre-approved for during your initial consultation. The reason is quite simple, the bigger the mortgage, the bigger the commission. The same goes for realtors who will often tell you that you should go well over asking price even if it is not what should be done. That is why finding a good, trustworthy realtor and lender is so key.
Furthermore, the mortgage pre-approval takes only a few factors into consideration and leaves out other key factors. It takes into account income, debt and a few expenses such as property tax and fees. What it doesn’t take into consideration is your lifestyle and several other expenses such as utilities and maintenance. The mortgage itself will be a fairly small part of your monthly budget even though it is probably the biggest single expense. This is why using the “Backwards Budget” technique brought to me from my friend Shawna Ireland of MoneyMomma.ca is so important. Starting with income and deducting expenses until you get to your remaining number will tell you if you can afford a home or not. A key problem with overbuying based on the pre-approval amount is that you are starting right from the brink of your monthly housing budget. This leaves very little variance and could make you exposed to disaster, ie. getting sick, job loss, etc. The key point of this topic is that your budget is YOUR BUDGET. It isn’t what someone else tells you that you can afford, period.
Will your lifestyle change?
The short answer to this question is, no. The longer answer is that it will probably get worse. Very few people buy a home and then become a hermit because their expenses went up. Let’s be real for a second here. Did you buy a home so you could shelter yourself and not entertain? Also, filling that new home with furniture and accessories is not cheap. This reminds me of the movie “Boiler Room” where one of the characters’ lives in a mansion but can’t afford a couch. Chances are you will still go on outings with friends, take your annual vacation, buy presents for family and overall live the rockstar life that you always did. When you overbuy on a home it puts your lifestyle in jeopardy for this reason. People then turn to credit to fill in the gap. This leads to a dangerous cycle that puts everything at risk including your family’s well-being.
Other costs can crush you
I mentioned before that there are other costs associated with homeownership that you may or may not know about going into your purchase. Upfront you can get dinged with a variety of costs for things like:
Taxes and more
They say to anticipate about 2 to 5% of the home’s value in closing costs. That is not cheap my friends. Even worse is the ongoing costs that you might not have bargained for. These include:
Higher utility costs due to larger space
While you might not spend a whole lot extra every month on these costs compared to what you spent while you were a renter, maybe a $200-$300 more a month, if you overbuy it could euchre you. Again, overbuying puts you right near the edge of what is fiscally possible for your monthly budget. This leaves no room for error. Not having an emergency fund makes this doubly dangerous. Again, credit is often used to fill the gap here as well.
Defaulting is serious business
I mentioned how any sort of emergency could derail your monthly budget. Without proper emergency savings, it could be catastrophic if you miss mortgage payments. This is why you should always incorporate emergency savings into your monthly budget even if it means buying less of a house. You may say, “well I have disability insurance through work.” Did you know that legally you cannot receive more than 80% of your monthly earnings from a disability plan? Even worse, most only pay you around 66% of your monthly earnings and that is if you qualify. Could you live on only 2/3’s of your monthly income? You definitely can’t if you have pushed your mortgage budget right from the get-go. If you get to the point of actually missing a mortgage payment, you have now crossed into new territory, scary territory. You are now at risk of your home being taken from you and being put on the streets. Also, you are at risk of your credit being hit hard and not being able to get future funding. This could mean years trying to repair something that could have been right from the start. It sounds very doom and gloom, but it is not without merit. Think 2008 and the housing crisis.
Your first term, 5 years, is vital to your success
The average person in our country owns over 4 houses in their lifetime. This means that your first home more than likely will not be your last. In previous weeks I discussed how difficult it can be for some to come up with their first down payment. One of the benefits of getting that first down payment is that you are on the way to having a transition piece for all the other housing you will own throughout your lifetime. During those first 5 years, you are paying down the mortgage as much as you can which leads to some equity being built up. While it won’t be much because of front-heavy interest charges, it should be enough to possibly transition out of the starter home into an upgrade. That is unless you overextend yourself and pay down too little during those first five years to get out from under that mortgage. Even worse would be if you fell into crippling consumer debt on the side while paying your monthly mortgage. Now you are stuck no matter what you do, for the time being. You must look at your home not as an investment, but as a bank account. You put money in and if you do it the right way, you can eventually take that money out in the future. This is why having a manageable monthly mortgage payment is key to your success. It will eliminate being house poor and allow you to put your extra money somewhere far more valuable, like say your retirement account.
A frenzy is just that, a frenzy. We don’t have to get caught up in the hype. Just because your “dream home” has 15 offers for it, doesn’t mean you have to get caught in the mix. More important than any home, is your monthly budget. There will always be other homes, including ones that fit your idea of “perfect.” There might not be if you chase that dream too soon and are ill-prepared to do so.
“Vanity can easily overtake wisdom. It usually overtakes common sense.” – Julian Casablancas
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