Buying a house is a huge financial decision with far-reaching implications.
Even so, I think the financial advice rules to determine if you're ready to make the leap to homeownership are pretty straightforward:
- Have an emergency fund in place (three to six months' worth of expenses is ideal).
- Create and follow a budget (based on post-purchase expenses).
- Save up a big down payment (20% is ideal).
- Have confidence in your job security.
- Be able to keep the house for a long time (at least five years).
Unfortunately, even though these rules aren't complicated, they aren't followed very often. People -- and in the interest of full and fair disclosure, I'd include myself in this group -- buy houses all the time without following each of these "rules" to the letter, and their financial situations don't fall to pieces as a result.
So does that mean these rules are useless? I don't think so. In fact, I think they're actually a great set of guidelines to follow if you're trying to both buy a house and stay out of financial trouble. With this in mind, here are my thoughts on why each rule is important, as well as my thoughts on when and how far you can bend them.
Rule 1. Have an emergency fund.
Having money set aside to cover life's unexpected expenses is critical when you own a house. Why? Because homeownership comes with an almost never-ending supply of expenses, many of which are unexpected and large.
To decrease the chances of your dream house turning into a financial nightmare, it's important to have an emergency fund in place before you buy one, preferably three to six months' worth of your committed expenses. This is above and beyond what you need for a down payment, closing costs and move-in expenses.
Can you bend this rule? Yes, just don't break it completely by having nothing set aside. And don't bend it for too long. As soon as you make the decision to buy, start stockpiling as much cash as you can. If you don't have some money set aside to which you regularly make additions, you're just asking for trouble. Home-related expenses are regularly measured in thousands of dollars, so the more cash you have on hand, the better.
Rule 2. Create and follow a budget.
Besides your mortgage payment, you'll also have real estate taxes, homeowners insurance, utilities, maintenance expenses and possibly homeowners association fees. Also, since you'll be taking on a mortgage debt, you may need to increase or buy new life insurance. The bottom line is that things can easily get away from you if you don't take the time to build a solid budget for your new digs.
Can you bend this rule? Yes, but do so at your own peril. Working out a budget before you buy is essential to determine if you're going to be able to make ends meet with the big change. If you don't make the effort to add up the numbers and slightly underestimate what you can actually afford, you'll probably be able to scrape by. But if you're way off, you've just turned your exciting home purchase into a lifetime of not-so-exciting financial challenges.
Rule 3: Save up a big down payment.
Even if you can get a loan that allows you to get by with little or no down payment, still making a down payment (or at least having the money available) is typically a good idea. This way, if the real estate market drops and you end up needing to sell the house before the market recovers, you'll have equity in the home or money available to cover the shortfall, and hopefully avoid getting trapped in a situation where you owe more on your mortgage than your property is worth.
Can you bend this rule? Yes, especially if you qualify for certain types of loans. Just understand that you're setting yourself up for some steep financial challenges if you have to sell your house and it's not worth enough to pay off your mortgage and all of the associated selling costs. A situation like this can force you to rent the house instead of selling it, stop you from buying another home, and force you to sell other assets to generate the extra needed cash. In other words, you could be facing a huge amount of stress in a very short period of time. The more you put down upfront, the less likely this is to happen.
Rule 4: Have confidence in your job security.
For many homeowners, more of their take-home pay is consumed by household expenses than any other category in their budget. Add in the long-term commitment of owning a home, and it becomes clear you need to be confident in the sustainability of your earning ability. If you're a two-income family, try to limit the purchase to a house you can afford on one income. That way you'll have financial wiggle room, especially if one of you loses a job.
Can you bend this rule? No.
Rule 5: Be able to keep the house for a long time.
For now, at least, the days of flipping houses for a quick profit appear to be over. So if you can't plan to own a house for at least five years or longer, you might want to wait. For military personnel with three- or four-year assignments, buying a home rarely makes sense. Instead, try to bank some of your basic allowance for housing and then buy when the time is right for you.
Can you bend this rule? Not unless you're in one of the very rare housing markets in the country where prices are appreciating more than 4% to 5% a year. Your local realtor should be able to help you get a better understanding of real estate price trends in your area of interest.
