Home-Buying Basics: Can You Really Afford that House?

The housing market is heating up, and many are rushing to buy before mortgage rates rise, but it is worth stepping back to make sure you can really afford a home before you put your money down.

The housing market has been on the mend for more than a year now, but a recent phenomenon has increased the urgency among some to buy a house—rising mortgage rates.

For years, rates have stayed low because of the Federal Reserve’s practice of buying $85 billion worth of bonds each month. Known as quantitative easing, the program has supported the financial and housing markets and kept interest rates low. However, there are now concerns that the Fed will curtail its bond buying, and rates have increased slightly.

In early May, the interest rate on a 30-year fixed mortgage was 3.35%, but rates are now averaging 4.45%. We are nowhere close to seeing rates as high as 6% or 7%, as we did during the housing boom and before the recession; however, rates have increased enough over the last few months to spur some who were already considering buying homes to move up their timeline.

However, not everyone is financially ready to purchase a home, and financial advisor Jon C. Ylinen explains why renting might be better for some people. While owning one’s own home is part of the American Dream, the country is only 5 years out from the last time people made home purchases they couldn’t afford. And for all that lenders tightened up their standards and required larger down payments immediately following the crash, they’ve eased up as mortgage rates have risen.

If you are considering buying a house, you should plan on making a down payment of 20%. This means that the bank has 80% equity in your house. A 20% down payment on a $212,000 house (the median sale price in August 2013) comes out to $42,400. If you’re looking for a house in New York State, then the median listing price is $679,984 (requiring a $136,000 down payment); but if you’re in Iowa, then the median listing price is $177,300 (requiring a $35,500 down payment), according to numbers from Trulia.com.

Home buyers need to be able to come up with their down payment without dipping into their emergency fund. If you can’t come up with 20%, you can still get that house, but you’ll likely have to pay private mortgage insurance (PMI). The fee can vary, and it’s an additional expense on top of your monthly payments.

I’m currently at the age where friends and friends of friends are buying houses, and I’m noticing a scary trend: a lot of them are putting down 10% or less. So not only will their monthly mortgage payments be large, but they’ll also be paying PMI fees—and most likely hefty student loans as well. It’s reminiscent of the behavior that led to the housing crash and the subsequent recession in the first place. Back then, people were taking out loans on houses priced way out of their range.

Making such a small down payment also puts you at great financial risk. What happens if home prices decline again? With just 10% down on a house, you could easily find yourself underwater—meaning your house is worth less than the amount you owe the bank. This could mean a foreclosure or a short sale.

Next time we’ll discuss getting a mortgage, the options available, and choosing a lender.