First Home — Considerations for Living the American Dream
Owning a home has long been part of living the American dream. For many, it represents success and security. A recent survey found that 73 percent of renters say that owning a home is one of their goals. A whopping 95 percent of current homeowners are happy they took on their home mortgage.1 Apparently, the dream is alive. Here are a few financial considerations as you pursue home ownership.
How much house can you comfortably afford?
What can you afford?
Generally speaking, your monthly mortgage payment, including principal, interest, property taxes and homeowners insurance, should not exceed 28 percent of your gross monthly income.2 When deciding which house to buy, factor in any remodeling, landscaping and other home improvement projects that the property may need — both now and later — to help determine if a particular property will fit into your longer-term budget.
So how much house can you comfortably afford? If you’re already functioning within a household budget, calculate home expense estimates — down payment, mortgage payments, insurance, utilities, maintenance and taxes — to name a few. Remember to think about how your income might grow over the years. Run the numbers on several different home price points and mortgage payments to get a feel for what your price range is and how much you’ll need for a down payment. Many people save to buy a house for three to 10 years before purchasing. You can set up a separate savings account and gradually build up enough for a down payment.
Borrowing from your retirement plan to fund a down payment has become a popular option, especially to lock in today's low mortgage rates. Essentially, when you borrow from your 401(k) plan, you pay interest to yourself. The interest rate is typically one or two percentage points above the prime rate.
Another attractive feature of borrowing from your retirement plan for a home purchase is that you may be allowed up to 15 years to repay the loan. And unlike some other types of debt, a 401(k) loan won't count in your debt-to-income ratio when you apply for a mortgage because the loan is secured by the money in your 401(k) plan.
However, if you fail to repay the loan, it will be treated as if you made a taxable withdrawal from your plan. You'll have to pay income taxes on the balance, plus a 10 percent early-withdrawal penalty if you're under 59½. Likewise, if you're laid off or fired from your job or you quit, you generally have only 60 to 90 days to pay off the outstanding loan.
Remember, borrowing from your retirement plan means you’ll forego a loss of possible earnings growth that could leave a gap in your nest egg. The dent will be even deeper if you suspend or reduce contributions to your 401(k) while you're paying off the loan. And the tax code doesn't work in your favor: You repay the loan with after-tax dollars, and you'll pay taxes on that money again when you take withdrawals in retirement.
So while owning a home is a dream for many, it’s also a major investment, which is why it’s important to know all the facts before getting in over your head. Being able to afford a home without jeopardizing your other investments and future well-being should be the ultimate goal.
1Survey conducted May 2011 by Public Opinion Strategies of Alexandria, Va., and Lake Research Partners of Washington,D.C.
2Source: Bankrate.com, December 2011.