For generations of middle-class Americans, homeownership has been a significant rite of passage to adulthood. After all, mortgage payments are often cheaper than rent, and homes tend to gain value, so you might someday sell the property for a profit.
There are plenty of perks to owning a home, but it’s an expensive endeavor. The real cost of buying a home is a lot more than the price on the for-sale listing. So before you start visiting open houses, take some time to educate yourself so you can make a practical decision.
Real Costs of Purchasing a Home
Many folks grossly underestimate the actual cost of purchasing a home. Here’s a list of expenses to keep in mind.
1. Down Payment
The gold standard for a down payment is 20% of the purchase price. On a $250,000 house, that means forking over $50,000 cash.
Although there are exceptions, almost all lenders require private mortgage insurance (PMI) if you’re making a down payment of less than 20% of the purchase price.
PMI protects the lender against losses if you default on your mortgage. Some lenders require an upfront premium when you purchase the home; others collect it in monthly installments. Either way, it will increase your out-of-pocket costs.
The cost of PMI varies, but according to Freddie Mac, you can expect to pay $30 to $70 per month for every $100,000 borrowed. On a $250,000 mortgage, that can increase your monthly mortgage payment by up to $175.
2. Closing Costs
If you clear out your bank account for a whopping down payment, hold your breath — because there’s more. You’re also expected to show up at closing with an additional chunk of cash to cover certain costs payable to the lender and other parties. These closing costs typically include:
- Appraisal Fee. Paid to a professional appraiser who gives the lender an estimate of the home’s market value.
- Attorney Fees. Some states require the buyer to be represented by an attorney. This fee covers the attorney’s time spent preparing and reviewing all closing documents.
- Credit Report Fee. Many lenders pass the cost of accessing your credit report and credit score on to you.
- Flood Determination. This fee is paid to a third party to determine whether the property is located in a flood zone. If your property is in a flood zone, your lender may require you to purchase flood insurance, which will also increase your costs.
- Home Warranty Fees. If you choose to purchase a home warranty on the property, the premium may be included in your closing costs.
- Homeowners Association (HOA) Fees. If your neighborhood has a homeowners association, the association may charge a fee to help cover services and capital improvements. Many HOAs require the buyer to pay a fee or a portion of their annual dues at closing.
- Homeowners Insurance. The first year’s premium for your homeowner’s insurance must be paid in full at closing.
- Inspection Fees. These fees are paid to home inspectors to evaluate the home and tell you whether the property is in good condition and whether it’s infested with termites and other pests.
- Land Survey. Your lender may require a surveyor to conduct a property survey to determine the property’s lot size and legal boundaries.
- Origination Charges. These are upfront charges from your lender for making the loan. These charges may include an application fee and underwriting fees.
- Notary Fees. This covers the cost of having a licensed notary public certify that the person named in the documents did, in fact, sign them.
- Points. Mortgage points — sometimes called discount points — are fees paid to the lender in exchange for a reduced interest rate. Paying points upfront can lower your monthly mortgage payment.
- Prepaid Interest. When you close on your loan in the middle of the month, your lender collects interest on your loan from the closing date until the end of the month.
- Property Taxes. At closing, you may be required to pay six months of property taxes, or any property taxes due from the date of closing until the end of the tax year.
- Recording Fees. State and local governments may charge a fee to record your deed and other mortgage documents.
- Title Insurance. Title insurance provides protection if someone later claims to have a lien against your home, either for delinquent taxes or contractors who were not paid for work done on the house before you purchased it.
- Title Search. A fee paid to the title company to search the public records of the property you are purchasing.
Your total closing costs depend on your location, lender, and loan amount. Realtor.com estimates that closing costs typically run anywhere from 2% to 7% of the home’s purchase price. On a $250,000 home, that translates to between $5,000 and $17,500. Sometimes buyers can negotiate for sellers to cover these costs, but it’s not something you should count on.
3. Mortgage Payment
Unless you managed to buy your house with cash, you’ve got to contend with a mortgage payment each month — and several factors contribute to the amount you’ll pay.
- Principal. This is the amount of money you borrowed to finance your home. With a $250,000 house, assuming you made a $50,000 down payment, you would owe $200,000 in principal.
- Interest. Interest is essentially the fee that lenders charge in exchange for the loans they give to homeowners. Mortgage interest rates fluctuate wildly, but they are hovering just below 3% for a 30-year fixed loan at the time of this writing.
- Property Tax. Your local government levies taxes on your property to fund schools, parks and recreation areas, police and fire departments, road construction and maintenance, and other local services. Rather than forking over your whole property tax bill in bulk once per year, it’s usually broken down into 12 installments and included in your monthly mortgage payment. Your lender deposits that amount into an escrow account to keep it separate from other funds. When your property tax comes due, your lender pays it out of the escrow account. Property tax is calculated as a percentage of your home’s value, and rates vary significantly by location. In Alabama, property taxes average just 0.40% of a home’s assessed value. In New Jersey, the average is 2.21%. On a $250,000 home, that would cost you an additional $5,525 per year, or $460 per month.
- Insurance. Your mortgage payment may also include homeowners insurance, the premium for which — like property tax payments — is deposited in an escrow account. After you take out a homeowner’s insurance policy, your lender makes the payments on your behalf. Lender policies vary, so be sure this applies to your situation. Unlike private mortgage insurance mentioned above, homeowners insurance policies often cover theft, vandalism, fire, and weather damage. Floods and earthquakes tend to be excluded from standard policies. According to the Insurance Information Institute, in 2017, homeowners insurance policies averaged $1,211 per year nationwide. However, your actual premium will depend on your home’s construction, your location, and the coverage options you select.
- Private Mortgage Insurance (PMI). As mentioned previously, your lender will likely require private mortgage insurance if you make a down payment of less than 20%. PMI may be included in your monthly mortgage payment.
- HOA Dues. Again, if you buy a home located in a neighborhood with a homeowners association, you will have to pay monthly or yearly dues to cover maintenance of common areas and other amenities. Realtor.com estimates that HOA dues cost the average homeowner $200 to $300 per month.
Now you know that your mortgage payment will be much more than just principal and interest. But how much more? You can get an idea by using a mortgage payment calculator, like the one available from The New York Times.
To illustrate, say you are buying a home for $250,000. You only have enough cash to cover a 10% down payment plus closing costs, so you must pay PMI to the tune of $125 per month. Your interest rate is 3.0%. You pay 1.6% of the home’s value in property taxes each year, $1,500 per year for homeowners insurance, and $250 per month for HOA dues. Your monthly payment on a 30-year, fixed-rate mortgage would be:
- Principal and Interest: $949
- PMI: $125
- Property Tax: $333
- Property Insurance: $125
- HOA Dues: $250
- Total: $1,782
After taking into account PMI, property taxes, homeowners insurance, and HOA dues, your monthly payment is nearly double what you would pay if you just had to cover principal and interest on the loan.
Pro tip: Make sure you’re getting the best homeowners insurance coverage for the lowest possible rates. PolicyGenius allows you to compare multiple insurers in just minutes.
Calculating How Much You Can Afford
These numbers are daunting, yes, but it’s important to absorb the realities of homeownership and ensure that you purchase a house that doesn’t stretch your budget too thin. The question to ask, then, is how exactly do you ensure a reasonable purchase price for your income level?
The majority of financial experts recommend — and many lenders require — that your housing costs not exceed 28% of your gross monthly income. These costs include mortgage principal and interest, plus taxes and insurance.
For our sample house, you’d need an annual income of roughly $77,000 to hit that 28%. Of course, 28% is the maximum recommended number for housing debt-to-income ratio (HDTI). You’ll have a little more wiggle room in your budget if you can manage 20% to 25% HDTI.
Remember, for most people, housing costs aren’t their only debt. That’s why many lenders look at your full debt-to-income ratio (DTI) to take all your recurring monthly debt obligations into account. These include car payments, student loans, child support or alimony payments, and monthly minimum credit card payments. Most lenders don’t want your total debt obligation to exceed 36% of your gross income.
If you currently have zero debt, you can more comfortably get away with squeezing the top end of the recommended housing debt percentage. However, if you are juggling a car loan, a student loan, and paying off credit cards, steer far, far away from the 28% housing ratio.
Buying a home is expensive — even in the best circumstances. That’s why you need to be realistic about what you and your family can comfortably afford. If this is your first time buying a home, save up as much as you can to cover your down payment and closing costs, shop around for the best interest rate, negotiate closing costs with your lender, and consider asking the seller to cover closing costs.
The more you can save on closing costs and monthly mortgage costs, the more cash you’ll have in your pocket for furnishing your new house and making it feel like home.