Are you in the market for a new home? If so, I wouldn’t blame you if you want to avoid being House Poor. 

What does it mean to be “house poor?” It’s a term used to describe people who have overspent on a home and cannot fund other expenses (i.e. housing expenses) or build wealth.

One of people’s biggest mistakes when buying a home is overestimating how much they can comfortably afford. People often only look at the monthly mortgage payments and fail to factor in other monthly expenses, including property taxes and homeowner’s insurance.

Buying a home is an exciting milestone and one of the wisest, most stable investments available. But if the associated expenses don’t leave any financial wiggle room, the experience can quickly become a painful financial burden.

This article will discuss ways to purchase a dream home without becoming house poor. By the end, you’ll become better prepared to buy a home that builds wealth instead of draining it.

Wait Until You’re Ready: 4 Signs You Can Buy a Home

The thought of buying a home excites most people. Homeownership is a huge accomplishment and a valuable investment that can provide physical and financial stability throughout every phase of life.

Unfortunately, the promise of lifetime security pushes people to buy a home before they’re ready, forcing them to become house poor. Rushing to homeownership can seem like a responsible choice, but the unintended side effects can make it hard to build wealth or choose a place to retire. 

Before eager homebuyers start shopping, they need to verify that they’re genuinely ready to buy a house. Here’s a checklist that can help anyone decide if they’re prepared to buy a home.

Your Debt-to-Income Ratio Is Under Control

Homebuyers need to present lenders with an optimal debt-to-income ratio (DTI) to get the best loan conditions.

DTI is the percentage of gross monthly income used to pay off debt. It includes car payments, credit card statements, student loans, and mortgage payments. And a lower DTI ratio means a better chance to comfortably afford a home.

What is a good DTI?

An ideal DTI is lower than 36%.

Future homeowners should calculate their DTIs before shopping for real estate. They should also estimate how a mortgage will change their DTI. If buying a home pushes their DTI above 36%, they could be at risk of becoming house poor.

It’s not necessary to be 100% debt-free to buy a home. However, debt payments will get included in an accurate homebuying budget. 

People who want to buy a home but aren’t ready due to high debt payments shouldn’t be discouraged. Instead of looking at debt as an obstacle, view debt as an opportunity to take control of spending and optimize credit.

Your Credit Score Is High Enough to Avoid High-Interest Payments

Contrary to popular belief, an excellent credit score isn’t required to buy a house. Unfortunately, buying a home with sub-prime credit sets buyers on course to become house poor.

A sub-prime credit score is below 580 on the 300 to 850 scale. Mortgage lenders see sub-prime borrowers as high-risk and, as a result, charge these applicants higher interest rates.

A high-interest mortgage payment will dominate house-poor budgets. 

Enjoying the perks of homeownership takes a lot more than getting approved for a loan. Anyone who wants to own real estate that builds wealth instead of draining it should take the time to optimize their credit scores before signing on the dotted line.

You Can Accurately Predict Your Earnings For the Life of the Loan

Job stability prevents circumstances that lead to being house poor. Life happens, and very few jobs last forever. However, homebuyers should be able to predict their earnings for the life of the loan.

Those newly self-employed or who have recently started a new job might not have an easy time estimating future earnings. In this case, it’s probably best to wait until circumstances become more stable before buying a house.

The same goes for anyone who’s in the process of changing careers. It can be challenging to estimate earnings when gross income is inconsistent or subject to change.

Even small changes in monthly income can significantly impact a homeowner’s ability to keep up with mortgage payments and other house-related expenses.

Finally, job satisfaction is an essential component of stability. People who feel unhappy in their professional roles should consider finding a new job before buying a house. The experience of feeling trapped in an unrewarding job by a high payment is almost worse than being house poor.

You’ve Saved Enough That a Down Payment Won’t Zero-Out Your Account

Overspending on a down payment is another easy way to wind up house poor. Imagine an investor with a $100,000 emergency fund, sitting in a savings account. That doesn’t mean they have $100,000 to put towards the house.

When saving up for a new home, it’s important to remember other expenses. New homebuyers need additional savings set aside for:

• Closing costs
• Property taxes
• Homeowners Association (HOA) fees
• Furnishings & decor
• Unexpected repairs
• Housing emergency fund

People who own a home but cannot keep up with regular maintenance are considered house poor. Homebuyers should budget to have three or more months of living expenses after buying the home.

Get the Best Down Payment Deals & Mortgage Rates

Speaking of financing a home, rushing into a down payment and mortgage commitment without thoroughly exploring all available options pushes thousands of Americans to become financially drained homeowners.

Getting the best possible deal on a mortgage is the first step a consumer can do to avoid being house poor. Further, it sets buyers up for long-term financial success. Consumers can find the best deals by researching low down payment mortgages, learning about fixed and adjustable loans, and understanding how to conduct a cost/benefit analysis when deciding how much to set aside.

Research Mortgage Options That Don’t Punish Low Down Payments

A 20 percent down payment is standard for conventional loans. However, a larger down payment becomes a more harrowing obstacle with house prices soaring to record highs.

Fortunately, some mortgages can get secured with a low down payment and no penalties.

FHA Loans

The first type is a Federal Housing Administration (FHA) loan. First-time buyers commonly use FHA loans, but other candidates can also qualify.

Borrowers can put as little as 3.5 percent down on an FHA loan as long as their credit report shows 580 or higher. Credit scores as low as 500 can qualify for 10% down, but experts encourage people to strive for a 580 score before applying.

FHA loans typically require mortgage insurance for the life of the loan unless the lender presents a 10% down payment.

VA Loans

Veterans and active-duty military members can apply for a VA loan to buy a house with zero money down.

To qualify, applicants must have served at least 90 days during wartime or 181 days of continuous service during peacetime.

Other requirements include having a credit score of at least 620 and sufficient income to support the mortgage.

USDA Loans

The third option is the USDA loan, which the U.S. Department of Agriculture offers to help spur ownership in rural towns.

To qualify for a USDA loan, buyers can only purchase homes in designated rural areas (although some suburban areas apply).

If approved, the buyer can receive a loan with zero money down, although private mortgage insurance fees will apply for the life of the mortgage.

Know the Difference Between Fixed & Adjustable Mortgages

There are two main types of mortgages: fixed and adjustable. Understanding how to leverage the advantages of each type can be the difference between a lucrative investment and the woes of being house poor.

A fixed mortgage has the same interest rate for the entire loan duration. This type of mortgage is great for when interest rates are low, because the monthly payments will remain pretty much the same for up to 30 years. 

An adjustable-rate mortgage (ARM), on the other hand, presents exciting opportunities when federal rates are less favorable. 

The monthly payment can change with interest rate fluctuations with an adjustable mortgage. As a result, the monthly financial commitment could spike above the initial rate.

A 5/1 adjustable-rate mortgage allows homebuyers to get the best of both loan types. This hybrid loan belongs to a particular subcategory of loans that guarantees lower-than-average interest rates for the first five years. After that, the interest rates will return to traditional ARM rules.

At that point, homeowners can refinance (effectively swapping their loan) for a 15-, 20-, or 30-year option with preferable rates. 

Understand When It Pays Off to Make a Bigger Down Payment

As mentioned previously, avoiding overspending on a down payment is one of the best ways to prevent homebuying pitfalls. However, there are some exceptions to the rule.

Overpaying on a down payment leaves buyers vulnerable to house-poor circumstances because it wipes out their resources for ongoing costs. However, providing a carefully calculated higher-than-average down payment can reduce interest rates and several other expenses.

The math is simple: putting down more money reduces monthly payments by lowering the loan size. It also eliminates the need for private mortgage insurance.

A buyer should always make the largest down payment that they can effectively include in the monthly budget. For most people, the best choice is to choose a low down payment mortgage.

People with high-volume liquid assets (and perhaps less stable cash flow) should consider paying 20 percent or more upfront to lock in the lowest possible payments for the life of their loan. Doing so will allow them to minimize expenses as they recoup the cost of buying their home.

Down payment sizes vary significantly among individuals. Deciding how much to put down for a mortgage comes down to budgeting.

Making a Budget For Buying & Owning a Home

The question “How do I avoid becoming house poor?” is complex, and there’s no correct answer. However, the most satisfactory one-word answer would be “budgeting.”

Making a budget and sticking to it is essential for financial success in life. Creating a budget establishes economic boundaries between building wealth and draining it. By knowing where the line is, homeowners can avoid crossing it. Here are a few ways to budget for buying a home.

Use the 28/36 Rule to Balance Home Debt With Other Debt

The 28/36 rule is a tried-and-true debt management guideline that states that no more than 36% of a household’s income can go to paying debts. Of that 36%, 28% of an individual’s monthly gross income (before taxes) can go towards housing costs.

The 28/36 rule is essential in avoiding house poor scenarios because it expresses housing expenses within the bigger picture of a person’s overall debt.

The 28/36 rule provides valuable insight, but it’s not a perfect science. The efficacy will vary from person to person. However, as a general rule, anyone looking to take on a mortgage that would inflate their total debt to more than 36% of their income is at risk of becoming house poor.

Choose a Starter Home: The Perks of Buying Below Your Budget

It can be tempting to buy a dream house. Perhaps even the most luxurious (and, likely, most expensive) home in one’s budget. However, doing so can set people up to become house poor.

Choosing how much house to buy, i.e. a starter home over an ultra-luxe mansion reduces the financial risk of the investment. Starter homes are generally less expensive and come with lower monthly payments. As a result, it makes them an excellent option for those just starting out or who have a limited budget.

In the long-term, starter homes can pay off. People who purchase homes below their means have a greater chance of profiting when selling. Buyers who extend their budgets beyond their means will fight an uphill battle to recover that costly overhead.

Buyer Beware: Avoid Fixer-Uppers & High-Maintenance Properties

People who want to buy houses for cheap are often drawn to fixer-uppers. However, it’s important to remember that these homes have many hidden costs.

Fixer-uppers require a lot of maintenance, which can be expensive. People with exceptional DIY skills can save costs on contractors and flip the renovated property for more than they paid.

However, non-experts are at risk of falling for the misleading price tags of fixer-upper properties. When people fail to consider maintenance costs, it’s easy to become house poor.

Approach New Builds With Caution

Similarly, new construction homes can carry unexpected costs that prevent buyers from budgeting safely.

While these homes come with many benefits, supply-chain interruptions, construction setbacks, and a slew of other unforeseen circumstances can easily blow the most secure financial plan.

A fully customized new build probably isn’t the best choice for first-time buyers. However, new-build homes in master-planned communities can come with affordable price tags and a delightful never-lived-in feeling.

Estimate the Total Annual Costs of Owning a Home

To make a proper homebuying budget, buyers need to factor in the annual expenses after the initial purchase.

Building a budget off of the monthly mortgage payment alone isn’t sufficient. For the most accurate budget, experts recommend setting aside up to 2% of the entire cost of the home for insurance, association fees, and repairs.

Budget to Pay Off Your Mortgage Early (But Not Too Early)

One of the most hotly debated topics is whether or not to pay off your mortgage early. The widely agreed-upon definition of house poor is someone who’s over-paying on their homeownership expenses. However, someone who spends their last dime paying off a mortgage early could also be left feeling house poor.

On the one hand, paying off your mortgage early can save you thousands in interest payments. It can also free up extra cash each month, reducing stress and providing a financial cushion in tough times.

On the other hand, putting extra cash towards your mortgage means you might not have money set aside for unexpected repairs, discretionary spending, or other emergencies. It can also make it challenging to invest in other opportunities, like stocks or bonds.

Stay Liquid: Pursue Diverse Investments In Addition to Owning a Home

Real estate is an excellent investment for long-term growth, but it’s not very liquid. 

A house-poor person can technically have a high net worth without having much wealth.

Owning a multi-million dollar estate is a great way to have a high net worth, but it doesn’t put food on the table. Pairing affordable real estate investments with highly liquid assets provide multi-faceted protection from being house poor. These are the best ways to remain liquid enough to cover daily expenses after purchasing a home.

High-Yield Savings Accounts

Any successful homebuyer probably already has an emergency fund consisting of at least a high-yield savings account. (Or at least they should!)

A high-yield savings account is a type of bank account that offers a higher interest rate than traditional savings accounts. This type of account allows people to enjoy wealth-boosting perks while saving for the short-term.

Sure, the interest rates for these accounts won’t make anyone rich overnight, but the growth is better than nothing. The goal is to keep savings momentum trending upwards after purchasing a home.

Common examples include money market accounts and cash management accounts. These services typically don’t have minimum deposits and will allow customers to withdraw at any time for no fee.

Bank Products and Treasurys

Investing in treasury bonds and certificates of deposit can provide stability and security for your financial future.

When you invest in treasury securities, you’re lending money to the U.S. government. In return, you receive a guaranteed rate of return backed by the full faith and credit of the United States.

Treasuries are among the safest investments because there’s minimal risk of default.

Stocks

Investing in stocks is painted as a high-risk, high-reward endeavor. However, with the proper guidance, anyone can have a robust portfolio of wealth-generating stocks.

Investing in stocks keeps people avoid being house poor because there’s generally an inverse relationship between the stock market and real estate prices. Simply put, homeowners can rely on increasing stock values when property values are low, and they can fall back on secure home prices when the stock market is down.

The most common pitfall is making rash investment decisions to “read” the stock market. Wise investors don’t treat their stocks like a checking account. Instead, they think of them as a break-in-case-of-emergency” piggy bank.

People should prepare to let their investments sit and fluctuate over time. All significant purchases and withdrawals should be made under the guidance of a trusted financial adviser.

Monetize Your Real Estate Investment

There are near-endless ways to prepare for success in homeownership, but life can always get in the way of our plans.

If worst-case scenarios become a reality, there are several ways owners can monetize their homes and avoid becoming house poor. 

House hacking is a term used in real estate that means buying a property and living in it for free, or close to free, by renting out the extra space. This strategy can pull people out of the grips of financial disaster when the costs of the monthly mortgage payment and unexpected repairs add up.

Similarly, owners can choose to move out of their home and rent it out full-time, either long-term or short-term. There are pros and cons to each. Long-term rentals typically provide reliable passive income, while short-term rentals appeal to vacationers ready to pay top-dollar.

As a very last resort, people may choose to sell their house if they become overwhelmed by the financial burdens of owning it. When choosing this route, it’s imperative to study the local market, consult a professional, and do everything possible to sell for a capital gain.

Don’t Be Drawn Into The House-Poor Pit

Owning a home is a possibility for everyone, even after bankruptcy. However, it’s essential to follow a plan set for success.

The house-poor cycle can be easily avoided by following a few simple tips. Don’t buy a home until you are ready. Get the best deals on down payments and mortgages, budget carefully, and hold onto liquid assets. 

These measures may seem like common sense, but consumers often ignore them to get into the housing market as quickly as possible. It is important to remember that buying a home is a long-term investment and should not be taken lightly. You can ensure that your dream home builds your wealth without draining it by following these guidelines. 

This article How To Avoid Being House Poor originally appeared on Rick Orford.