This was an answer I gave on Quora but I liked it so much I decided to post it as a blog article as well.
I’m going to answer this question in three parts because I think buyers make mistakes before, during, and after buying a house.
Let’s use buyer Brad as an example throughout this answer.
Buyer Brad makes about $50,000 per year, has one kid, and his wife Nancy is a stay at home mom. They currently rent a 2 bedroom apartment and want to buy a house.
- Mistakes BEFORE buying a houseExample: Brad decides he’s had enough renting. He wants his own place, with a big backyard, and at least 3 bedrooms and 2 bathrooms. He calls the bank and asks how much he can borrow.The bank asks how much he makes and what his car payment is and if he has good credit. Brad says he makes $50,000, has a $350 car payment and says yes, he has good credit. The bank then says he can afford a $250,000 home. So Brad starts looking at homes online priced $230k-$250k.Brad makes several mistakes here.
- He doesn’t go through a full pre-qualification with the lender. I can’t tell you how many times I have seen this. The buyer has a brief talk with a lender and then lender gives him a number. The lender didn’t ask about school loans, or credit card payments, or even run the credit check.This sets Brad up for a lot of potential disappointment down the road. Brad needs to fill out a full loan application with the lender so that everything is disclosed and the lender can actually give him an accurate answer.If Brad has other debt, he will qualify for less. If he has poor credit (under 600) it will be difficult to get a loan. If he has fair credit (600–700ish) he will be able to get a loan but he may have to pay a higher interest payment. If he has good credit (700+) he will get the best loans.
- He doesn’t look at houses based on his personal budget
Most buyers want to buy the most expensive house they can. They figure, “if the bank says I can borrow this much, then I must be able to afford it.”It’s not the bank’s job to do a personal financial analysis with Brad (although in my opinion, they should). The bank usually just wants to write a large a loan as possible. They are most likely going to sell the loan right away anyway so they really don’t care much if it is going to be a financial burden to Brad down the road.Banks will lend something like 40% debt to income ratio. So if Brad brings home $4,000 per month and only has one debt of $350. They will ok a monthly mortgage payment of about $1,500.
- He doesn’t figure in the extra costs of a houseThis goes along with the previous mistake. Brad sees the monthly mortgage payment of $1,500 and figures he can handle it. After all his rent payment is $1,250.What he doesn’t think about is what that rent covers. The rent covers water/sewer, garbage, and ALL maintenance issues. Water/sewer and garbage can easily add up to $250 depending on location.It is suggested that homeowners spend 2–4% of the homes value on regular maintenance. On a $250,000 home, that’s $5,000-$10,000 per year. But most of these expenses come as big lump sums and homeowners forget to save for them (roof, heating system, siding, etc)
- HE DOESN’T SAVE ENOUGH MONEYThis is the number one mistake that buyers make. They simply don’t save up enough money before house shopping. In most areas, the minimum a buyer needs is a 3.5% down payment. For a $250,000 house that is almost $9,000.A lot of first time home buyers use gift money from parents or grandparents. This is very generous of the family member but oftentimes that means that the new buyer hasn’t saved anything. This will make it very difficult for them after they buy the house and a big expense comes up.3.5% down will get you into a house but it will cost Brad tens of thousands of dollars over the course of time. He will pay higher loan fees each and every month (about $150-$200). He will also pay more in interest.Many buyers do not even think about the loan costs involved with buying a house. Borrowing a quarter million dollars isn’t cheap. Loan costs on Brad’s $250,000 home could easily reach $7000 (loan fees, appraisal fees, mortgage insurance, home insurance, property taxes, etc).
2. Mistake DURING buying a house
As Brad and Nancy begin searching for a home they connect up with a real estate agent (good idea!). They look at a couple homes in the $240,000-$250,000 range. Then they ask if they can see the house across the street that is for sale. The realtor tells them it is $300,000 but they want to see it anyway, “just for fun.”
- They start at the top of their price rangeI always recommend my buyers look at the cheapest homes first and work their way up from there. The problem with looking at the most expensive homes first is that Brad will almost always compare the cheaper homes to the more expensive homes and easily gets sucked into buying more than he actually needs.
- They look at homes more EXPENSIVE than they can affordThis is the same problem as the previous mistake, except now they want a house that they can’t even afford. In their minds, Bob and Nancy will now have to “settle” for a cheaper house. They will start off their home ownership already wanting something bigger and better.
- They shop based on WANTS and not NEEDSFinancially speaking, it almost always makes sense to buy the cheapest home that checks all the “needs” boxes. The chances are that in 5–7 years, their needs will be different and they will want to move. This is most likely true whether they buy a $175,000 house or a $250,000 house.
- They don’t think about maintenance Houses are built and maintained to varying degrees of quality. Some houses are going to need much more upkeep and repair costs than others. Bob and Nancy only think about the upside when looking at a home and never at the downside
3. Mistakes made AFTER buying a house
Bob and Nancy find the house of their dreams. It ended up costing $260,000 (they were “gifted” another $10,000 from Nancy’s parents) but they love it. It was an older home with some deferred maintenance but it had great “character”. As soon as the loan was completed they decided they had to redo the kitchen because it was ugly and put the $10,000 renovation onto credit cards. They figure they can just re-finance the home in a couple years and pay off the credit cards and the parent’s “gift”.
Most of the mistakes that Bob and Nancy make after buying the home are financial mistakes.
- They paid more than they could “afford.”According to the bank, they could afford a $250,000 home but they ended up buying more than that because they figured $10,000 wasn’t that big of a deal. It is very solid financial advice to never borrow more than 25% of take home pay on the mortgage payment. That means that Bob and Nancy should not have even considered anything above $1,000 per month (about a $175,000 home). It’s very likely that their new mortgage payment is going to be very difficult to pay. It might mean Nancy has to go find a job.Lenders will allow a gift from a family member. The family member must state that it is a gift and there are no strings attached. I know for a fact though that many buyers tell the family member they will pay them back. Legally speaking, they are under no obligation, but ethically and morally, they have committed themselves to even more house debt.
- They immediately start making changesThere is nothing wrong with making improvements to the house. But you always want to think how it will affect resale value. If all the other homes in the neighborhood have similar existing kitchens, putting in a brand new one won’t necessarily raise the price that much.Also, they start buying furniture and making changes that they don’t have the money for. They increase their monthly obligations. They should wait at least 3–6 months to get used to their new monthly expenses.
- They don’t save for big repair costs
Older homes with lots of “character” are great (I own one myself) but they do tend to come with some repair needs. Bob and Nancy spend every cent they have, plus thousands more, without thinking about having an emergency fund for when the roof starts leaking or the old furnace dies.
- They refinance or take out a home equity line of credit
Every time home owners borrow more money against their house, they are kicking the can further down the road. They are spending more money (refinances cost thousands!) and paying more in interest over the life of their loan.By doing this, Bob and Nancy are not really getting ahead financially over their apartment.I have seen it many times, I meet with a homeowner who wants to sell their house. They’ve owned the home for 10–15 years. I tell them “great! You must have a lot of equity in the home than to use as a huge down payment on your next house.” But sadly, they have refinanced and refinanced and have no equity to show for it. And when I ask them where all that money went, they usually say something like “I don’t know, but it sure seemed important at the time.”
I am all for home ownership and buying real estate for investments. And I certainly haven’t made all the best decisions myself. But I see a lot of people setting themselves up for financial difficulty in the way they treat home ownership. I want people to buy a house that they can love and enjoy. But I also want them to be set up for the future. And too many people put their future at risk because they want too much now.
I will soon write a follow-up to this article about how to avoid these mistakes and how to make home ownership not only enjoyable now, but also financially beneficial in the long run.
If you are looking for a good book to read about good financial habits, I highly recommend “The Millionaire Next Door” by Thomas Stanely. It is a study on the lifestyle of the typical millionaire (I’ll give you a hint, it’s probably not what you would expect it to look like). I have read this book several times over the last few years and it always helps keep me motivated.