Homeownership has long been considered a central part of the American dream. To achieve that dream, some millennials are doing whatever it takes to scrap together a down payment, including dipping into their retirement accounts, according to a recent poll from Bankrate.
Given that first-time homebuyers can sometimes get approved for loans with just 3% down, it's easy to confuse being able to afford a down payment with being able to afford a home. That's simply not the case, according to financial experts.
"By and large, homeownership has long been touted as the way you build wealth," Deborah Kearns, a mortgage analyst at Bankrate, told Grow this summer. "While that's still true to some extent, you can't overextend yourself to make that happen."
Before you buy, make sure you can answer the questions below. If not, you might want to put off making a down payment on that dream home, even if you can scrape it together.
Kevin O'Leary, investor on ABC's "Shark Tank," cautions against buying unless you can pass this two-question test: Are you married? Do you have kids? If the answer to either of those questions is no, he says, then you're probably better off renting until you're more settled.
Experts also say you probably don't want to take on a mortgage if you plan on moving within five years, for example, or if you're already struggling to pay off debt. "I think the key to life, particularly when you're young, is to stay out of debt," O'Leary told CNBC Make It last year.
If you have to tap into retirement savings or an emergency fund to cover upfront homebuying costs of the down payment and closing costs alone, then you may very well find yourself in a tough financial spot when your monthly mortgage payments arrives. Plus, you may actually be putting your future at risk.
Let's say you decide to take $10,000 out of your retirement account to put toward a first-home purchase, and you're 32, the average age of first-time buyers. If you instead left that money in the account and it saw average returns of 8% over the next 33 years until you retire at 65, those funds would have grown to more than $126,700.
If you have to rent for a few more years and put off buying a house, that's OK. For some people, it's even a better choice: One recent study found that about half of millennial homebuyers ended up with regrets. The No. 1 reason for regret: mortgage payments that are too high.
Before you buy, figure out how much of your financial "pie" you want to go toward housing, says Mark La Spisa, a certified financial planner and president of Vermillion Financial Advisors in South Barrington, Illinois. "Mortgage, taxes, [and] insurance shouldn't exceed 25% of your gross income," says La Spisa.
Some experts use the "28/36 rule," which suggests that you should spend no more than 28% of your gross monthly income on housing costs and no more than 36% on total debt, including housing and other debt.
Once you start putting more than 28% of your income toward housing, you're limiting your cash flow, which can have a major impact on your quality of life. "A lender isn't looking at your child-care bill, your grocery bill," adds Kearns. "They're not looking at all the lifestyle things you want to do to be happy."
People are still inclined to view buying as as a good investment: In a 2019 Bankrate survey of 1,000 Americans on what they consider the best way to invest money they won't need for 10 or more years, the most popular response (31%) was real estate.
In practice, real estate simply is not always the best or easiest way to grow wealth.
"Generally, we can assume that over the long term, if we invest in a low-cost diversified index fund, we get about 7% annualized returns," Sethi told CNBC Make It. "Can you beat that in your area, over time, with real estate appreciation?"
Buying a home can be a good way to build equity in an appreciating asset, but it isn't always. If you're buying a home as an investment, consider that the return on investment in residential housing isn't as good a bet as the stock market usually is.
"If you run the numbers, like me, you might discover that for where you live it actually makes no financial sense to buy," Ramit Sethi, author of "I Will Teach You To Be Rich," told CNBC's Make It in an interview last year.
Sethi suggests using one of the many "Buy vs. Rent" calculators offered by real estate and personal finance websites to see whether it makes sense for you.
As a homeowner, you'll have to account for a lot of ongoing expenses, starting with annual property taxes and homeowner's insurance. Plus, if you put down less than 20%, you may be required to purchase private mortgage insurance.
Owning a home also requires upkeep. Kearns suggests putting 1% of the home's purchase price into a separate fund that's dedicated to repairs and maintenance. "When a furnace goes out, that's a one-time expense that's thousands of dollars that really hurts the budget," she says.
Use a mortgage and housing cost calculator to factor in all these expenses and help you determine whether or not it still makes sense for you to buy.
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