young children, Walter and Susan didn’t want to work such crazy long hours; yet they were forced to do so to meet their gargantuan mortgage payments. The initial payments on their adjustable-rate mortgage were low, but they ballooned gigantically as the loan’s interest rate increased.
The financial strain led to personal strain as Walter and Susan had frequent arguments about money and childcare. We know of others who stretched themselves the same way that Walter and Susan did. Many of them continue slaving away long hours in jobs they don’t like and making other unnecessary sacrifices, such as limiting the time they spend with family, in order to make their housing payments. Some end up divorcing, due in part to the financial strains. Others default on their loans and lose their homes and their good credit.
The Cost of Buying and Owning a Home
Before you set out in search of your dream home, one of the single most important questions you should answer is, “What can I afford to spend on a home?” To answer that question intelligently, you first need to understand what your financial goals are, what it will take to achieve them, and where you are today. If you haven’t yet read Chapter 2, now’s the time (unless you’re 100 percent sure that your personal finances are in tiptop shape). In the following sections, we dig into the costs of buying and owning a home.
Mortgage payments
In Chapter 6, we discuss selecting the best type of mortgage that fits your particular circumstances. In the meantime, you must still confront mortgages (with our assistance) because mortgages undoubtedly constitute the biggest component of the total cost of owning a home.
Start with the basics: A mortgage is a loan you take out to buy a home. A mortgage allows you to purchase a $200,000 home even though you have far less money than that to put toward the purchase.
With few exceptions, mortgage loans in the United States are typically repaid over a 15- or 30-year time span. Almost all mortgages require monthly payments. Here’s how a mortgage works. Suppose that you’re purchasing a $200,000 home and that (following our sage advice, appearing later in this chapter) you have diligently saved a 20 percent ($40,000, in this example) down payment. Thus, you’re in the market for a $160,000 mortgage loan.
You sit down with a mortgage lender who asks you to complete a volume of paperwork (we navigate you through that morass in Chapter 7) that dwarfs the stack required for your annual income tax return. Just when you think the worst is over (after the paperwork blizzard subsides), the lender proceeds to give you an even bigger headache by talking about the literally hundreds of mortgage permutations and options.
Don’t worry — we can help you cut through the clutter! Imagine, for a moment, a simple world where the mortgage lender offers you only two mortgage options: a 15-year fixed-rate mortgage and a 30-year fixed-rate mortgage (fixed-rate simply means that the interest rate on the loan stays fixed and level over the life of the loan). Here’s what your monthly payment would be under each mortgage option:
$160,000, 15-year mortgage @ 4.75 percent = $1,245 per month
$160,000, 30-year mortgage @ 5.00 percent = $859 per month
As we discuss in Chapter 6, the interest rate is typically a little bit lower on a 15-year mortgage versus a 30-year mortgage because shorter-term loans are a little less risky for lenders. Note how much higher the monthly payment is on the 15-year mortgage than on the 30-year mortgage. Your payments must be higher for the 15-year mortgage because you’re paying off the same size loan 15 years faster.
But don’t let the higher monthly payments on the 15-year loan cause you to forget that at the end of 15 years, your mortgage payments disappear, whereas with the 30-year mortgage, you still have 15 more years’ worth of monthly payments to go. So although you have a higher required monthly payment with the 15-year mortgage, check out the difference in the total payments and interest on the two mortgage options:
| Mortgage Option | Total Payments | Total Interest |
| 15-year mortgage | $224,064 | $64,064 |
| 30-year mortgage | $309,312 | $149,312 |
Note: In case you’re curious about how we got the total interest amount, we simply subtracted the amount of the loan repaid ($160,000) from the “Total Payments.” Also, the monthly payment numbers previously cited, as well as these total payments and interest numbers, are rounded off, so if you try multiplying 180 or 360 by the monthly payment numbers, you won’t get answers identical to these numbers.
With the 30-year mortgage (compared with the 15-year mortgage), because you’re borrowing the money over 15 additional years, it shouldn’t come as a great surprise that (with a decent-size mortgage loan like this one) you end up paying more than $80,000 additional interest. The 30-year loan isn’t necessarily inferior; for example, its lower payments may better allow you to accomplish other important financial goals, such as saving in a tax-deductible retirement account. (See Chapter 6 for more information about 15-year versus 30-year mortgages.)
In the early years of repaying your mortgage, nearly all your mortgage payment goes toward paying interest on the money that you borrowed. Not until the later years of your mortgage do you begin to rapidly pay down your loan balance, as shown in Figure 3-1.
Lender’s limits
Because we’ve personally seen the financial consequences of people borrowing too much (yet still staying within the boundaries of what mortgage lenders allow), you won’t hear us saying in this section that lenders can tell you the amount you can afford to spend on a home. They can’t. All mortgage lenders can do is tell you their criteria for approving and denying mortgage applications and calculating the maximum that you’re eligible to borrow. (For the inside scoop on lenders and their limits, see the first section of this chapter.)
Mortgage lenders tally up your monthly housing expense, the components of which they consider
