You’re hitting your stride in your career, you’ve been saving money for a few years and mortgage rates are low…now you’re ready to dive in and buy your first home. First off, congratulations! As we discussed in our American Dream lesson, owning a home for the younger generations is harder than ever and just getting to this point is definitely an accomplishment. However, the truly challenging decision you now need to make is whether to buy a starter home vs. dream home?
If you’re anything like us, my partner and I go back and forth to exhausting lengths questioning and rationalizing this decision. Sure, we start off looking at homes well below our budget, but then go down the Zillow or Realtor.com rabbit hole where all of the sudden a $1.2 million home feels like the perfect fit (even though irresponsibly above our budget). We eventually come to our senses, but within our existing budget, there is room for two scenarios: a starter home vs. dream home. In this lesson, we will explore both options and layout some considerations to help you decide which home makes the most sense for your first home purchase.
Opportunity Cost of Buying a Home
There are a lot of emotional factors involved in homebuying, and we will cover some of these in the considerations below. However, buying a home needs to be viewed through the lens of financial investment. Like all decisions in life, there is an opportunity cost associated with investing in a home. You can think of a home as another asset in your financial investment portfolio and finding the right portfolio mix is important to financial success.
As lesson 3 of building wealth outlines, we all have limited resources and we should do everything in our power to make those resources multiply. When we consider whether to buy a starter home vs. dream home, is it more financially beneficial to go with a cheaper starter home, freeing up more money to pay down debt quicker or bolster your retirement savings? This is dependent on your personal financial situation, but if you are carrying large debt loads, it would likely be beneficial to invest in a cheaper home so you can pay off high-interest debt quicker.
Keep this top of mind as we consider buying a starter home vs. dream home.
Defining Starter Home vs. Dream Home
According to our timeless lessons to building wealth article, lesson 5 states to “make thy dwelling a profitable investment.” By this standard, homeownership is a key contributor to building long-term wealth, so regardless of whether you pick a starter home or dream home, you’re on the right path to financial independence.
As we look at how we are defining a starter home vs. dream home, let’s assume for the sake of this conversation that our total home buying budget is capped at $750K.
What is a Starter Home?
Everyone will have their own definition for a starter home dependent on their budgets, needs, and of course, location. Starter homes should be a home that doesn’t quite tick off everything on your wishlist and is well below your budget. Given our total potential homebuying budget is $750K for this example, we will consider a starter home to be anything under $550K.
Some concessions we may make in a starter home may be:
- Square footage may be lacking
- Lower bedroom and bathroom count
- Lacking large backyard
- Poor school district
- Shared walls with neighbors
- Less-than-desirable community
- Outdated design and appliances
- Possible renovations needed
What is a Dream Home?
On the other hand, a dream home is a house that you are so in love with that you want to grow your family and stay in this house for years to come. In this scenario, you are willing to spend up to your upper budget limit of $750K.
Elements that draw us to a dream home:
- Square footage to grow into
- Big backyard
- Cul-de-sac or family-oriented community
- Great school district
- Detached home
- Move-in ready or room in the budget to renovate
First-Time Homebuying Considerations
Now that you’re ready to begin your housing search, let’s dive into the important considerations to help you determine if you are on Team Starter Home or Team Dream Home.
Down Payment
The down payment is often the biggest barrier for first-time homebuyers to overcome. A downpayment is the upfront collateral you are going to pay to your lender prior to securing financing for the remainder of the house sale price + closing costs. Usually, younger buyers have not yet had the chance to accumulate stashes of cash due to debt payments, lagging career growth, or numerous other reasons. While this is a challenging barrier, fortunately, the general guidance that you have to put 20% down is not a requirement. In many cases, lenders will allow you to put as little as 3% down, especially for first-time homebuyers.
While putting a smaller proportion of the sale price down makes it easier for first-time homebuyers to cover a downpayment, it is important to understand three key consequences of this approach:
- Increased principal = increased monthly payments
- Your principal, or the amount still owed to pay off the house, is calculated by taking the full value of the loan and subtracting the down payment. For instance, if you buy a home for $750,000 and put 3% down, or $22,500, your remaining principal will be $727,500.
This is important because your monthly payments will be higher to stick to your payment schedule (usually 15 or 30-year terms) plus you will be paying interest on a higher principal. Over the life of the loan, you will have paid more in interest than if you paid more upfront.
- Higher mortgage interest rates
- When you go through the mortgage application process, your rates will be determined by a number of factors, but most heavily affected by your credit score and your downpayment. Lenders are more likely to give you their best rates when you are able to put at least 20% down up front.
- Private Mortgage Insurance (PMI)
- Private mortgage insurance is additional insurance you need to take out so that lenders are comfortable allowing you to put less money down. By putting less down, you are a riskier borrower because you have less skin in the game. What PMI does is help guarantee the value of your loan, but you required to pay PMI monthly fees until you have earned about 20% equity in your home. PMI is typically required for borrowers who put less than 20% down.
In the above situations, you will end up paying more monthly due to higher principals and PMI monthly fees. While we’d recommend always trying to put at least 20% down, this may not be possible for all first-time homebuyers, and that is okay.
Efficient Use of Money
As we discussed earlier, every financial decision you make is associated with opportunity cost. If you buy a more expensive home, you are committing to spending more on paying down that home over the next 30 years (or however long you are locked into your loan). Because of this, it is important to consider your immediate and long-term financial goals as part of the overall home decision process.
Even though a home is an appreciating asset (it gains value over time), let’s explore a few scenarios where it is important to ensure you’re not putting all of your money into your home.
Paying Off Debt
Debt is one of the most emotional and stress-inducing elements of personal finance. Personally, I have struggled for a long time to pay off my student debt and it has financially and emotionally hampered me. As I outline in this personal account of struggling with student debt, because I have not paid it off quickly enough, despite never missing a payment, I actually owe more now than I borrowed. This is a trap that many Americans have fallen into and is even worse if you find yourself in credit card or high-interest debt.
If you are carrying around lingering debt, you need to prioritize paying down your debt when considering a home purchase budget. Can you buy a starter home that frees up $500 extra per month to help pay down debt quicker? Maybe you have to wait 5 years to buy your dream home, but the longterm financial savings and emotional relief will be worth it!
Boosting Retirement Investments
Our goal is to #Retire50 and all of our financial decisions revolve around allowing us to retire at 50 years old. A huge part of this is ensuring that our long-term savings can support a financially independent retirement. With this in mind, we are doing everything we can to max out our IRAs and contribute larger portions to our 401Ks than we ever have in the past.
Similar to our debt scenario, if I purchase a more expensive home, I will have less cash available to boost my retirement savings at a time that is critical to ensuring I am getting the most out of the power of compounding. To hammer this home, for every dollar I invest in my 30s, I will need to invest three dollars in my 40s to get the same return in retirement. The earlier you start saving for your retirement the better shape you will be in later in life. Do not purchase a home so expensive it doesn’t allow you to continue to maximize your retirement savings.
Family Planning
First-time homebuyers may be newly married couples or those that are looking to expand their families. This makes sense…more people, more space! Family planning is a huge factor when considering between a starter home and your dream home.
First, depending on the size of your family, you want to make sure you have the square footage to create a comfortable living situation for your whole family. Do all your kids get a bedroom? Will your parents be staying over often? Is there a backyard where the kids and dog can run around?
Second, if you have kids or are planning to have kids that are entering school age, is your designated school district high quality? As a parent, you are going to want to ensure your kids are getting the best education possible. In some cases, a few blocks in one direction may put you into a school district that is inferior, and no one wants that. Additionally, good school systems will help maintain housing value over time.
Lastly, consider the personality of your community. Are you living in a community with similar-aged families, many family-friendly community centers, and plenty of public outdoor space?
Your focus on many of these community and home traits is highly dependent on your family planning and timing. If you have no plans to have kids, school districts may be deprioritized in your search. Additionally, homes in good school districts will likely carry a higher home value which may be a deterrent for first-time homebuyers.
Market Conditions
Life is all about timing and how you capitalize on opportunities. Housing follows historical trends, similar to financial markets, where house prices drop and fall depending on many factors. Without getting into a deep financial lesson, let’s just agree that it’s better to buy a home when home prices are down instead of expensive (obviously!). If you look at the chart below, following the 2008 Great Recession, home values plummeted, in large part due to high rates of foreclosures. While this was a horrible period for many existing homebuyers, it presented a bargain opportunity for first-time homebuyers to get into a new home at a discount.
It is important to understand the market in which you want to buy a home. If it is a seller’s market (many potential buyers and little inventory), home prices will be higher. In comparison, a buyer’s market (more inventory than potential buyers) will present more attractive home prices for buyers. In a seller’s market, it may be unrealistic to buy your dream home and you may need to get a starter home until market conditions are more favorable for you to obtain a larger home.
As we make our way through the fallout from Covid-19 (as of June 25, 2020), mortgage rates are at an all-time low, so borrowers are flooding the market. However, because sellers don’t want people viewing their homes because of fear from the virus, there is limited inventory on the market. This means that despite high unemployment and many other economic factors, it is a seller’s market. Taking a macro perspective of the market like this is helpful when determining the right time to buy.
Be patient and wait for your opportunity to lock in your dream home.
Revenue-Generating Property
If it isn’t clear yet, buying a home is expensive! One way to help offset the cost of homeownership is to buy a home that has the capacity to generate revenue. This can take many forms: renting out a bedroom or guest house or even putting your property on AirBNB every so often. Generating revenue with your home can be a smart tactic to help pay off the home, but be careful not to rely on it. Many things could happen that would restrict you from being able to rent out parts of your property and then you will be left financially overextended.
Solving the Dilemma
Let me jump to the spoiler…there is no right answer when it comes to the starter home vs. dream home debate. It is a deeply personal decision, dependent on your overarching financial situation. You need to take into account all of the considerations above and decide what is the right financial and emotional decision for you and your family.
The one north star I will leave you with is this: Pick the home the best meets your needs and doesn’t leave you house poor. Being house poor means contributing such a large portion of your income into your house, that you can’t afford anything else. While a house is an investment, do not put yourself in this stressful situation.
How Do I Start The Homebuying Process?
Once you’ve compiled your pros and cons list, meditated on all of the considerations, and conducted a financial deep dive, now you’re ready to become a homeowner. Check out this Beginner’s Guide to Homebuying to help you navigate the mortgage and home search process.
Best of luck on your homebuying journey. Leave a comment to let us know if you’re on Team Starter Home or Team Dream Home.
Check out additional topics to make personal finance SLIGHTLY EDUCATIONAL on our Personal Finance page.
