Regular Money Talks readers know I have strong feelings about debt.
As I told you in one of my first columns back in January, taking on too much debt nearly ruined me. And I sincerely believe that getting out of debt is the single most important step most folks can take to dramatically improve their lives.
Fortunately, becoming (and staying) debt-free isn’t as complicated as you might expect.
As I explained in that column, in most cases all it really takes is a firm decision and the patience to follow a few simple steps over time.
(If you or someone you love is currently struggling with debt, be sure to check out that original column right here.)
However, I’ve found there is one common situation that can trip people up. It has to do with making large purchases, which for most folks means buying a new home or a new car.
We all need a place to live. And even in a post-COVID world, many of us still need a car to get around.
But for those who have experienced debt problems in the past, the thought of spending a large chunk of your savings or taking on new debt can be unnerving.
So over the next couple of weeks, I want to share some of my own “best practices” for making these purchases without jeopardizing your financial future.
There are some important distinctions between buying a home and buying a car. We’ll take a look at each of them separately.
But before we do, I want to cover a couple of critical ideas that apply to any major purchase.
Just like with paying down debt, the first idea has to do with mindset.
As I mentioned before, those of us who have overcome struggles with debt can get emotional when it comes to big purchases. Feeling guilty about spending a significant amount of money is especially common.
So, the first step is simply to give yourself permission to make the purchase.
It might sound silly. But as I explained in that first column, gaining control of your finances isn’t about deprivation. Rather, it’s about being intentional with your spending. Outside of essentials, that means spending money only on things that truly bring you joy.
As long as you can afford it (more on that below), there’s no reason to feel guilty about wanting a new home or car.
Next, I recommend building up a rainy day fund before making any large purchases.
I covered this a bit in that previous column as well. Specifically, I recommended putting aside a portion of your income until you have at least a few months’ worth of expenses in savings to cover emergencies.
However, once you’ve paid down your debts, I recommend building this rainy day fund until you have at least a full year’s worth of minimum expenses.
By “minimum,” I mean the amount you would need to cover the essentials — to pay your rent or mortgage, pay all your bills, and put food on the table — for at least a year.
This may seem excessive, but it will give you tremendous peace of mind and help ensure you can handle the most common financial emergencies.
OK, now that we’ve covered those basics, let’s look at some specific guidelines for buying a home.
Now, you’ve probably heard that buying a home is the single largest investment most folks ever make. However, I urge you NOT to think of your home as an investment at all.
It’s true that owning a home has generally been a good investment over the long run. But home prices aren’t guaranteed to rise every year or even every decade, so you should not buy a home with the expectation that you’ll be able to sell it for a significantly higher price down the road.
It’s also great to want to build equity in a home. But you really need to think about what that means.
For example, suppose you take out a $500,000 traditional 30-year fixed-rate mortgage. Even at today’s historically low rates, that loan will actually cost you nearly $800,000 over the life of the loan.
Without significant capital appreciation, you probably aren’t building the equity you think you are.
For a similar reason, I would also encourage you to buy a home only if you intend to live in it for a significant amount of time. That means at least five years, but 10 or more is ideal.
You don’t want to be in a position where you need to sell in a bad market.
Next, while I’m generally against taking on debt, I’m willing to make an exception for a mortgage.
As I mentioned before, rates are near historic lows, which means the cost of carrying a mortgage is cheaper than ever. And frankly, the reality is that very few folks could afford to purchase a home without one today.
But it must be affordable.
In this case, affordable doesn’t just mean that you can cover the monthly payments with your current income.
It means you could cover those monthly payments — along with all your other minimum expenses — with your rainy day fund for at least a year if necessary.
Depending on your current lifestyle and the size of your rainy day fund, this could be a significant difference.
I would also urge you to borrow no more than 80% of the value of the home. This means you would make a down payment of at least 20%.
Again, this might seem overly conservative by today’s standards. But it can make a huge difference in your peace of mind.
For example, suppose you buy a house and suddenly lose your job. You’re able to cover your expenses with your rainy day fund as planned. But after many months, you are unable to fully replace your lost income and realize you can no longer afford that home.
Well, if you did put down 20% on the home, you can simply sell it. Sure, you may have to sell it for less than you paid, and you’ll lose some money due to fees and taxes.
But you can avoid foreclosure (and its nasty consequences on your credit) and likely still walk away with some equity.
Finally, if you can afford to put down more than 20%, you can also take advantage of this extra equity with a home equity line of credit (HELOC).
HELOCs are essentially just a loan on the equity in your home. Most folks use them to finance home renovations or other purchases. However, I like to use them to bolster my rainy day fund.
To do this, you’ll simply apply for a standard HELOC on the excess equity on your home (above that 20% threshold). But instead of spending the cash like most folks do, you can turn around and pay the loan off immediately.
There aren’t usually fees to do this, but you will likely be charged one or two days’ worth of interest depending on how long the payment takes to clear.
At this point, the loan is now paid off. However, the bank will typically leave the line of credit open for several years.
I like to think of it as an extension of my rainy day fund. If things really go wrong and I need immediate access to cash, I won’t need to go to the bank and plead for a loan. The money is already there and ready if I need it.
That’s it for this week. Next time, I’ll share some guidelines on safely purchasing a new or used car. (And I suspect you might be surprised by what I have to say!)
In the meantime, I’d love to hear about your own experiences buying a home. Do you agree with my guidelines? Do you have some of your own? Let me know at [email protected]. As always, I can’t personally respond to every email, but I promise to read them all.
Regular Money Talks readers know I have strong feelings about debt.