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No. 22
Why Read?
It’s a big and important decision
You can’t afford to screw this up
Nine simple steps to home ownership
In my last post I outlined how to think and do the math on renting vs. buying. Some readers were a bit shocked by the example that I provided, but keep in mind that as interest rates and the cost of energy continue to increase, the price of homes should begin to decline.
This post will focus on how to prepare to purchase your first home. With the help of my friend and mortgage broker, John H., we have outlined 9 steps to prepare to buy a home. If you have questions after reading this post, please leave them in the comments and John H. promises to answer them.
Step 1 – Check your credit score and begin working to improve it
Once you have decided that you need to get out of your crowded apartment where you’ve been “hot bunking” with someone who works the night shift, the first thing to do is check your credit score. This is easily done by requesting a credit report from each of the three credit reporting bureaus (Experian, TransUnion, and Equifax).
Your credit score determines whether you will qualify for a mortgage. Most mortgage programs (Fannie Mae, Freddie Mac) require a score between 580 and 620 to qualify, but if you want to qualify for a good rate or a jumbo mortgage you must have a 740 or better. If you are not within this range, you’ll need to take steps to improve your score.
Check each report for accuracy and dispute any inaccuracies immediately. Low credit scores with either disqualify you entirely or, if you can get a mortgage, it will not likely be at the best rate.
Step 2 – Lower your debt-to-income ratio
The debt-to-equity ratio is used by lenders to determine your ability to pay down the loan. It includes your estimated monthly housing costs (principal and interest on the loan, homeowners’ insurance, property taxes, and any additional fees, such as HOA/Co-Op fees) plus all other recurring monthly debt (car loans, student loans, credit cards) divided by your monthly gross income. The general rule is that a household should not spend more than 43% of its monthly gross income on total debt servicing.
Some mortgage lenders allow a higher debt-to-income ratio, but only when a borrower has “compensating factors” such as a high credit score or a large cash reserve.
Step 3 - Determine what you can afford to buy
The above calculation should give you a good sense of what you can afford to buy based upon how much debt you are able to service. However, if you want to get a more granular view of the numbers, check out this Housing Affordability Calculator. You simply plug in the numbers and percentages and let it do the hard work.
Remember that if you put down less than 20% you may have to pay private mortgage insurance (PMI). That can add a few hundred dollars per month. There will also be other new expenses like homeowners’ insurance, property taxes, other fees, and ongoing maintenance costs (utilities, repairs, etc.).
You do not have to be completely debt free to qualify for a mortgage, but less debt and a good credit score can increase your purchasing power. While some may encourage you to stretch to purchase your first home, you can’t stretch to the point that you are living paycheck to paycheck and scraping together your mortgage payment each month by sacrificing your health or safety. Run the numbers and understand what you can and cannot afford at this point in your life.
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Step 4 – Save for your down payment
Saving for a down payment can be the most frustrating part of buying your first home. In the past few years with home prices rising at a record pace, the down payment can seem elusive. You are also responsible for closing costs which can run between 3% - 5% of the loan amount.
Most lenders would like to see you put down a full 20%, but some will tolerate less (5% - 15%) if you have a good credit score and a low DTI ratio. If you don’t have enough cash on hand, lenders will allow you to use gift funds to cover all or part of mortgage related expenses. If you are receiving a cash gift for down payment, you’ll want to be sure you document the gift properly. If the gift is not done properly the lender may reject your application for a loan.
There are exists a large array of loan programs including FHA loans, USDA loans, and VA loans which allow you to put down a lower amount for your down payment or even assist you with a down payment.
Step 5 – Research loan programs
Take your time and research various loan programs and types of mortgages available to you before you begin to look for a home. If you wait to start this research, you may get caught up in the purchasing process and be forced to make a long-term decision with limited time and information.
Think about what you are trying to optimize. For instance, do you want a loan that allows for the lowest down payment? Are you trying to get the lowest monthly payment option? Are you trying to avoid private mortgage insurance (PMI)? Are you trying to pay off your loan as quickly as possible? Do your homework, understand the tradeoffs, and know which options are best given your financial situation.
Step 6 – Get pre-approved for a loan
This is the most important step before you begin house-hunting. Some sellers and agents won’t even work with you if you are not pre-approved. Having a pre-approval can jumpstart the entire home buying process.
The process of pre-approval is about as much fun as you first visit to the dermatologist – you stand there with a napkin covering your private parts while the doctor examines every inch of skill under a bright light. The mortgage application itself is not terribly complex or time consuming. The supporting documentation (several years of tax returns, paycheck stubs, 2 yrs. of employment history, 2 yrs. of W2s, several years of financial statements (banks and investments), documentation of other loans/liabilities, explanation of employment gaps, a detailed credit check. There is no hiding from your past here.
And when it is all over, there is still no guarantee that you will be approved for the loan. It merely states that you have the credit to get a loan. The lender may still decline your application if the home fails the inspection, or the appraisal is significantly different from the purchase price, or any adverse change that may have occurred since you went through the pre-approval process.
Step 7 – Location, location, location
Before engaging a real estate agent get an understanding of where you want to live, neighborhood, style of home, etc. The easiest thing to do is drive around to different neighborhoods and observe. Determine what is most important to you:
Young families
Schools and playgrounds
Day care
Daily commute
Public transportation
Restaurants and shopping
Noise level
Crime
Traffic
Regarding the style of home that you want you might consider the following:
Year built and build quality
Number of bedrooms/baths
Kitchen/Family Room layout
Parking
HVAC type/age
Roof type/age
Laundry area
Closet space
Basement
Landscaping
Square footage
Appliances
Understand what is most and least important to you and be prepared to make tradeoffs. Try not to get emotionally attached to any property. It is a business transaction and you don’t want to be blinded of a property’s deficiencies. The better idea you have about neighborhoods, home types, and affordability the better you are prepared to engage an agent. Download and use this Home Evaluation Tool to keep organized.
Step 8 – Find an agent
For most people buying a home is the biggest financial decision of their lives. It is a complicated and intimidating process, so get a professional that you are comfortable working with and will act with your best interests in mind. The seller’s agent is not your friend. This person’s job is to sell a home, collect a commission, and disappear. Get a buyer’s agent.
Ask friends and family for recommendations and read online reviews. Interview a few agents before selecting one. Sound tedious? It should be. This is a big decision so don’t cut corners.
Step 9 – Be ready with your deposit
When you find the home of your dreams, you’ll want to make an indication of your intent to buy with an earnest money deposit. This is a good faith deposit that says, “Hey, I’m serious.” These are typically 1% - 2% or the purchase price or a minimum of $500 - $1000 dollars, so have liquid cash available.
The money will be held in escrow and either returned to you at the closing or applied to the closing costs or down payment.
Once you’ve put down your earnest money deposit the agent will move faster than a dog chasing a meat truck to get to a signed Purchase & Sale Agreement. This gets the ball moving on things like a home inspection, hiring of lawyers, and finalizing your mortgage.
I’ll cover this and the mortgage loan process and math in a future note. Until then, feel free to leave comments/questions for my mortgage broker friend.
John H? Hmmm sounds familiar
Re-reading, love this one!