Owning a home is an integral part of the American Dream; a possibility afforded by the design of our society. The 'American Dream' as coined by James Truslow Adams, allows 'opportunity for each according to ability or achievement’. While nothing comes easy, sometimes we forget the opportunities we have.
We receive a lot of questions on how to best prepare for a home purchase. The process has changed quite a lot recently, whether as a first-time buyer or purchasing your family's forever home. My wife and I bought a home at the beginning of the year, I’ll share from our experience and give you a few ideas to help you prepare and to make your own purchase smooth.
Know your credit score.
Your credit score is the basis for most decisions involving financing, and a higher score will lead you to better terms on the loan that you are hoping to secure. Prior to applying for a loan or pre-approval letter, it is wise to pull your credit report and score. Look for any discrepancies or negative items that need to be corrected and evaluate potential ways to increase your score if necessary. With a score between 660-680 you may be looking at a higher interest rate or sizable fees on your loan, below that range is essentially the cutoff point for most underwriting decisions. With a score of 700-720 you should be able to obtain quality terms and a score above 750 will get your preferred rates.
I discovered an unpaid parking ticket from the great city of Washington DC on my credit report. It had been reported against me as a charge-off, this had not only lowered my credit score but was a glaring negative mark as a collection against me. Thankfully I had started the process of evaluating my credit early on and I just had to pay the appropriate amount of blood money to the collection agency to make it disappear. That process took about a week or so in whole. Look for items like this and clean up that report!
How much house can you afford?
This is an important question. Your debt-to-income ratio is crucial from the lender's standpoint. They evaluate your debt-to-income on the front end (all payments allocated to housing costs) and the back end (housing and all other debt obligations). In most cases the limit on your front-end or housing payment ratio is 28% of gross income, while the back-end or all-combined debt ratio typically tops out at 41-43% of gross income. However, this doesn’t mean you should approach those limits. You can ‘try on’ an anticipated mortgage payment in advance to see how it feels by calculating the payment amount, removing it from your monthly living budget, and banking it in a savings account. Does this payment allow you to meet your other obligations and savings goals? If you feel too strapped then you know it’s too much. Generally speaking your fixed expenses should be around 50% of your gross income, leaving 30% to allocate toward financial priorities (lifestyle choices), and the remaining 20% to building long-term wealth. Play with the numbers for your situation. Be very careful not to reach for housing and sacrifice your ability to save & build your long-term investments. 20%-25% is a good maximum target.
Saving for your down payment.
The housing market is expensive in almost every part of the country and envisioning your down payment can be a real drag. We talk a lot about budgeting and how to allocate your resources to best meet your goals and this topic can get a little tricky for some. We recommend budgeting for a 20% down payment and planning to save or use liquid assets to fund this amount. While we recommend a 20% savings rate to long-term investments, it is ok to split your efforts between retirement accounts and a designated investment account for your down payment. This goal is a part of your long-term wealth building effort. In addition we recommend revisiting your financial priorities and lifestyle choices to cut unnecessary items during this time period in order to increase your savings rate.
Some FHA loans will allow for a down payment as little as 3% of the purchase price. While this might get you into a more expensive home or allow you to put less money down, it does pose a few issues. Most notably, if you are unable to stay in the house for a length of time you face the risk of potentially owing more than its worth on the market. Additionally if you are putting less than 20% down you will be required to pay for private mortgage insurance (PMI) which can be as much as 1% of the overall loan balance annually.
Nowadays it’s almost required to be pre-approved by your lender if you want to be competitive and secure the property you want. The pre-approval process also defines a maximum limit on how much you can borrow for your purchase, which is very helpful to know. Be prepared to assemble an inventory of all of your financial documents including: income statements and pay stubs, account statements on all investments and retirement accounts, documentation of any other properties and rental agreements, and statements on all outstanding loans. Most pre-approval letters expire after 90 days, however your loan officer can easily update your letter. *Remember if you are self-employed you will need to show at least a two-year history of income.
Plan for closing costs.
Closing costs are additional fees and expenses you will need to complete the loan transaction, including your down payment in addition to other items such as insurance, taxes and bank fees. Most lenders will require that you secure property insurance in advance and escrow 6-8 months of property taxes. There is also title insurance and fees charged by the lending institution such as points or origination fees. These costs can be as much as 2-5% of the purchase price. You can find all of this information on your Good Faith Estimate from your lender.
Buy a house you love, BUT, don’t get emotional.
I have to admit, I broke this rule with our purchase. Luckily my wife is level headed and was able to be the voice of reason in our price negotiations. It’s easy to fall in love with a place and usually it’s one that stretches your financial limits. Stay strong and stay within your predetermined budget. There will always be another property to fall in love with. Your realtor should also help with this, if they aren’t helping you to be realistic find a new one.
Know your additional costs.
Unfortunately additional expenses can be an unwanted surprise for many first time homebuyers. Taxes & property insurance are unavoidable costs and maintenance and upkeep costs can also be significant in the first year. Plan for home improvement costs on items such as painting, plumbing, and any other repairs as well as potentially needing new appliances.
Look out for hidden dangers & risks.
Is there a dangerous tree looming over your house? Faulty stonework, potential plumbing issues, and HVAC or roof replacement are all things to look out for. We ran into an issue with an ancient oak tree, that I hated to see go.
A few last items:
- Know that the mortgage approval process is painful. Don’t expect to close sooner than 60 days and be prepared to send and re-send every account statement since the beginning of time. Liquidity is a big advantage; it’s wise to source your funds in advance to the account you will be using to pay closing costs. We had to show additional documentation because I didn’t move funds to the final destination early enough.
- Pay off debt in advance. Your credit usage should be less than 50% of your total available credit.
- Find the right real estate agent, one that will work for you and is not just looking for a transaction. Be wary one who is just encouraging a purchase.
- Watch out for home ownership myths. It’s not always the better to buy than rent, and homes can go down in value.
While it’s a rewarding process buying a home can definitely be challenging. Just remember to do your research, lay out your financial goals in advance of the search process, and above all use common sense. Also, if you have one please share your purchase stories with us, we'd love to hear additional tips and things to look out for. Good Luck!
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.