Buying a home will likely be the biggest purchase you make in your life. At least until you buy your second, more expensive home. Recently, the real estate market has appeared to be cooling. All the same, home ownership is still a major part of the American Dream. It can also be a great way to help build wealth over time, when done properly.
Here are six things you need to know when buying your first home.
- Begin with Getting Ready to Borrow via a Mortgage.
Your dream home may or may not be within reach today. You might be able to buy more house than you really need. How much of a mortgage payment you can truly afford will likely depend on your lifestyle as well as assets, income and debt. Before you run off and find your dream home, you should put some time into determining what you can really afford.
You should also check your credit score. A low credit score means you will likely have to pay a higher interest rate on your mortgage. This can dramatically change the total cost to purchase a home.
Assuming your credit is in good shape, ideally higher than 720 and extra credit for those above 760, you should begin talking with a lender. You can have a preliminary conversation about a mortgage and get what is called “pre-qualified.” This is an educated guess of what type of mortgage you may be able to qualify for based on your income, debt and assets. You may wish to start the conversation with your local bank but I do recommend shopping around for your mortgage. Rates and fees can vary greatly from lender to lender. Even small changes in the Annual Percentage Rate (APR), or interest rate, can mean tens of thousands of dollars in extra interest over the life of a loan.
- What You Qualify for versus What You Want to Afford.
If you have a conversation with a mortgage broker, they will answer the question, “How much can we qualify to borrow?” You can likely qualify for as much as 43% debt to income. That means the total of all your debt payments, plus the mortgage, can be up to 43% of your gross income. If you decide to go that high, you may end up feeling house poor after paying for other expenses like taxes, food and dining out with friends and family.
The general rule of thumb is to try and keep your total housing cost below 30% of your gross income. The lower the better. Of course, the more debt you have (car payments, student loans, credit cards) the more pressure your budget will feel with a mortgage this high, or worse, higher. Don’t set yourself up to be house poor for the next thirty years. Life is stressful enough.
There are some exceptions to this rule. For those with large savings but lower income, you may feel more comfortable with a slightly higher debt-to-income ratio. That is especially true if you have the cash to pay off the mortgage at any time. The other exception is for self-employed folks who often look much poorer on paper than they likely are. With all of the available tax breaks for small business owners, they may have more disposable income to spend on housing than one might expect based on their net income.
- How Much of a Down Payment Should You Make
Historically, the standard down payment was 20 percent or more. However, first-time home buyers can often purchase a home with a down payment of little to nothing. Making a larger down payment may not always be a smart move. At the same time, if you can’t come up with a down payment at all you may not be ready for home ownership. Why? Because expenses like the mortgage, taxes and insurance are just the beginning. There will inevitably be maintenance and repair costs which could easily turn a home into a money pit.
Ideally, you would at least have the 20% down payment. You can make the educated decision with your financial planner and lender of how much to actually put down. Keep in mind that if you make a down payment of less than 20 percent, you will likely get stuck paying principal mortgage insurance (PMI). This is a frustrating and annoying waste of money because you’re basically paying for insurance to protect the lender. This insurance will also count against your debt-to-income ratio. You may also consider a first mortgage combined with a HELOC or second mortgage if you can’t come up with the full 20% down payment.
- How to Save for a Down Payment
If you have some idea of what a home that fits your needs may cost, it’s time to get serious about saving for a down payment. The more expensive that home is, the more down payment you will need.
If you are really stretching, you may need to come up with an even bigger down payment in order to qualify for a mortgage and be able to buy the home. Let’s say you qualify for a $900,000 mortgage but want to purchase a $1.2 million home. Again, I’m writing from Los Angeles where that is likely the asking price of a condo or fixer upper. In this hypothetical situation, you would likely need to make at least a $300,000 down payment in order to make the purchase work. Better start saving.
Additionally, your lender may need you to pay off, or reduce, other debts. The lesson here is don’t go buy a new car or make any major purchases on a credit card if you are house shopping. You’d likely be devastated if you missed out on your dream home because of credit card charges.
If you are lucky enough to have family members who are going to kick in for the down payment, you will need to “age” the money. Depending on the lender, you will need the money to have been in your bank account long enough to show up on two bank statements. Other lenders may need more time. If you are house shopping, try and get an idea of what your lender requires and act as soon as possible to get the money from the bank of mom and dad.
- Should you get a 30-year Mortgage?
Most first-time home buyers will want to go with a 30-year mortgage. Shorter mortgage terms are typically cost prohibitive. But I’m also aware that a shorter mortgage term could potentially help you save on interest and pay off your mortgage faster.
I’ll tell you that I’m not a huge fan of paying your mortgage off faster than needed. The Trump tax plan makes the choice even easier. Unless you are saving enough for your various other financial goals, you shouldn’t look at a much shorter mortgage term. This will likely mean you technically pay more interest to fully pay off your home mortgage. But if the difference is invested, you will likely come out ahead earning more in the stock market. This math could change if mortgage rates continue to increase. But with mortgage rates still in the range of three-to-five percent, it shouldn’t be hard to earn more with a diversified investment portfolio over the long term.
Having options and flexibility is also important. If you are dead set on paying of your mortgage in 15 years (or less) consider getting a 30-year mortgage, but paying like it was a 15-year mortgage. This will allow you to weather any financial storms that could come into your life. Think job loss or health issue. You may also find it harder to qualify for a shorter mortgage term depending on your income.
- Will the Bigger Payment Really Fit in Your Budget?
I often advise clients who are thinking of buying a home to try and save the difference between their rent and estimated mortgage payment. That’s in addition to taxes and insurance, of course. Ideally, you would do this for six-to-twelve months to make sure you don’t miss any unexpected expenses or emergencies.
This helps avoid being too house poor or getting sucked in by an ever-growing housing budget. Another benefit is this money will help with the down payment, give you some extra money to move or help to furnish the new place.
If you can’t make the higher payment work, what else are you willing to give up? If nothing, you may need to lower your housing budget. Personally, I love to travel. I’m willing to cut back to own a home. I’m not willing to cut out traveling completely.
A home is major purchase. Work with a Fiduciary Financial Planner to help make sure you can buy a house that you can afford without sacrificing your financial future. Then, a realtor can help you find the right house while a mortgage lender helps you find great mortgage options. The Certified Financial Planner™ can help you choose which of those options are best for your personal financial situation.
Source: David Rae