So, you’re looking to purchase your first home….Congratulations! This is a very exciting time!
While going to open houses and researching neighborhood data are equally important, making a financially sound purchase is vital. Here are a few things to keep in mind as you go through the process.
How Do You Know If You’re Financially Ready To Be A Homeowner?
Before you buy a home, pay off all consumer debt – credit cards, car notes, student loans, etc. – and have a fully funded emergency fund (3-6 months worth of expenses). Owning a home can be expensive, and you want to be in the driver seat, directing where your money goes rather than owing someone else.
How Much Can You Afford?
Let’s start by considering a price limit. Unless you have the cash to purchase the home outright, you’ll be taking out a mortgage. Lenders will look at your income and expenses to determine whether you qualify for the loan you’re requesting. Some lenders will approve you for a higher mortgage loan than what you can reasonably afford. Remember that they’re looking to make money, which is not necessarily in your best interest.
Mortgage lenders look at two general ratios: housing expense and total debt. For the housing expense ratio, they’ll look at your total housing costs (including mortgage, insurance, property taxes, private mortgage insurance (PMI), and homeowners association (HOA) fees) and compare those to your gross monthly income. As a general rule, this ratio should not exceed 28%. Banks look more favorably on the loan amount if it is 28% or lower.
Next is the debt ratio. This ratio shows the percentage of your income necessary to cover your monthly debts and housing costs. This debt includes any student loans, installment loans, and older credit balances, all of which are added to your basic housing costs and divided by your gross income. This ratio should not exceed 36%.
While banks will approve you for a 28% housing expense ratio and 36% debt ratio, we suggest you’re debt free and that your total monthly housing costs are 25% or less of your monthly take-home pay. Try this free mortgage calculator to get an estimate of the monthly payment you can comfortably afford.
Additionally, you may need to make a down payment on your purchase. Generally, if you’re able to put down 20% or more, you’ll receive a lower interest rate and avoid having to pay private mortgage insurance (PMI). PMI is insurance that protects your lender (not you) if you fail to make payments, so avoid this if you can.
If 20% down is too high as a first-time home buyer, a smaller down payment of 5-15% is okay, too. No matter how much your down payment is, make sure your monthly note is no more than 25% of your take-home pay.
You also have to budget for closing costs. There’s a home inspection fee, application fees, an appraisal fee, a survey, title, title insurance, and attorney fees, among many others. All these can total anywhere from 3% to 8% of the purchase price.
Finally, don’t overlook the costs of owning a home. In addition to your mortgage payments, you’ll pay for utilities, repairs, insurance, landscaping, trash removal, repairs, appliance replacement, and — get ready for it — repairs. This is why it’s crucial to have a fully funded emergency fund BEFORE buying a home.
Choosing a Mortgage
If possible, we recommend a 15-year fixed conventional mortgage. These typically have higher monthly payments than 30-year mortgages, but you’ll pay off your home in half the time. You’ll end up saving thousands of dollars in interest over time. Having a fixed interest rate means you always know what to expect. Even if you choose a 30-year mortgage, making one extra payment towards the principal each year will reduce your mortgage term by 7 years and save you thousands in interest.
No matter what, avoid adjustable-rate mortgages (ARMs), as your lender can raise your interest rate (thereby increasing your mortgage payment). Just say no!
Choosing a Lender
Talk to several lenders and compare interest rates, fees, and customer service to find one who is the best fit for you.
Get Pre-approved Before House Hunting
Getting pre-approved means your lender has verified your financial information and given you a letter saying how much you can borrow. Preapproval means you’re serious about buying, and it will make your offer more competitive in a tight housing market.
Looking For Your First Home
Most importantly, know yourself! Really consider what you need versus what you want in your first home. You may not be able to buy your “dream home” immediately, and that’s okay. What things are you willing to sacrifice, and what is non-negotiable for you? If you find some of your needs put you at a higher price point, take more time to save for your down payment.
Find a solid real estate agent you trust who can guide you through the home-buying process.
Sharing up to 5 things your house must have (i.e., within a certain mile radius of your job, number of bedrooms and bathrooms, etc.) with your realtor will help you narrow down your search.
Finally, just because you can afford a house’s selling price doesn’t mean that is what it’s worth. It’s important to survey the values of nearby homes, especially those with similar layouts. The more informed you are as a purchaser, the more financially sound your decision will be.
Your first home is likely one of the biggest purchases you’ll ever make. Take your time to do things right, and enjoy the process! You can do it!