- Should determine what they can afford before shopping for a home
- The home buying process involves finding a property, lining up financing, closing, and recording.
- First-time buyer programs may help with down payments and closing costs.
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If you’re a first-time buyer, the homebuying process can be intimidating. The homebuying process involves a lot of personal finance, and being judged by mortgage lenders and home sellers can be stressful. This article breaks down the process into manageable steps. Follow them, and you can buy a house with less stress.
How to Buy a House: Affordability
How much house can you afford? Determining your price range is the first step in buying a home. There are several ways to perform this calculation.
- Base your home price on what you’re currently paying for housing
- Mortgage lender prequalification amount
- Multiply your annual income by three, four, or even five times, depending on your debt load
The correct method for you depends on your current financial position, future goals, and expected income.
If you’re living paycheck-to-paycheck or are concerned about becoming “house poor,” basing your home purchase price on your current housing cost makes sense. Decide if there is room in your budget for higher monthly housing costs and how much more you can comfortably afford. Then, run the numbers through a mortgage calculator to determine what home price gets you an affordable payment. Don’t forget to factor in property taxes, homeowners insurance, and repairs/maintenance.
Another method is to contact a mortgage lender and provide your income and expenses. The lender can run its calculations and give you a home price range. This method is not full-proof, however.
First, prequalification is not preapproval, and there is no guarantee that you’ll get an approved mortgage in that amount. More importantly, mortgage lenders don’t consider all your costs or potential costs. They’ll calculate debt-to-income ratios without factoring in your plans to have children or send them to college, your costly commutes to work, your expensive hobbies, or your savings goals. That’s not their job; it’s yours. So make sure the proposed payment is in your comfort zone.
The income multiple methods go like this:
- You can spend up to three times your annual income for a home if you devote 20% or more of your gross (before tax) income toward paying other debts.
- You can spend up to four times your annual income if less than 20% of your income goes toward debt service.
- You can send up to five times your annual income if you have no debts other than your new mortgage.
That’s obviously flawed; there’s a vast difference between spending 20% of your income on debt repayment and 50% of your income. And this method does not account for mortgage interest rates.
The primary consideration for home affordability is what monthly payment allows you to pay down or pay off the other debt you have, save money for retirement and other goals, enjoy the hobbies that are important to you, and weather potential emergencies? It won’t matter how lovely your home is if your bills keep you up at night.
How to Shop for a Mortgage
It’s crucial to compare quotes from several providers when you shop for a mortgage. Several studies have concluded that comparing four or more quotes instead of one or two can save homebuyers thousands in closing costs. It’s easy to get mortgage quotes online, and failing to do so could mean leaving a lot of money on the table.
When you contact mortgage lenders, give them the same information – your credit score range, down payment amount, desired loan amount or home purchase price, and how long you plan to own the home. They should come back with a Loan Estimate disclosure or worksheet. Note that the Loan Estimate provides consumer protections that a worksheet does not. Compare closing costs and interest rates and choose the loan with the lowest cost.
To simplify the process, you can tell each lender the rate you want and pick the provider that delivers the desired rate at the lowest cost. Or you could dictate how much you are willing to pay in closing costs and then choose the lender with the lowest rate for that price.
Mortgage Prequalification and Preapproval
Smart homebuyers get preapproved for a mortgage before home shopping. Smarter homebuyers get preapproved for a home loan before shopping. What’s the difference?
Mortgage prequalification means providing the lender with your income and expenses. You’ll get a letter stating you should be able to afford a home purchase of X amount. Many times the lender doesn’t check your credit. A prequalification letter tells sellers you’re more serious than a ”looky-loo,” but it does not guarantee you can close on home purchase.
Mortgage preapproval, however, is much more powerful. To get preapproved for a mortgage, you have to go through the application process – complete an application and submit proof of income, bank statements, and anything else the underwriter needs to make a decision. The lender will pull your credit.
You’ll get a letter stating that you are cleared for financing up to X amount if preapproved. Preapproval means that as long as nothing changes in your finances and as long as the property meets the lender’s guidelines, you’ll be able to complete your purchase. A preapproved offer is almost as good as a cash offer, and your bids will get a lot more respect.
Types of Home Purchase Mortgages
The right mortgage for you depends on a few factors:
- Your down payment amount
- Your time frame (how long you plan to own the home)
- Your qualifications (credit score, income)
Here’s a quick rundown of the most popular mortgage programs for a home purchase.
Conforming mortgages are programs offered by Fannie Mae and Freddie Mac lenders. Freddie Mac and Fannie Mae buy and sell most of the mortgages in the US. The loans are called “conforming” because they must conform to guidelines set by the two corporations to be accepted by them.
Conforming mortgages require 20% down, or the borrowers must purchase mortgage insurance. Conforming programs have minimum down payments as low as 3%. The most popular conforming programs are 30-year fixed, 15-year fixed, and 5/1 ARMs, with rates fixed for five years.
Conforming loans are often called “conventional loans.” Conventional loans include all products that the government does not back, including conforming mortgages.
Government loans: FHA, VA, and USDA
Government-backed loans make homeownership easier for buyers challenged by down payment or other requirements. Government-backed loans are only available for primary residence purchases (not rentals or vacation properties), and there are limits to the amount you can finance. Government mortgage programs are actually insurance programs that compensate lenders if borrowers default (don’t pay) on their mortgages. This protection makes lenders willing to fund loans to people with smaller down payments, less income, or lower credit scores.
FHA home loans have flexible underwriting and require just 3.5% down for applicants with credit scores of 580 or higher and 10% down for applicants with credit scores of 500 to 579. However, FHA home loans come with expensive mortgage insurance – a 1.75% upfront premium, which can be wrapped into the mortgage, and a monthly premium that depends on your loan amount, program, and down payment
VA home loans are a benefit to military service members and veterans. They require no money down and no mortgage insurance, just a funding fee that can be wrapped into the mortgage. Interest rates for VA home loans are often lower than other programs.
USDA home loans (also called rural housing loans) help buyers with low-to-moderate income buy homes in less-populated areas. About half of the US population lives in areas eligible for USDA financing. USDA home loans require no down payment. There are two types of USDA loans – Direct loans made by the government to the low-income borrower with subsidized interest rates, and Guaranteed loans funded by private lenders and backed by the government. USDA loans also have upfront and monthly mortgage insurance premiums.
Finding a Property
Now that you have your financing lined up, it’s time to shop for a home. First, make a list of needs, wants, and deal-killers. You’ll tour and evaluate properties independently or with an agent and take notes. Does the home meet all of your “needs,” which “wants” does it address, and are there any deal-killers? Your agent should be taking you to properties that you can afford and have the features most important to you.
Making an Offer
Home purchase offers have several components – price, timing, what’s included, financing, and contingencies.
Know your maximum price before you make an offer. If you have a mortgage preapproval or prequalification letter for an amount higher than the price you want to pay, ask your lender for a letter with the lower amount. Submit that letter with your offer.
You’ll include a set of dates in your offer – to perform inspections, complete appraisals, get full loan approval, and close. Your seller may want to close quickly or have a longer escrow. Your offer will be more successful if you accommodate the seller’s timeframe.
You’ll also negotiate what’s included – home, appliances, and personal property like furniture, hot tubs, snow blowers, garden sheds, etc. Personal property must be conveyed at “zero value” because mortgage lenders only finance property.
If you want to be successful in a seller’s market, experts recommend making your offer as “clean” as possible. Here are some common contingencies that you may need to include:
- Financing – getting the loan you want in the amount you need
- Selling your current home before you can close
- Passing a home inspection
- The home must appraise for at least the purchase price
- The title must be clear and insurable
Inspection contingencies often contain a clause stating that the seller will cover repairs up to a specific amount without changing the contract. Higher amounts require renegotiation, and either party can back out.
Finally, expect to include earnest money with your offer. Earnest money is a deposit you lose if you back out of the purchase for any reason not covered in your contract. Earnest money proves that you are serious and makes your offer much more attractive.
Escrow is the process of working through all the legal requirements of a home purchase. Escrow companies (or lawyers in some states) take in and disburse money among the parties involved. These funds include earnest money deposits, closing costs, down payments, mortgage funds, real estate commissions, and payments to third parties like real estate appraisers and home inspectors. Escrow officers also make sure the home purchase is recorded with the county and that your ownership is public.
Closing is the final process when buying a home. You’ll sign the last set of mortgage documents. These legally bind you to the loan, so make sure the application is accurate and that the loan – amount, interest rate, program, closing costs – is what you expected. Do not sign and do not close if you have questions. You’re on the hook for that mortgage, so commit only when satisfied with the terms.
You’ll get a copy of all disclosures and a settlement statement (also called a HUD-1 or closing disclosure). The HUD-1 lists all transaction costs to both the buyer and seller. There should be no surprises because those costs should have been set out in your Loan Estimate from your lender.
You’re entitled to a copy of your home appraisal if you request it in writing. Keep it and all of your closing documents for future reference. You’ll be glad you did when you refinance or sell your home.
How long is mortgage preapproval valid?
Most lenders consider a preapproval valid for 60 to 90 days. It’s a good idea to keep a file for your pay stubs and bank statements so you can update your approval if necessary.
Can a lender cancel my loan approval?
Absolutely. If your profile changes for the worse, the lender may rescind your approval. Lenders usually reverify your information immediately before closing. If you have lost your job, run up more debt, or incurred significant damage to your credit score, your file could at best be sent back into underwriting and at worst declined. Never apply for credit or make expensive purchases on existing accounts while in escrow on a home purchase. And if you change jobs, make sure the new position is in the same line of work and pays the same or better.
Do I have to get home inspections for a mortgage?
That depends. Most lenders do not require a home inspection, and it may help you compete with other buyers if you skip it. However, a home inspection protects you – and it might be a red flag if your seller doesn’t want you to get one.
Some programs require certain inspections – for instance, you’ll need a termite inspection for a VA home loan. FHA mandates well tests in areas with known water problems. For many programs, septic tanks must be pumped and inspected if it’s been five years or more since the last cleaning. For a complete list of lender and program requirements, ask your lender when you get preapproved for your home loan. There should be a list of conditions required to close.