Buying a home is a big step into adulthood. And although homeownership used to be viewed as a rite of passage, as wages have gone down, home prices have gone up and student loans have saddled many with debt, a new generation of would-be homeowners are thinking twice before they delve into owning a home for the first time.
These days, the question of whether you are ready to become a first-time homebuyer involves lifestyle and personal preferences as well as the usual monetary hoops. Even if you are fed up with being a renter (and asking your landlord permission to even paint the walls) and earn an impressive salary, you still should consider a multitude of other factors before starting a property search.
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Evaluate Your Lifestyle and Future
So much has been written about the finances of becoming a first-time homebuyer, from building a good credit score and amassing a down payment to finding a loan that works for you. Before you start chewing on debt-to-income ratio and pondering private mortgage insurance (PMI), think about your current lifestyle as well as your plans and dreams for the years ahead. Homeownership changes your life in some of the same ways that becoming a parent alters your vision of the world. Make sure it is a change that you actually want.
Experts suggest that a home purchase only makes sense if the buyer lives in the house for five years or more. There are so many costs involved that have to be factored in, including moving costs, closing costs and renovation costs. Ask yourself about your plans for the next few years: If it doesn't involve maintaining a stable job in the city where you are currently living, then you may not be ready to settle into homeownership just yet. Buying and then having to sell because of a job transfer might mean you don't build any equity and have to sell for less than what you paid.
Also keep in mind that houses need maintenance, and this is best managed when the buyer knows how to undertake simple repairs. In fact, homeownership involves lots of hands-on projects that you don't have to handle as a tenant. Rodents in the house? Bathroom backed up? Garage door won't open? A homeowner has to be able to deal with these types of issues on a regular basis all year, so consider whether you are up for it. While calling in expert help is possible, that will certainly result in increased costs.
Check Your Credit Score
Anyone who is considering becoming a first-time homebuyer will likely need to borrow money from a bank or financial institution to finance the purchase. There are a variety of fees you may have to pay for that mortgage, but the biggest one is the interest on your mortgage balance. The better your credit, the more likely it is that you will be offered loans with low interest rates (helping you to pay less on the mortgage overall).
The first way to assess your credit is to look at your credit score or credit rating, a three-digit number that demonstrates to a creditor whether or not you are a trustworthy borrower. It is developed from your credit report and can range from 300 to 850. A credit score of 700 or above is considered good, and 750 or above is considered excellent. If your score is below 650, you'll most likely need to work on improving it before you hire a real estate agent.
You can get your credit score and a credit report from any of the three major credit scoring agencies: TransUnion, Experian or Equifax. You can get one free every year from each agency just for the asking, and checking your credit score in this way won't ding the score at all.
Build a Down Payment
Most people have to borrow money to buy a house, but the borrower is expected to come up with a chunk of change for a down payment. The standard down payment is 20 percent, and that's what opens the doors to the lowest interest rates. However, down payments below 20 percent come with the added responsibility of paying private mortgage insurance every month with the mortgage until you build up 20 percent equity. This type of insurance will cost between 0.5 and 1 percent of your entire loan amount every year, so it's a great idea to avoid it if possible. If you are considering a $400,000 home purchase, a 20 percent down payment would be $80,000.
A big down payment of 20 percent or more is good for another reason: You'll be financing a lower percentage of the home purchase price and will therefore have lower mortgage payments. But coming up with 20 percent down is not the only option. Many people — in, fact more than half of recent home buyers according to Zillow — put less than 20 percent down on their homes. Here are some popular loan options for those who don't have a large down payment:
- Both Fannie Mae and Freddie Mac offer Conventional 97 loans that let you buy a house with only 3 percent down.
- The U.S. Department of Veteran Affairs offers VA loans for no money down to members of the military or their surviving spouses.
- Federal Housing Administration (FHA) loans were created to give low-down-payment loans to low- and moderate-income households, requiring a minimum down payment of
3.5 percent down.
As you are getting your down payment together, however, don't go so far as to clear out your emergency savings account for the down payment. You will likely need emergency cash flow when you own a home since you are on the hook to pay for all problems that arise (such as a major plumbing incident or an inoperable stove).
Consider Your Debt
Buying a home can be a great investment over time, but it can also be a cash drain, with the mortgage payment, property taxes and all of the associated fees and costs, including home maintenance. First-time homebuyers need to be sure they have (and will continue to have) plenty of income to pay these costs in addition to regular debts. Some experts even suggest that you shouldn't buy a home until you are debt-free, getting student loans and credit cards down to zero before taking the plunge.
While that is not a hard and fast rule, carrying other big debts will certainly mean you'll need a higher income to make buying real estate work. Lenders do this by looking at a borrower's debt-equity ratio, comparing all of the monthly expenses a person will have after buying a home to his gross monthly income. While the debt-to-income (DTI) ratio varies among lenders, the FHA uses a 43 percent DTI guideline for approving mortgages. That means when you add all of your regular monthly debt payments to all of the monthly expenses you will face as a homeowner, it should not be more than 43 percent of the amount you make each month.
For example, if your monthly income is $10,000, your total debt payments for a month should not exceed $4,300. If your current monthly debt payments total $1,000, you can afford a mortgage payment of $3,300. A word to the wise: Many lenders want your front-end DTI ratio to be under 28 percent. Front-end DTI ratio looks at the monthly payments you incur just from housing expenses — like mortgage payments, property taxes and homeowners insurance — and compares that to your income. In this example, that would mean a lender might not loan more than $2,800 on a monthly income of $10,000.
Evaluate the Housing Market
It's likely you've read about certain markets being "hot," with prices remaining high even during market downturns. This is the case in many urban centers, but also increasingly in non-major metropolitan areas.
That's why it's important to consider housing market economics in the area in which you are thinking of buying a home. This will help you evaluate whether you can afford a home and also whether the real estate purchase makes sense from a financial perspective. Compare the cost of renting in your chosen area to the cost of buying. If it is cheaper to buy than rent, that's another reason to consider homeownership. Real estate does tend to appreciate over the years, although a bad economic outlook in the region could change that.
Ideally, you want to buy when real estate prices are depressed, termed a "buyer's market." However, if the prices are depressed for a specific reason, like in a town that has been flooded several times in the past decade or has seen the collapse of an important industry, then it may be a market to avoid. If you're unsure which type of market you're living in, ask a real estate agent for advice on whether or not it's a good time to buy in your area.
Get a Preapproved Mortgage
A prospective homebuyer will need actual mortgage approval before shopping for a home. You start that process by talking to the loan officers of several lenders or to a mortgage broker, an intermediary who arranges mortgages with a variety of lenders. These mortgage professionals will look over your finances and tell you how much of a mortgage you qualify for. It pays to talk to several different lenders or brokers, as each shop offers different options.
A critical factor in a mortgage is the interest rate, and this will be central in determining monthly mortgage payments. Rates fluctuate, going up in some years and down in others. It is best to shop for a mortgage while rates are low. Ask the lender or mortgage broker if rates are falling or are expected to fall, which might be reason enough to wait to buy real estate. Rising rates are an incentive to act quickly.
If you find a mortgage that works for you, get a mortgage preapproval from the lender. Real estate agents for a seller won't be sure you are serious about buying if you aren't preapproved for a loan. When you have a preapproval in hand, the seller sees that you come to the table prepared to buy, making transactions quicker and giving the seller some reassurance that the deal will go through.
Enlist a Real Estate Agent
As a homebuyer, you can look at houses and make offers to buy on your own, but it's easier when you have a real estate agent working with you. Ask your friends and family for referrals and then pick an agent who has experience working in the area where you plan to buy a home. Agents have a lot of knowledge and expertise to offer and can give you up-to-date information about local market conditions. A real estate agent will arrange for you to see homes in your price range that have the features you want. A real estate professional will advise you on how seasons can affect sales in that locale and when would be the best time to shop. She can also help you with arranging inspections and negotiating the sale price.
You can prepare for that first meeting with your agent by making a list of things that are important to you in a new home. For example, the number of bedrooms or a big backyard might be non-negotiable, while other items, like a manicured backyard, might be nice but optional. Remember that if the "bones" of the house are right for you, you can redo the garden or update the kitchen over time, but adding a third bedroom would be a much greater challenge.
Avoid Big Changes
After you've been approved for a mortgage and you've selected a real estate agent, try to avoid any big changes. Taking on new debt, like purchasing a new car, is not a good idea and might change your credit picture. Don't quit your job or even switch jobs as lenders want to see a long, steady work history and a stable bank account go along with it.
This is a time to proceed with care since a wrong step might imperil the purchase of your dream home. After all the effort you've put into figuring out whether you are ready to buy a home, you don't want to hit a snag on something minor that can wait until after you're handed the keys to your brand new house.