As you begin your quest to buy a new home, it’s important that you understand what you’re getting into. This is especially true if you are a first-time home buyer. You have to be on top of your household budget and savings. That’s because your current financial state will permit you to determine if you’ll be able to cover the immediate upfront costs associated with actually buying a house, as well as assessing if the monthly payments will be affordable.
But that’s not all. Your finances will reveal whether you have sufficient income to pay for the ongoing expenses required to own and maintain a home.
In this article, you’ll learn several big things to consider before buying a house. After absorbing these tips and information, you should be able to go through the home buying process without encountering any major financial surprises.
Step 1: Assess the Real Estate Market
Did you know that the real estate market has its up and down cycles just like the stock market? It’s true. Experts and economists, who have studied the real estate market. have noticed a pattern over the last 100 years.
By no means is it a perfect pattern that would make it easy to guess exactly when the market will be up or down, but it’s good enough let you know whether you should jump in or not.
For example, here’s one article that I came across that discusses why each real estate market cycle lasts about 18 years.
Essentially, a cycle is defined by the combination of up and down years. I suppose if you want to keep things simple in your own mind, you could split it between 9 up years and 9 down years. Just understand that the split isn’t perfect or predictable.
In any event, the article mentions that the latest cycle began in 2006. I’ve read other articles that say it began in 2008. Nevertheless, if you apply a bit of logic and assume that the cycle is reasonably accurate, it means that the real estate market should remain down until around 2015-2017, and then trend upward for about 9 years.
Whether that turns out to be true, I have no idea. However, if you’re thinking of buying a home, it’s best to purchase when market prices are low, but are about to rise. And you should not buy when market prices have peaked and are about to fall.
You can identify when the market is at rock bottom when foreclosures are high, there’s very little new home construction, and few properties are selling. Conversely, the market will be at it’s supreme peak when construction is booming, home prices are shooting up, and properties are selling in days rather than weeks.
So keep this cycle in the back of your mind as you contemplate whether now is a good time for you to buy.
Step 2: Analyze Your Current Financial Situation
Check your credit files
It is critical that you have your finances in order before buying a home. You would be amazed by how much your financial and credit history can impact your ability to get a mortgage and the interest rate you’ll be charged.
Take a look at the chart below that I copied from my FICO credit report. Notice the 30 year mortgage rates that you would be offered for the highest FICO score range (760-850) versus the lowest range (620-639).
If you take the high interest rate of 4.818% and subtract it from the low rate of 3.229%, that’s a difference of 1.589%. Do you think that would amount to chump change on a 30-year, $200,000 mortgage loan? Don’t bet on it!
Let’s do the math. If you want to follow along, use the Mortgage Calculator.
When you plug-in the loan amount of $200k @ 4.818% into the calculator, your monthly payment (principal + interest) would be $1,051.51. And over the entire life of the loan, your total pay out would be $378,542, of which $178,542 would be the interest portion.
Now, if we perform the same calculation using an interest rate of 3.229%, your monthly payments would be $868.11. And the grand total of your payments over 30 years would be $312,519 of which $112,519 would be interest.
If you then subtract the two interest totals ($178,542-$112,519), you’ll get $66,023. This is the amount of extra money that will come out of your pocket simply because you had a poor credit score. I don’t know about you, but that’s enough to make me weep!
So, the first thing you should do is get your credit reports from the three major credit bureaus (Equifax, TransUnion, and Experian) as well as your FICO credit scores. To learn how to go about doing this smartly, read our article called Cleaning Up Your Credit Report
If your FICO credit scores are low, you should not apply for a mortgage loan until they fall within the 720 range at a minimum. You still want them to be sufficiently above 700 to provide a cushion. Keep in mind that not all lenders apply the ranges exactly as you see them in the above chart.
Calculate your debt-to-income ratio
When you sit down with a mortgage loan lender, not only will they closely analyze your credit history, but they will also want to know about all income sources and your spending habits. This is why it’s important that you establish a household budget and monitor your cash inflows and outflows long before you meet with the lender.
A key measurement that all lenders use to determine if you will qualify for a loan is called the Debt-to-Income ratio. This ratio is actually pretty easy to calculate.
First, tally your gross (before taxes) monthly income and add any bonuses, commissions, etc. Next, add up all your monthly recurring debts. Basically, this would include any payments associated with a loan or agreement, but NOT your water bill, cable, groceries, and other ordinary expenses. Here are some examples of what to include:
– Mortgage (principal + interest + property taxes + insurance)
– Credit cards
– Auto loans
– Student loans
– Home equity loans
– Child support
– Other loans
Then, divide your total monthly debt by your total monthly income. So, if your monthly debt payments are $2,000 and monthly gross income is $5,000, your debt-to-income ratio will be 40% ($2,000/$5,000). As a general rule of thumb, lenders like to see this percentage at 36% or less. Naturally, the lower this percentage the better.
But there are some lenders that allow higher percentages. For example, if you apply for an FHA loan, the debt-to-income ratio must be less than 43%. So, the best thing to do is to contact the lender you’re thinking of using and simply ask them the question, “What is the desired debt-to-income ratio to qualify for a 30-year fixed interest rate mortgage loan?”
Now, you might be wondering how the calculation works if you’re currently renting a house or apartment. If you want to, you can plug your rental amount into the formula just to see if you’re under the limit. But ultimately, the lender will plug in what your future monthly mortgage payment will be once you apply for the loan. You can also use online calculators to determine how much house you can afford. Try these two:
Another simpler calculation that will give you quick insight into whether your finances are in good shape to qualify for a loan is the “Housing-Expense-to-Income” ratio. For this one, you would just divide your projected mortgage payment by your gross income. So, if your expected monthly mortgage payment will be $1,200 and your income is $5,000, the Housing-Expense-to-Income ratio will be 24%. Ideally, this percentage should be less than 28%. But at the end of the day, the Debt-to-Income ratio will carry more weight.
Figure out the loan-to-value ratio
In addition the debt-to-income ratio, another important computation that mortgage lenders make is the loan-to-value (LTV) ratio. This is calculated by dividing the mortgage loan amount by the appraised value of the property. The ratio is expressed as a percentage.
So when you apply for a mortgage loan, the lender will have specific guidelines that say the loan-to-value ratio cannot exceed 90% or 80%. To make this clear, let’s use an example.
Let’s say that the home you’re seeking to buy is appraised at $300,000. Further, this is also the price that the seller is asking.
If you sought a mortgage loan for the asking price, the LTV ratio would be 100%. But if the LTV ratio cannot be higher than 90%, that means the most that the bank will approve is $270,000. You would have to come up with the $30,000 difference as a down-payment.
This is important to know because the “official” or “professionally” appraised value of a home could be a little different than the estimated current market value that your real estate agent comes up with by quickly scanning what other similar homes have sold for.
The bottom line is that if you plug in the current market value of the home into the formula and ask the bank for it’s LTV ratio, you’ll get a pretty good idea of how much they’ll ask you to provide as a down payment. Or, you can simply assume that the down payment amount will be 20% of the final selling price.
Step 2: Identify your immediate out-of-pocket costs
As you probably already know, by the time the realtor or closing attorney hands you the keys to your new home you will have shelled out a big chunk of money. Here’s a list of some of the upfront costs you should expect and have sufficient savings to cover:
– Down payment – This could be anywhere from 5% to 20% depending on your credit and the lender’s requirements. However, it could be lower if you can qualify for a VA or Federal Housing Administration (FHA) loan. FHA loans are designed for low to moderate income families. If you qualify, the down payment amount could be as little as 3% to 4% of the home’s price. Just keep in mind that if your down payment is less than 20%, the lender will probably require you to carry Private Mortgage Insurance (PMI), which can run you about $25 to $70 per month for every $100,000 that you borrow.
– Mortgage loan application processing fee – Lenders want to make sure that you’re not wasting their time. Plus it takes some work to process an application. So this fee could be anywhere from a couple hundred dollars up to a thousand dollars. Non-refundable, of course.
– Homeowner’s insurance – You may be asked to pay the first year’s homeowner’s insurance premium at the time of closing. This could easily amount to several thousand dollars depending on the price and location of the home.
– Property taxes – You may be asked to pay the first 6 month’s or more upfront.
– Loan discount points – For some mortgage loans, you might be quoted a loan rate of something like 3% with 1 point, or 2.5% with 2 points. These interest rates will be clearly lower than some other mortgage rates in the marketplace. That’s where the “points” come in to play.
Each point represents 1% of the loan amount. So, on a $200,000 loan, that comes to $2,000. By paying the point upfront, you get the benefit of a lower interest rate and lower monthly payments for the life of the loan. These can be great deals if you have the extra money.
– Home inspection fee – You should never buy a home without getting it inspected by a professional. You’ll want to shop around for a reputable home inspector, but the costs can range from $200 up to $1000, depending on the property.
– Appraisal – You should have the house appraised by a professional to make sure that it’s worth what everyone is saying. This might run you several hundred dollars.
Of course, the above items are just some of the most important out-of-pocket costs you should know about. But as you can see below, there are others. And they could easily pile 3-4 thousand more dollars onto your closing bill.
Homeowner’s association fees
All of those fees looks like a lot of mumbo jumbo talk, huh? Nevertheless, it’s important that you get at least a rough estimate of these costs as early as possible into the buying process. Your realtor or closing attorney can get them for you.
Step 3: Know Your Expenses Once You Move In
Congratuations! You are now the proud owner of a beautiful home. I wish you and your family nothing but good memories and joy. But, wait. Make sure you’re aware of the ongoing costs that most homeowner’s face.
– Property taxes – These costs don’t end when you close on the house. Property taxes are used to support schools and other aspects of the community. So you’ll be paying them every year, and the amount will be in the thousands of dollars. In most cases, these taxes will be included in your monthly mortgage payment.
– Homeowner’s insurance – When you get a mortgage loan, the bank will require that you maintain homeowner’s insurance until the mortgage is paid off. After all, they want to protect their interests.
– Lawn maintenance – Whether you do it yourself or use a service, this could be a new expense for you.
– Homeowner’s or Condo association fees – This is usually a monthly expense that many neighborhoods or buildings charge to maintain a security service, community pool, tennis courts, common grounds, etc. If you don’t care about any of these things, you might come to see these fees as a waste of money. So ask about them before you buy.
– Utility costs – If you’re moving into a larger space, it stands to reason that your electricity, water, and gas bills will be higher. Sometimes the increases can be shocking. You can ask the real estate agent about the average costs for these services or contact the utility companies directly.
– Growing costs – Maybe this won’t happen to you, but when many people move into a new home, especially if it is spacious, there is a tendency to want to fill it. Most people don’t like to see empty rooms. So they’ll stuff it with new furniture, furnishings, accessories, and decor. The process can seem endless.
If this sounds like you, just be sure to plan out how and when you will gradually spend money to get the space to look exactly like you want it to.
To summarize, you now know three major things to consider before buying a house. Start by analyzing your current financial situation. Next, identify how much money you’ll need to have saved up just to qualify to purchase a home. Then, determine what your ongoing expenses will be after you move into your home. If you’ll take the time to layout the numbers and be objective about what’s ahead, then you won’t make the mistake of buying a home and later regretting the decision.
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