Purchasing a home for the First-time is a major commitment. That’s why you should 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 track down the right house, while a lender will help you find great mortgage options. Here, Forbes discusses six things first-time buyers need to know.
1. Begin with getting ready to borrow via a mortgage.
How much of a mortgage payment you truly can afford likely will depend on your lifestyle, as well as assets, income, and debt. Before you begin the search for your dream home, put some time into determining what you can really afford. You also should check your credit score.
A low credit score means you might have to pay a higher interest rate on your mortgage, which 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.
2. What you qualify for vs. what you want to afford
A mortgage broker will answer the question, “How much can we qualify to borrow?” You likely can qualify for as much as 43 percent debt to income. That means the total of all your debt payments, plus the mortgage, can be up to 43 percent of your gross income.
If you decide to go that high, you may end up feeling house poor after paying for other expenses such as 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 percent of your gross income. 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.
There are some exceptions to this rule. Those with large savings but lower income 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 a more disposable income to spend on housing than one might expect based on their net income.
3. How much of a down payment should you make?
Historically, the standard down payment was 20 percent or more. However, first-time homebuyers 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. Meanwhile, if you can’t come up with a down payment at all, you may not be ready for homeownership because expenses like the mortgage, taxes, and insurance are just the beginning.
There will inevitably be maintenance and repair costs that could easily turn a home into a money pit. Ideally, you would at least have the 20-percent down payment. You can make the educated decision with your financial planner and lender of how much to actually put down, and keep in mind that if you make a down payment of less than 20 percent, you likely will get stuck paying principal mortgage insurance (PMI).
This basically is insurance to protect the lender, and this insurance also will count against your debt-to-income ratio. You also may consider a first mortgage combined with a HELOC or second mortgage if you can’t come up with the full 20-percent down payment.
4. How to save for a down payment
The more expensive a 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 to qualify for a mortgage and be able to buy the home. For example, if you qualify for a $900,000 mortgage but want to purchase a $1.2 million home.
In this hypothetical situation, you likely would need to make at least a $300,000 down payment to make the purchase work. 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.
5. Should you get a 30-year mortgage?
Most first-time buyers will want to go with a 30-year mortgage, as shorter mortgage terms typically are cost-prohibitive. While a shorter mortgage term could potentially help you save on interest and pay off your mortgage faster, you shouldn’t look at a much shorter mortgage term unless you are saving enough for your various other financial goals. This likely will mean you technically pay more interest to fully pay off your home mortgage.
But if the difference is invested, you likely will come out ahead of 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 3 percent to 5 percent, it shouldn’t be hard to earn more over the long term with a diversified investment portfolio.
Having options and flexibility also is important. If you are dead set on paying off 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 arise, including the loss of a job or a health issue. You also may find it harder to qualify for a shorter mortgage term depending on your income.
6. Will the bigger payment really fit in your budget?
Thinking of buying a home down the road? Try and save the difference between your rent and estimated mortgage payment (in addition to taxes and insurance) for six months to a year to make sure you don’t miss any unexpected expenses or emergencies.
This helps you avoid being too house poor or getting sucked in by an ever-growing housing budget. This money also will help with the down payment, give you some extra cash 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