Start with a Buyer's Assessment
Do a Financial Checkup
Unless you’ve won the lottery, play pro sports or have very rich relatives, you’re probably going to need a mortgage (another word for home loan) in order to buy a house. And taking out a mortgage means you’ll have to find someone willing to lend you the money.
The median home price in America is over $300,000. Needless to say, no one’s going to just hand over hundreds of thousands of dollars to prospective home buyers without being certain they’ll be able to pay the money back. That means a mortgage lender is going to closely go over your finances before offering you a loan.
It’s a terrible feeling to be told you don’t qualify for a mortgage, after your heart is set on that perfect home you’ve found for your family. How do you avoid that disappointment? By putting a magnifying glass on your finances before the bank does.
We’ll assume that you already have a steady job; if not, get one and build a history of regular paychecks. The lender has to know that you have a sufficient income stream to make monthly mortgage payments.
Your Credit
Now, check your credit scores and credit reports. The bank relies heavily on them to determine which type of mortgage you qualify for – or if you qualify at all. There are three major credit reporting agencies, Experian, Equifax and TransUnion, and you can request your full credit report (including your score) from each of them once per year, for free. Don’t rely on scores from outside sources, because those scores may not be accurate. Get the actual reports directly from the three agencies.
Your credit scores will be reported on what’s called the FICO model, as a number between 300 and 850. Score over 760 will earn you the best rates and terms, while scores under 500 are almost always too low a credit score for mortgage approval unless you’re applying for a VA loan.
Home buyers need at least 620 to get a conventional loan; 580 is generally the floor for an FHA loan but some lenders may go lower. And even if you squeak in at those minimum numbers, you’ll end up paying higher interest rates, higher fees or both. The higher your credit scores, the less you’ll pay and the more money you’ll save over the life of your loan.
What does that all mean? If you can’t currently qualify for a loan, or you’re barely going to qualify, it could be worth delaying your home purchase for a little while you pay off some bills or take other steps to improve your credit score.
One other thing before moving on: the actual credit reports will show problems like late payments reported by other lenders, like credit card companies. Check the reports carefully and dispute any incorrect information. That will save you major headaches later on.
There’s a final step to take when checking your finances: figure out how much cash you have to cover the down payment and the closing costs (which could be an additional 1-3% of the purchase price). Some mortgages only require a 3-5% down payment, but you could need a 20% down payment for some loan programs, and you’ll usually be required to pay for private mortgage insurance if your down payment is under 20%. If you’re way short on available cash, you may want to wait until you can save it up.
Set a Budget
It makes no sense to look at $400,000 homes when you can only afford one that costs $150,000. In order to narrow your search to a realistic price range, you’ll need to set an affordability budget.
Here’s how to budget for a house. Make an itemized list of your regular monthly expenses (including credit card payments, student loans, car payments and other recurring expenses) and add in all expenses related to your new house (monthly payments including mortgage, property taxes, homeowners insurance and mortgage insurance). Naturally, you won’t have specific numbers for a house you haven’t bought yet; there are lots of online calculators that will show you estimated payments for the house price you choose.
Now take your total monthly expenses and divide by your total monthly income. You’ll end up with a percentage number that’s known as DTI, which stands for debt-to-income ratio. The bank will look at that number to decide whether you can afford a house; 43% is the magic number to stay under. If you’re under 36%, you should receive much better terms and interest rates.
If you end up with a DTI above 43%, you can’t probably afford a house that requires the monthly payments you’ve included. Lower your sights and choose a lower home price which will mean smaller numbers for your mortgage payment and related expenses, and try again.
That takes care of the bank – but what about your own lifestyle? Barely sneaking in under 43% may qualify you for a house, but doesn’t necessarily mean you’ll have anything left over to go to dinner or see a movie. The common term for that is “house poor.” The smart move is to come in well under 43%, between 25% and 30%, so you’ll be comfortable in your new house without having to worry whether you’re getting yourself into financial hot water.
Talk To Mortgage Lenders and get a Mortgage Pre-Approval
No, you’re not ready to sign your life away just yet. But talking to lenders before you shop for a house is important for two reasons.
The first reason to talk to lenders is that they’ll give you a feel for the types of mortgages you may be able to qualify for. You can ask as many questions as you’d like about possible terms, interest rates, and specific requirements for credit scores and DTI. It also allows you to find the loan officer or mortgage broker with whom you’re going to get the best rate and be most comfortable doing business.
Second, you’ll be able to ask your chosen mortgage lender for a mortgage pre-approval. This isn’t a guarantee that you’ll get a loan; it’s simply a statement that you’re financially qualified to receive one, based on a preliminary examination of your finances. The pre-approval will include a maximum loan amount, which gives you a firm idea of what you can spend on a new home. Once you have a pre-approval, that doesn’t mean either side is committed to proceeding to a loan agreement. You can always shop later for a better deal once you’ve decided on a house.
A mortgage pre approval isn’t a necessity when you want to shop for a home, but it makes things much easier. Some sellers won’t give your offer the same weight as one from a pre-approved buyer; in fact, some won’t even show you their home without that magic piece of paper (or email). Similarly, some realtors won’t give you the same attention you’d receive if you’d been pre-approved. So while it’s not an absolute necessity, you might want to think of it as one.
(Important: a pre-approval is not the same as a mortgage pre-qualification. For the latter, a lender will just take your word for your income and expenses without any investigation or documentation. A pre-approval letter, which is backed by the lender’s research into your finances, is what sellers and agents want to see.)
Not sure how to choose a mortgage lender? While it’s tempting to simply go with a recommendation from a trusted friend or relative or get a mortgage from your current bank, it’s critical to research and shop around to get the best possible deal. Get quotes from a range of mortgage originators, including mortgage companies, national lenders, and local banks and credit unions (which often offer the most competitive rates). Read reviews about each potential lender and don’t be afraid to ask the loan officer what their commission is on your mortgage. Typically, the higher the loan officer’s commission, the more the borrower can expect to pay in either a higher interest rate, or in fees.
Find a Realter or Real Estate Agent You Trust
There’s little justification for buying a home without a realtor, since the seller usually pays the fees for the buyer’s real estate agent as well as their own. Nothing’s wrong with researching online real estate sites or going to open houses on your own, but an experienced agent can be your best ally when you get serious, particularly if this is your first home and you haven’t been through the process before. (If you’re wondering, realtors and real estate agents are basically the same; realtors just belong to an industry organization and agree to their code of ethics.)
An agent can provide valuable information on market conditions, pull up comparable sales to help you see whether a house is worth the asking price and whether it’s been sitting unsold for a while, help you prepare your offer and counteroffers, and work through any sticking points that might develop. She can also suggest available homes in the best neighborhoods or school districts if you’re new to the area, and may even have access to homes which haven’t yet been listed publicly.
Speak with a number of agents and get recommendations from friends or trusted online sources, before making your choice. The right agent can make all the difference between a smooth search and buying experience, or a frustrating one.
Shop For Your Dream House
Time to go house hunting.
Your realtor or agent will be your best guide through the process, but don’t be afraid to trust your gut. If you find your dream home and all it needs is minor cosmetic work, don’t lose it over a few thousand dollars. If all the numbers and details are supposedly “right” but you simply don’t think you’d be comfortable living in the house, don’t force yourself to go ahead and make an offer – there are plenty more out there.
As you look, however, be mindful of any timetable you may be working with since it normally takes 30-45 days to close on a new house. If you want to be settled before the start of a new school year, or your previous house is on the market (or your apartment lease is expiring) and you have to be out by a certain date, you may not have the luxury of searching for months on end.
Making a list (either in your head or on paper) of what you’re actually looking for in a new home may help you quickly eliminate the ones that aren’t right for you, and focus on the ones that are.
Gather The Documentation You'll Need
This step isn’t necessarily in chronological order. At some point, you’ll need to submit financial documentation to your lender – a lot of financial documentation. The sooner you start gathering it, the better, but if you haven’t already done it by the time you begin house hunting, you really need to get started.
Among the documents you’ll likely be asked to supply:
The last two years’ worth of your tax returns
Pay stubs or other documentation of income for the last two months
All bank statements, plus brokerage and investment account statements, for the last two years
Letter of recommendation from previous landlord, if you’ve been a renter
Proof of funds for down payment and closing
(or a gift letter, if someone is giving you the money)
ID (preferably a driver’s license or passport)
The lender may have more documentation requests as they process your loan, but these are the basics and will definitely get you started.
Make an Offer and Negotiate
You’ve found “the one,” swallowed hard and decided to buy it? Your realtor will once again be your best friend and can walk you through how to make an offer on a house. She’ll know the market and can advise you on the right amount to offer. She may even be able to find out how hot interest has been in the property and whether there are other offers pending or in the works. That will help you decide how aggressively to bid (or whether a lowball offer might be accepted).
As long as you’re not about to enter a bidding war, don’t be afraid to attach conditions to your offer. Those can range from a desired closing date, to a request that certain appliances or furnishings be included in the sale, or a clause saying the purchase is contingent on the sale of your previous home. You may have to go back and forth in negotiations for several days; that can be frustrating, because it usually has to be done with written counter-offers and response deadlines, but it’s all part of the “game” and the bargaining will be forgotten once your offer is finally accepted.
You’ll have to include a check or money order with your offer to show that you’re serious about the deal. This is called earnest money, and the amount you have to deposit often depends on local custom. It may be anywhere from 1-3% of the purchase price, or it could be a fixed amount like $2,000 or $3,000 for a house in what most of us would consider a reasonable price range. In a slow market, it could be much less. The money is held in an escrow account and applied to the purchase at closing. If the deal falls through because of a problem on the seller’s end, you get your money back, but if the problem is on your end (for example, if you can’t get financing), you may have to go to court to have a chance at recouping it.
Arrange for Financing
An approved offer is your signal to call your lender (or decide on one, if you’re still up in the air) to get the ball rolling on the actual mortgage application. Expect to go back and forth with your loan officer or mortgage broker multiple times during this process. Underwriters (the people in the back office who actually crunch the numbers) usually come with questions as they go through your financials in full detail, and may make several requests for more documents, or for letters of explanation if there are any specifics they find problematic and need further clarification.
Final approval may not come until shortly before the closing date, so don’t panic. It’s totally normal to feel like you’re being left hanging, but you’re not. The lender is going to be committing a huge amount of money, and wants to be 100% sure that you’re a good risk for the loan.
One unrelated task: find an insurance company (or call your existing one) to arrange for homeowners insurance coverage. Other menial but important details like having a title search done and title insurance issued are handled from your end, but your agent and lender can guide you on this and may even do it for you.
Get Home Inspections and an Appraisal
No purchase should be completed without having a house inspection performed, and no contract should be signed without a contingency clause saying the house must pass inspection. This will assure you that there are no hidden structural or functional problems with the house, and will give you ammunition for any contingencies which must be written into the contract. The buyer pays for the inspection, and your realtor can suggest several reputable inspectors. You’re welcome to stay with the inspector as he does his work, and you’ll receive his entire house inspector checklist when he’s done.
A home inspection could find minor problems like electrical or plumbing issues that can easily be repaired, or may find more serious problems like mold or a cracked foundation. It’s up to you whether the issues are serious enough to back out of the deal, to demand that the problems be repaired before closing, or (for relatively small problems) to agree to the sale “as is” and cover the repair expenses on your own.
A termite and pest inspection should also be done. Some home inspectors do those too, or you may need to call a separate exterminating company for the job. The lender will also want an appraisal done to ensure that the home is worth what you’re agreed to pay for it, and will arrange for the appraisal to be done (at your expense).
Closing on your New Home
You’ve finally made it. Purchase agreements are done, inspections are complete, contingencies have been met and financing is in place. All that’s left is signing mountains of paperwork and receiving the keys to your new house.
Before the final day, make sure that you have a certified check or scheduled a wire payment for your down payment and closing costs, your homeowners insurance is in place and you have a written “binder” proving it, and you have your ID with you.
The closing process itself is sometimes completed in person, but in more than a dozen states it can now be done online through a secure digital eSigning service. If you have an attorney, they should be with you at the closing to read all the documents before you sign them, and if you can’t attend an in-person closing you can assign your power of attorney to another party.
You’ll experience a mixture of nervousness, anticipation and boredom at a closing, since you’re making a huge commitment, excited about taking possession of your new home, and sitting there for an hour signing document after document.
But it’s not difficult, and it almost always goes smoothly. Before you know it, you own a brand new house – and at least after a few days, you’ll realize that the craziness and stress was all worth it.
Welcome to home ownership!
