By Katie Moore, CDFA
Buying your first home is probably one of the biggest assets you’ll ever purchase and one of the largest debts you’ll ever carry, so it is crucial to approach the home-buying process in the most prepared way possible. There is a lot of paperwork and details to work out during the home-buying process, but it doesn’t have to be overwhelming. Here are four tips on buying your first home that will make the process easy and manageable:
1. Get a Mortgage Pre-Approval
As a first-time home buyer, real estate agents will want to make sure that you can qualify for the homes that you view. You don’t want to waste your time or theirs looking at homes out of your price range. Having a pre-approval letter gives a realtor proof that you are serious about purchasing a home, as well as a third-party estimate of what you might be able to afford.
This also gives you an idea if you need to work on your credit first. When buying a home, you don’t want any open collection accounts or late payments. So make sure that you are paying all your bills on time. If you do have things that need to be cleaned up, get those accounts settled and paid off. (For more, see: First-Time Homebuyer's Guide.)
Additionally, if you have any old accounts showing on your credit report that need to be updated or removed, you can work to get those things cleared up before moving forward with the actual financing. These things will drag down your credit score and keep you from qualifying for lower rates. You want to qualify for the lowest rate possible.
Request a pre-approval amount from your bank or mortgage lender. This is not a final approval, it is simply an initial look at your financial situation to see how much mortgage you might be able to handle. At this point, the rate is not locked in, and your final approval is still pending. Keep in mind that a pre-approval is generally only good for up to 90 days, but may be extendable if you don’t manage to find the right house in that time.
2. Budget for the Payment
Getting pre-approved tells you what you qualify for, but it doesn’t tell you what works best within your budget. For example, you may be pre-approved for a mortgage of $400,000, but you not be personally comfortable with the payment that would come along with that. Maybe you’d rather look at homes in the $250,000-$300,000 range.
You also don’t want to max out your budget to the point that you are strapped for cash every month. Give yourself room for other expenses that you may encounter in life, such as taking vacations, furthering your education, having children someday and setting aside money for retirement.
Your total mortgage payment each month is the sum of your payments on your loan principal, interest, private mortgage insurance (PMI), homeowner’s insurance and real estate taxes. Looking at all of these parts separately will give you a better idea of how it works:
- Your principal payment is your total loan amount divided by the number of months in your mortgage. So if you borrow $150,000 in a 30-year mortgage, your monthly principal payment will be approximately $416.67.
- Your interest payment is your total loan amount, multiplied by 1/12 of your interest rate. So if that $150,000 mortgage has a 5% interest rate, your interest payment would be approximately $625.
- PMI protects the lender in case you default on your loan. It’s mandatory if your down payment is less than 20% of the cost of the home and it goes away automatically once you have equity in the home equal to a 20% down payment. PMI is based on the value of your home and the amount you pay down.
- Homeowner’s insurance protects you if anything happens to your home. While the bank will give you numbers for it, you as a consumer have the option to shop around for the best rates. Check with your lender to find out what their minimum coverage requirements are before you do so. One important note: homeowner’s insurance does not include title insurance, which protects you if, after the sale, someone makes a legal claim to the property.
- Real estate taxes vary by state and municipality based on the value of your home. Use an online calculator to help you estimate your property taxes. (For more, see: How Long Should It Take to Save for a Down Payment?)
3. Save for a Down Payment
To qualify for a better mortgage program, you are going to want to have a down payment saved up - preferably 20% of the cost of the home. That’s the magic number that allows you to avoid PMI. Private mortgage insurance is an insurance premium that you are paying because the bank is looking at you as a higher risk because of the high loan-to-value ratio. Even if you have an excellent credit score and always pay your mortgage on time, the bank will still penalize you for not having enough equity in your home.
Remember that PMI may be taken off of your loan once you have reached 20% equity, and is automatically removed once you reach 22% equity. However, that’s based on your home’s value at the time of the appraisal to determine if you’ve reached the 20% mark. A home appraisal can cost between $300 and $600 based on the size of your property, where you live and your home.
Putting 20% down at the time of purchase will allow you to avoid this extra charge and the hassle of getting it removed altogether.
4. Decide on Location of Home
We’ve all heard it said: the three most important things about a home are location, location and location. You can change virtually anything about a house, but not where it is. Before you start searching for your home, determine where you want to live. Some factors to consider are:
- The length of your commute: If you are buying a home with a spouse or partner, factor in their commute as well and prioritize. If you are a doctor and your partner has an office job, shortening your commute may be a higher priority than shortening your partner’s.
- Property taxes and city taxes, if applicable: This information is generally available online.
- If you have children, or may in the future, research area school districts, magnet schools and private school options.
- Overall cost of living: The cost of living in a large city, for example, is radically different from both small towns and quiet suburbs.
One strategy for narrowing down your locations is to map them out. You can use a printed map of your state or a private Google map. This strategy is especially useful if you are house hunting in an unfamiliar area, like moving for a new job.
Ultimately, buying your first home involves making a series of major decisions. It’s completely normal to find that process intimidating. Like any major change, though, you can break it down into smaller parts and tackle them in sequence. (For more, see: The Hidden Costs of Home Ownership.)
This article was originally published on Investopedia.