Easy Money: How to buy a house

Easy Money: How to buy a house

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Buying a house isn’t hard, per se. (We’re talking the process here; saving money to buy a house is certainly a challenge.) It’s more … intimidating. After all, you can’t practice buying a house, so inaugural house hunts can feel very Choose Your Own Adventure. But we can get you ready for what’s coming next. Here’s how to buy a house.

Before you begin your home search

  1. Check your credit, because lenders will when you apply for a mortgage. Those digits determine whether you qualify for a home loan and the interest rate you’ll pay. You need a score of at least 620 to get a conventional mortgage, with scores of 740 or higher netting the best rates.
  2. Know your debt-to-income ratio. That’s how much debt you’re paying each month (car loans, credit card debt, student loans, etc.) vs. how much money you’re bringing in. Lenders ideally want to see your DTI at or below 36%, though 43% is the official cutoff for a qualified (read: non-predatory) mortgage.
  3. Get your down payment ready. In a perfect world, everyone puts down 20% of their future house’s price. But we don’t live in a perfect world. Rents are high and you can get a mortgage when putting down less. Thing is, the more money you pay upfront, the lower — and more affordable — your monthly payment. Plus, you pay less in interest over the life of the loan. In other words, you have to crunch the numbers to determine if buying a house with less than 20% down is a good move for you.
  4. Figure out how much house you can afford, so you know your price limits. Sounds obvious, but, remember, your monthly mortgage payment isn’t just principal and interest. It also includes property taxes and homeowners insurance. Fortunately, there are plenty of solid mortgage calculators online that help you run through various down payment and loan scenarios. There are also calculators designed to give you an idea of what home price point you can comfortably swing. We like this one from Zillow.
  5. Remember the closing costs, because they’re no small chunk of change. You’ll want to have that money saved alongside your down payment. Closing costs typically run between 2% to 5% of a home’s purchase price.
  6. Research neighborhoods, so you have an idea of where you want to live and what houses cost, including taxes, in the area.
  7. Find a good real estate agent. You can go it alone, but professional help makes the process much easier. Plus, the seller covers your agent’s commission.
  8. Get pre-approved for a mortgage, so sellers know you’re a serious shopper. And you get a better idea of how much the loan is going to cost. Big note: Pre-approval doesn’t guarantee you a mortgage. You still have to go through the full underwriting process.

Let’s talk mortgages

Because you probably need one to buy your house. And, yes, that’s kind of scary. Mortgages represent the biggest debt most people take on in their life. But if “shopping for a mortgage” has you stuck at “Go,” here’s a spoiler: If you’re house-hunting in an ideal or near-ideal scenario — your credit is good to excellent, you’ve got plenty of money to put down and your debt levels are low — your best bet is a conventional home loan. Having said that, here’s an overview of the four major mortgage types.

Conventional home loans: the Big Momma of mortgages. Conventional home loans aren’t backed by the government. About half of conventional loans are known as “conforming” loans, meaning they’re issued by lenders in accordance with guidelines set by Fannie Mae and Freddie Mac, the two big names in the secondary mortgage market. (They buy home loans from lenders and resell them to investors as mortgage-backed securities.)

Who they’re for: People with good credit, a down payment of at least 5% and a DTI of 43% or less. Note: Borrowers who makes a down payment under 20% almost always have to pay private mortgage insurance. PMI protects the lender (yes, the lender) from losing big money if you default on the loan. It gets rolled into your monthly mortgage payment and canceled once you accrue a certain amount of equity (usually 20%) in your home.

FHA loans: Mortgages issued by private lenders, but backed by the Federal Housing Administration, an agency of the Department of Housing and Urban Development. FHA loans are designed to promote homeownership via less stringent underwriting standards than conventional loans.

Who they’re for: People with less-than-stellar credit, lower income and not a ton of cash on hand. You can get one with a credit score as low as 580, a down payment as low as 3.5% and a DTI of 43%. But you pay for those lax lending standards: There’s an upfront mortgage insurance premium (the private mortgage insurance of FHA loans) of 1.75% at closing, plus an annual premium of up to 1.05%, depending on your down payment and mortgage term.

VA loans: Mortgages issued by private lenders, but partially backed by the Department of Veteran Affairs. VA loans are available to military members and veterans, including reservists and the National Guard.

Who they’re for: Military members and veterans. Spouses are also eligible if their loved one died in active duty or became disabled during active duty. VA loans don’t require a down payment. However, service members must pay a one-time funding fee of 1.25% to 3.3%, depending on their type of service and down payment amount.

USDA loans: Mortgages issued by the U.S. Department of Agriculture or a private lender, but backed by the USDA. These loans are designed to promote homeownership in rural areas of the nation.

Who they’re for: Low- and moderate-income borrowers looking to live, build, rehabilitate or relocate a home in an eligible rural area. Specific income limits vary by area and household size. USDA loans don’t require a down payment, but you pay a mortgage insurance premium if you put down less than 20%.

The skinny on mortgage rates

Mortgage rates in general are affected by the economy. We could get real granular here and talk about market indicators, like the prime rate, treasury securities and inflation, but this is Easy Money, so here are the big things to note:

  1. Base mortgage rates go up and down, so some times are better to get a mortgage than others. (This, incidentally, is why refinancing is a thing.)
  2. High-rate environments happen when the economy is strong (for reasons akin to supply and demand), while low-rate environments happen when the economy is weak (as the Federal Reserve pushes rates down to stimulate a rebound.)

Having said that, your mortgage rate is primarily driven by your risk of default (the higher the likelihood, the higher the rate) and lenders consider the following factors during underwriting.

  • Credit score
  • Down payment
  • Home price vs. loan amount
  • Location

Rates also vary by loan type (see above), loan length and interest rate structure. So, yes, that means you’ve got more decisions to make. But, again, no need to despair: Lenders can walk you through all your options, but most people opt for a fixed-rate mortgage or an adjustable-rate mortgage.

Fixed-rate mortgage: Fixed-rate home loans have a — you guessed it — fixed rate. That means the interest you’re paying — and, by extension, your monthly payment — won’t go up or down during the life of the loan. Fixed-rate mortgages most commonly come with a 30-year term or a 15-year term. Longer terms tout more interest in total, but lower monthly payments. Shorter terms tout less interest in total, but higher monthly payments.

  • Pros: Fixed-rate mortgages are straightforward. Your monthly payment and interest rate stay the same for the loan term, no matter what’s going on in the market.
  • Cons: You’ve got to refinance if you want to capitalize on a lower rate environment, which means you have to close — and pay the fees associated with doing so — again.

Adjustable rate mortgage: Also known as variable-rate mortgages or ARMs, the interest rate on one of these goes up or down (but usually up) over a set period of time. For example, say you have a 5/1 ARM. Your rate is fixed for five years, then changes every year alongside a popular market index. The interest rate — and by extension monthly payment — on ARMs commonly change every month, quarter, year, three years or five years.

  • Pros: The teaser (read: opening) rate on an ARM is usually lower than the fixed rate on a fixed rate mortgage, so they’re usually a cheaper option for people who don’t plan to stay in their home for more than five years.
  • Cons: Rate increases can make your monthly payment a real burden, particularly if the teaser rate led you to buy more home than you could afford. (There’s a reason ARMs are commonly associated with the 2008 subprime mortgage crisis.) There are no guarantees in life, so you can’t bank on selling the house and getting out of the loan before a higher interest rate kicks in. Plus, ARMs are confusing AF, particularly for first-time homebuyers.

To give you an idea of how all this translates numerically, here are the average mortgage rates for the most popular home loans as of Feb. 15, 2018, per Freddie Mac.

Average U.S. mortgage rates
30-year fixed 15-year fixed 5/1-year ARM
4.38% 3.84% 3.63%

How to score a lower mortgage rate:

  • Improve your credit
  • Comparison-shop mortgage lenders
  • Put more money down
  • Choose a shorter loan term
  • Pay points (an upfront fee paid at closing in exchange for a lower rate)

During your home search

Now that we’ve got the mortgage talk out of the way, here are some best practices to keep in mind while actually house-hunting.

  1. Check out the inventory via real estate listing sites like Realtor.com, Zillow and Trulia. If you’re working with a real estate agent, ask them to compile a list of homes on the market in your price range and desired area.
  2. Sign up for listing alerts in your zip codes of choice, especially if you’re in a seller’s market where properties move fast.
  3. Line up the rest of your team. Now’s the time to vet the real estate attorneys, home inspectors, title companies (which manage escrow and make sure the seller does, in fact, own the home in question) and mortgage brokers and lenders available to get you through the homebuying process.
  4. Comparison-shop for homeowners insurance, because if you put it off until the mortgage underwriter asks for proof of insurance (a thing they’ll do as your near approval), you might rush into a policy that’s not the best or most affordable for you. You can learn more about homeowners insurance here.
  5. Go to the open houses, and, yes, that includes hitting up listings you’re not gaga over. Not because there’s a chance the pictures don’t do the home justice. (If anything, you’ll encounter the opposite.) But because a multitude of visits is a great way to learn your local housing market — and what is or isn’t a reasonable asking price for your desired property type.
  6. Consider all expenses associated with homes that strike your fancy. Remember, your monthly mortgage payment includes principal, interest, property taxes, homeowners insurance and, if you’re putting down less than 20%, private mortgage insurance or mortgage protection insurance. Plus, you’ll need to consider ancillary expenses, like closing fees, future utility bills, furniture and moving costs.
  7. Prepare to compromise. Hate to break it to you, but you’re probably not going to find a home that has every item on your wish list. Decide what you can live without (say, those dual walk-in closets) and what stuff is a deal breaker.
  8. But don’t settle. The last thing a new homeowner needs is a serious case of buyer’s remorse.
  9. Brush up on your letter-writing skills. Because you’ll have to write one when you put a bid on a home — and that correspondence can make a difference. Fortunately, we’ve got a proven template for a home offer letter right here.
  10. Consider what you’re willing to do to sweeten a deal. Offer price is of utmost importance, but there are other steps shoppers can take to sway a seller their way, including agreeing to a short or longer closing, waiving the inspection contingency (your right to back out if the home inspection doesn’t go so well), making a higher earnest money deposit (good faith funds you’ll put down shortly after the contract is signed) and paying in cash.
  11. Lay off the credit cards or adding any new debt in general during your home. It can show up on your credit report — even if you pay it in full by the end of the month, due to issuer reporting practices — and hurt your credit score. A lower credit score, remember, leads to a higher mortgage rate.
  12. Stay the course. We’d say not to get too attached to a particular place, but, the truth is, buying a home is emotional. There’s a chance you’ll be disappointed at some point during your search. That doesn’t mean you’ll never find a home. You will — unless you stop searching for one, of course.

A step-by-step guide to the homebuying process

So what happens after an offer gets accepted on a home? The particulars vary by location (states have their own laws about this stuff), but here’s a high-level view of what to expect.

Contract review: Some states require an attorney to be involved in this process. Even if your state doesn’t, it’s a good idea to hire one. Housing contracts aren’t exactly light reading and you’ll want someone who speaks to legalese to read the print before you sign. Once the terms of the contract are agreed upon and both parties sign, you’ll be expected to turn over your earnest money deposit. That money sits in escrow while you go through the rest of the process. It goes toward your down payment, which is due sometime before closing.

The home inspection. Your chosen vendor (yes, the buyer pays for the inspection) will meet you at the property for a thorough review. They’ll check everything from the roof to the plumbing and electrical systems. You’ll also have a sewer scope and radon test (though you might need to hire a separate service provider for these tests). The inspector will point at potential problems along the way and turn over their full findings in a report. Then the buyer and seller (or their attorneys) go back and forth to discuss how any issues will get addressed. Sometimes, sellers will agree to fix something or offer compensation. If not, you’ll have to decide to push, move forward or back out of the contract.

The appraisal. Your lender will hire an appraiser (on your dime) to determine how much the home is worth. This step is meant to protect you and the lender from paying too much for the home. What happens if the appraisal comes back lower than your offer? It depends on your contract. The lender won’t finance more than the home is worth, so someone will have to account for the short fall. Unless the buyer signed a contract that specifically puts them on the hook for the difference, they can ask the seller to come down in price. If they won’t, the buyer can pay out-of-pocket or walk away from the deal.

Secure full mortgage approval. Once you’re in contract, your lender will kick the mortgage underwriting process into high gear. They’ll ask you for personal information (name, address, telephone number, Social Security number, etc.), a ton of paperwork, call your employer, request your tax transcripts from the IRS and conduct a final credit check before you’re fully approved. Here’s a list of the paperwork you can expect to produce during the homebuying process.

  • Credit reports (usually pulled by lender with your permission)
  • Two years of W-2s or I-9 tax forms
  • Two years of tax returns
  • Two checking account statements
  • Two savings account statements
  • Account balances for assets, including retirement and investment accounts
  • Pay stubs from the last 30 days (at least)
  • Proof of employment (usually in the form of a letter from your employer)
  • Proof of homeowners insurance
  • A list of any current debts not on your credit report
  • Letters of explanation for negative information on your credit report
  • Settlement documents related to negative items on credit report
  • Gift letter (if you’re using a gift as part of your down payment)
  • Divorce decree (if you’re paying or receiving child support or alimony)
  • Bankruptcy discharge paper (if applicable)
  • Copies of cleared checks related to big account deposits or withdrawals

Title search: Before you close, your attorney or title company will verify the seller owns the home — and outright, meaning there are no liens, easements, back taxes or other issues that could block the sale. They’ll send you preliminary findings, so you can work out any problems with the seller and bring the paperwork at closing.

Closing time. Once you’ve checked off every box above, your attorney will finalize your closing date. On that day, you’ll do a final walkthrough of the property to make sure it’s in the condition you agreed upon while in contract. Then you will sign about 800 documents, usually at your attorney’s office. (Bring picture ID!) At this time, you’ll pay any down payment or closing cost balance via certified check. The funds will get deposited into escrow and dispersed to the appropriate parties.

What are these mysterious closing costs you keep hearing about? Basically, fees associated with all of the above. Charges vary, but here are the extra expenses incurred during closing:

  • Mortgage application: Sometimes includes the credit check. Some lenders will waive this fee, if you ask nicely and they really, really want your business.
  • Origination fee: Covers the mortgage lender’s administrative costs
  • Appraisal fee
  • Inspection fee
  • Attorney fee
  • Title search fee
  • Survey fee: Covers the cost of verifying property lines; not always required
  • Title insurance
  • Homeowners insurance: Most mortgage lenders require you to pay for your first year of coverage upfront
  • Prepaid property taxes, interest and private mortgage insurance: Lenders usually require you to pay a certain amount of property tax (usually three months worth), interest (usually one month worth) and, if applicable, PMI into escrow.

Closing costs are a killer — they’re generally 2% to 5% of your home’s price. So, for instance, you could wind up paying $25,000 to close on a $500,000 house. Your mortgage lender should provide a loan estimate at the start of the mortgage approval process that gives you an idea of what you’ll have to fork over at close. Still, it’s important to keep those percentages in mind as you shop for a home, since they can put certain properties out of your price range.

Move in! Once all the steps are complete and all the documents are signed, you’ll receive the keys to your new castle.

Some notes on mortgage protection insurance

A little PSA from us, since this falls in our wheelhouse: Expect to get bombarded with offers for mortgage protection insurance shortly after you’re settled. And, no, lenders aren’t retroactively trying to needlessly sell you PMI.

Mortgage protection insurance is essentially a term life insurance policy that helps your loved ones pay the mortgage on a family home in the event of your untimely death. Sounds useful, for sure, especially to new homeowners getting used to living with mortgage debt. Except MPI is generally more expensive and much less comprehensive (in that it only covers mortgage payments) than a traditional term life policy. As such, if you want coverage for your family, you’re probably better off comparing plain old life insurance quotes. You can learn more about mortgage protection insurance here.

Recommended Reading

Want to learn even more about the homebuying process? Our favorite resources for prospective homebuyers from around the web:

Image: JasonDoly