Thinking about buying your first house is simultaneously thrilling and terrifying. Think about all the space you could have...but it's a long-term commitment. You could have your own backyard...but there's a lot of potential expense. A kitchen you could actually cook in...now that's worth looking into.
Once you move past dreaming and decide that owning a home is something you want to pursue, understand that you have a lot of research and financial preparation ahead to make your home ownership dream come true. But, as a recent first-time home buyer, this former Brownie will give you a bona fide scout's honor that it's worth all the effort.
Start by polishing up your organization skills and get digging for information you'll need:
- Obtain a copy of your credit report as early as possible and scour it for accuracy. If time permits, Tracy Jean Ashfield, President of Ashfield & Associates Real Estate Consulting Firm, Madison, Wis., recommends pulling your credit report three months before you seek preapproval so you have time to rectify any unexpected issues or mistakes. Each major credit bureau must provide one free credit report annually to consumers requesting a copy. To obtain a report visit AnnualCreditReport.com or call 877-322-8228. Usually, it works well to order one report every four months from a different credit bureau. But when your plan is to buy a house, check all three at once—save up your "free" reports in the year running up to your project—because your goal is to identify discrepancies between the reports as well as to monitor your credit standing.
- Make copies of your W-2 forms from the past two years.
- Copy your two most recent pay stubs.
- Collect all financial account statements (including retirement accounts) from the past few months.
- If you have opened any lines of credit in the past six months, you'll need copies of those statements as well, since they might not show up on your credit report.
- Collect information about vehicles you own, including make, model, and resale value.
- Gather credit card account information, such as numbers and types of cards, balances and monthly payments.
- Assemble auto loan account information, such as account numbers and statements.
- Compile other loan account information, such as student loans and personal loans.
- If you're fortunate enough to have any money for your down payment given to you, identify how much and where it will come from; be prepared to document that it is a gift and not a loan.
Once you have your documents and personal financial information assembled, it's time to get preapproved. You won't know how much house you can afford without preapproval. Many credit unions or other financial institutions have online applications that are simple to fill out. Once you apply, the lender will review your application and supplemental documents, pull your credit report, and start the underwriting process.
You also may have heard of 'prequalification,' which is a review of only self-reported information that doesn't require underwriting. That can be a worthwhile step if you're still at the stage of deciding if you are even a good candidate for home ownership. But if you want to show sellers you're serious about buying a home, preapproval is the way to go. In fact, some realtors won't start looking at homes with clients until they are preapproved.
While your lender is working on preapproval, figure out how much you can afford for an initial down payment. Do you have money in an account, or do you need to sell stock or other assets, say, a second car? Have a plan to access the money that you'll be using. You'll need to provide proof of that money in an account before your closing.
You'll also need to determine how much you can afford to put toward housing each month. This should be the total cost, including the principal, interest, taxes, and property insurance (sometimes referred to as PITI). "As a rule of thumb, this should be no more than 28% to 30% of your monthly gross income," says Ashfield. For example, if you make $60,000 a year, your monthly gross income is $5,000. Forty-three percent of $5,000 is $2,150. "Another way to take into consideration your more complete financial picture is to ensure the combination of PITI, auto loan(s), and credit card debt are no more than 36% to 38% of your gross monthly income," Ashfield adds.
This should be the upper limit of your total monthly payment, but of course it might be best not to spend this much. Home ownership, especially in the first few years, brings many unexpected expenses. A little breathing room can make your entire home-buying and home-owning experience less stressful—after all, you have to have some money to furnish the lovely place you will buy.
Once your preapproval is complete, the lender will contact you to review the findings. Now is when you reap the benefit of good credit habits—that's because your credit score determines what interest rate you qualify for. Couple your interest rate and the size of your down payment (more money down = smaller monthly payment) and you'll be able to see how much you can afford to buy. The lender ultimately should give you a price range of homes you qualify for, although taxes, interest, and other variable factors can affect your total monthly housing costs. "What you qualify for is not necessarily what you can afford...the only person that knows what you can afford is you," cautions Ashfield.
get the big picture
Before you ever get to the closing process, you'll have to shell out money several times, so make sure you have some extra money in an accessible account for:
- Earnest money: Money sent with a purchase agreement to indicate you're serious about the offer. This generally will be about $1,000 to $2,000, but could be more depending on the purchase price of the home. Yes, it applies to the purchase price, but you surrender it if you back out of the deal for some reason.
- Money for a home inspection: $300 to $400 within a few days of finalizing a purchase agreement
- First year of homeowners insurance paid in full before closing: This likely will cost $500 to $1,000, depending on the house, your insured contents, and the deductible you choose.
- Private mortgage insurance (PMI): If you have a small down payment—generally less than 20%—you'll incur PMI, which protects the lender from defaults. This amount will be added to your monthly payment. You'll be able to drop PMI when your equity (the original mortgage amount minus what you've paid off) reaches 20%. Ask your lender if there are other conditions, such as paying your mortgage as agreed for a defined length of time, that allow you to drop PMI.
- Closing costs: Include origination fee, appraisal, title company charges, state recording charges, and other fees. "Closing costs vary wildly by state," confirms Ashfield. "Ask your lender for a ballpark percentage."
- Utilities: Gas, electric, sewer, water, cable, garbage collection, Internet—they all add up fast. Utility costs vary widely depending on the property, so budget more than you think. Remember, utility costs also can vary drastically by season. You will be able to find out what the sellers have paid in recent years from the power company.
- Association fees: If you're purchasing a condo or similar property, you'll likely incur additional association fees, which are posted on listings and vary based on property type, location, and amenities included.
- Big purchases upon move-in: You may need a washer or dryer, lawn mower, snow blower, air conditioner, or other large item shortly after moving in.
- Emergency fund: You've heard it before but, as a homeowner, an emergency fund becomes a lot more important. You should have at least six months worth of living expenses saved; 12 months would be even better.
Home ownership requires a lot more than just a down payment and a monthly mortgage payment, so carefully consider your entire financial picture before deciding to buy a house. If you're ready, congrats! Assemble your financial history in an organized way to pave a smooth path to the fun part—actually looking for your first home.
This article is Part One of a three-article series about buying a house. Look for Part Two, coming in December.