A lot goes into purchasing a home. First-time buyers are often especially anxious about the undertaking, but the prospect of having a place to call your own is also an exciting endeavor.
Knowing a few home-buying fundamentals can go a long way toward making you confident as you take the first steps toward home ownership.
Allio believes all people should have the financial tools necessary to buy a home – even in this tough economic environment. We’ll walk you through the steps with some extra nuggets of wisdom along the way to help demystify the home-buying process.
How a Mortgage Works
What are the first questions that come to mind when you search for a new home? Common ones include: ‘What neighborhood is best?’ ‘How close is it to where I work?’ ‘Are there good schools nearby for my kids?’ ‘What’s the weather like?’
The truth is there are many variables. Some are unique to you while others are factors everyone must deal with. From a financial perspective, almost all home buyers must know about mortgages. A mortgage is simply a loan extended by a financial institution such as a bank or credit union to homebuyers. According to the Consumer Financial Protection Bureau (CFPB), a mortgage is an agreement between you and a lender that gives the lender the right to take your property if you fail to repay the money you've borrowed plus interest.
When you take out a mortgage, you pay back principal (the money you borrowed) and interest (the cost of borrowing the principal) through monthly payments.
What’s great about a mortgage, though, is that every month you repay the principal to the lender, you build what’s known as “equity” in your home. The interest portion of a mortgage is a larger percentage of a mortgage early on, but principal repayment increases year by year. Over time, more equity builds as the loan amount dwindles. Once the loan term is up, you own the house free and clear. A paid-off residence is many folks’ biggest asset and is often a hallmark of financial independence.
Fixed-Rate and Adjustable-Rate Loans
First-time homebuyers might still be unsure of what type of mortgage could be best. Like so many aspects of personal finance, it depends on your situation.
Most would-be buyers seek out a conventional 30-year fixed-rate mortgage through a major lender. A fixed-rate loan will have the same annual percentage interest rate over the life of the mortgage unless you refinance into a new lower rate at some point in the future.
The other type of home loan is an adjustable-rate mortgage (ARM). The interest rate is usually fixed for a time but will then change based on market conditions after a set number of years – when short-term yields rise, you will likely owe more on your mortgage. When interest rates fall, however, you owe less. ARMs often feature a slightly smaller rate compared to a fixed-rate mortgage, but sudden rate spikes are a risk and can catch borrowers off guard.
Most financial planners suggest securing a loan at a fixed rate is better since you have certainty about what your monthly mortgage payment will be from now through the end of the loan term.
30-Year Mortgages Versus a 15-Year Mortgage
Along with the type of mortgage, you also must decide on the length of the loan. Both the 30-year and 15-year mortgage durations are popular, but most first-time buyers go with a longer-term loan since those feature small monthly payments. A 15-year mortgage usually has a slightly lower interest rate than a 30-year loan but will come with higher payments.
Buyers in a strong financial position could go for a 15-year mortgage if they have a strong desire to pay off the mortgage as quickly as possible. But there is nothing wrong with sticking with a longer-term mortgage and paying off the house slowly. What’s more, if you have a 30-year fixed-rate mortgage you can simply make extra payments to the lender if you want to pay it off sooner. So, there’s flexibility there.
How Much Can You Afford? How Much of a Down Payment Should You Have?
With all that mortgage know-how in tow, now you must figure out how much of a home loan you can carry and a good down payment amount. Determining the right amount to spend (and the maximum dollar figure) can be a challenging and uncertain task. Fear not! There are some rules of thumb that provide ballpark numbers.
First, a common general recommendation in personal finance is to save up so that you can put down 20% of the home’s cost. Why 20%? That amount usually avoids pesky Private Mortgage Insurance (PMI) that homeowners often owe when they put down a small down payment percentage.
In today’s market, a 20% down payment might be a daunting task, so be sure to carefully review your cash flow situation. It might even help to sit down with a financial advisor to outline the best path. You can also use tools, such as Allio’s short-term goal portfolios, to help set you up for success. A significant down payment amount helps avoid going “underwater” on your home should the value of the home fall in a down market.
There are other helpful tips for pinning down the ideal amount of house to buy. The 28% rule and 36% rule are helpful to determine a max housing cost and mortgage amount. According to popular wisdom, you should aim to have no more than 28% of your gross monthly income put toward total housing expenses. A maximum of 36% should go toward all of your debt payments, including your mortgage.
Another word to the wise: run a few rent versus buy calculators available online whereby you tweak the down payment amount and home price. Make sure the tool includes the cost of PMI. You might find that a lower down payment could make sense.
Special Mortgage Programs for First-Time Buyers: FHA, VA, USDA
Let’s hone in on first-time buyers. Often strapped for cash and without a big war chest of assets and experience, help is often needed. Many prospective buyers go with a loan through the Federal Housing Administration (FHA) backed by Fannie Mae or Freddie Mac. But there are other options that could feature better terms for first time home buyers.
Individuals and families with low income might be able to qualify for some financial aid through a U.S. government loan program. While the federal government does not directly lend, it does offer help to those most in need. There are income limits and a requirement that the house bought is your primary residence. Check with the Federal Housing Administration (FHA) through the Department of Housing and Urban Development (HUD) to see if you qualify for an affordable FHA loan. An FHA-backed mortgage is often available to folks with a lower credit score and those unable to make a big down payment.
A loan through the Veterans Administration (VA) is usually an option for eligible service members and their families. While there is a funding fee, your mortgage rate could be materially lower than what you might face with a conventional loan. There’s a slew of benefits like no credit score requirement, more favorable rate terms, lower closing costs, and you can even avoid PMI.
For first-time buyers, a low or no down payment requirement can be a huge plus. Goldman Sachs reports that FHA and VA applicants have FICO scores about 55 points lower than mortgages through Freddie Mac and Fannie Mae.
In addition to FHA and VA loans, a third popular program exists through the U.S. Department of Agriculture (USDA). A USDA-backed mortgage is available to certain borrowers in select rural areas, but here too there are household income limits and other guidelines.
What Are Freddie Mac and Fannie Mae?
For most people, 75% according to Loanlimits.org, purchasing a home means going with a conventional mortgage through the two big government-sponsored mortgage entities: Freddie Mac (Federal Home Loan Mortgage Corporation) and Fannie Mae (Federal National Mortgage Association). Funny names, sure, but they are big businesses designed to work with you and lenders to backstop mortgages. They got a bad rap during the Great Recession for needing bailouts so that the U.S. housing market would stay afloat. Today, though, you should have peace of mind with conforming loans through Freddie and Fannie.
Conventional mortgages have certain loan limits you should know about when house and mortgage shopping. The numbers update each year, usually in late November. Mortgages above those limits are dubbed “jumbo mortgages” and are not backed by a federal agency. Lenders see jumbo loans as riskier since the borrower takes on more debt, so they commonly have higher rates.
Be sure to check out any special programs that might be available in your state, too.
All That’s Needed to Apply for a Mortgage
Among the first steps to buying a home is shoring up your credit. First, check to see what your FICO score is, and be sure to review your credit report (which can be done for free through any of the big three credit reporting bureaus).
Next, determine your 28% rule and 36% rule amounts to get an estimate of how much mortgage you can take out and how much house you can afford. Another thing lenders are going to want to know about in detail is your source of income. Along with financial account statements, have verification of your salary on hand.
With your financial ducks in a row and an idea of how much you want to borrow, now you must go about choosing a lender. Comparing several mortgage providers helps to ensure you get the best rate possible. Review online comparison platforms, as well as banks and credit unions to make a short list of potential lenders before you go about the pre-approval process.
Getting pre-approved for a mortgage is not a huge deal. It is simply a basic credit background check that gives you an indicative mortgage rate and amount figure. In the eyes of sellers, pre-approved borrowers look better on paper compared with those who are not pre-approved.
Some people seek the guidance and help of a buyer’s agent who works to get the borrower the best home price possible. A buyer’s agent also shows prospective buyers homes that fit their desires in a certain area. They can be a resource in the nerve-racking process of negotiating an offer.
Plan For All the Other Costs
Understanding all the costs that go along with buying a home, particularly for first-time purchasers, is critical. It’s easy to get caught up in just how much the mortgage will be. In general, expect to spend anywhere from 3% to 5% of the value of the home in transaction costs. Typical expenditures include a home loan application fee, an appraisal fee, costs for a home inspection, loan origination fees, mortgage points, and a flood assessment fee.
Moreover, closing costs can be significant. The catch-all term includes up-front property tax payments, title insurance, fees paid to attorneys, transfer fees, and other taxes, not to mention realtor commissions and home insurance.
You will also want to consider expenses related to moving and taking time off from work since buying a house is not just a financial endeavor but requires a lot of effort. Budgeting for a new house is not cheap, but the reward is that first night sleeping in your bed as a homeowner.
Some tips to help save up for covering these costs can be reserving your tax refund for the home purchase, reducing high-interest credit card debt, cutting back on discretionary expenses like eating out and travel (just for a little while!), keeping a budget, and earmarking some of your monthly cash flow for closing costs.
The Bottom Line
Purchasing a home is no small task these days. There are many key milestones to hit and boxes to check to ensure you cover all the bases. With some knowledge and confidence, though, you too can achieve the American Dream with minimal anxiety. First-time buyers are often confused by industry terms and on a tight budget, but with preparation and motivation, you can go from a renter to an owner before you know it.