It's never been easier to start looking for homes on the market. Nowadays, there's Zillow, Redfin and other real estate apps. Simply type in a zip code, and you'll get an instant list of homes for sale.
But if you're not a little intimidated by the process, you should be. There is so much to know in order to make a wise decision. And the financial stakes are high. Purchasing a $200,000 home is completely different from buying a $1,000 smart TV. For starters, there's no refund policy!
So let's take a look at the necessary steps to buying your first home.
Know How Much House You Can Afford
First things first. Before house hunting, answer this question: “How much house can I afford?”
It's way more exciting to look at homes than at your finances. But don't set yourself up for the emotional roller coaster of guessing what you can afford — only to be disappointed that your estimate is way off.
Start your home buying process by meeting with a mortgage lender. Until you know what price range your budget supports, it's a waste of time to start looking at homes.
The mortgage lender determines how much you can borrow and how much interest you'll be charged. And it's based on a lot of factors, including your credit rating, the amount of down payment you've saved and your annual income.
You're entitled to a free credit report from the major credit reporting agencies each year. And there are free services like Credit Karma where you can instantly find your credit score. Before applying for a mortgage, find out whether there are any discrepancies on your report and where you can improve it. The better your credit score, the lower your mortgage rate.
Now you're ready to set up a meeting with a mortgage loan officer. Here's what you will be asked to bring with you:
- Copies of your two most recent pay stubs.
- Copies of your federal tax returns and W-2s for the past two years.
- Copies of your bank statements for the past two months.
- Two forms of photo ID — driver's license and passport are preferred.
- Landlord information for the past three years.
How to Get a Prequalification Letter
With this information (along with your credit score, which the lender will pull and verify), you can leave the lender's office with a prequalification (or “prequal”) letter. This indicates you have a high probability of getting approved for a loan up to a specific purchase price. You need this before you can make an offer on a home — and before real estate agents will take you to see any homes. That's because it doesn't benefit anyone involved in the process for an unqualified buyer to look at homes he can't afford to buy.
Better yet, get preapproved. This is one step farther than the prequal letter. Preapproval is confirmation that the mortgager will indeed finance a set amount for a home. This will likely take a few days, so use your prequal letter in the meantime.
How does the loan officer arrive at your preapproved purchase price? There are two calculations that come into play: housing expense ratio and debt-to-income ratio.
How to Calculate Your Housing Expense Ratio
The golden rule of lending is that your housing expense should not be more than 28%. That means that up to 28% of your gross annual salary can be spent on housing (including property taxes and homeowner's insurance). If your annual salary is $75,000, you can afford to spend $21,000 a year, or $1,750 per month. A purchase price of $250,000 with a 5% down payment on a 30-year fixed rate mortgage at 5% interest would be approximately $1,650 per month.
To start, use a simple online mortgage payment calculator to estimate how much house your desired monthly payment and down payment will qualify you for. There are lots of free mortgage calculators available online if you want to put in some different numbers to estimate your monthly payment. You will need to get preapproved for a mortgage from at least one lender. Even better, get at least three preapprovals, so you can find the best mortgage rate and terms.
How to Calculate Your Debt-to-income Ratio
To get your debt-to-income ratio, simply add up your total debt obligations and divide by your total income. Include such debts as car loans, credit cards, student loans, child support and alimony, as well as housing costs as defined above. Your lender will look for a debt-to-income ratio that's no higher than 36%.
So let's say you have a car payment of $250 per month, credit card debt with a payment of $250 per month and a student loan debt of $100 per month. Add to that the $1650 per month in housing costs. Your total monthly debt is $2,250 per month, or $27,000 annually. Your debt-to-income ratio is 36 ($27,000 divided by $75,000). You would most likely qualify for the $250,000 home, assuming you have saved the $12,500 (5%) down payment and have a decent credit score.
A mortgage officer is also familiar with loan features and the terms and qualifications needed to be approved. There are a lot of mortgage types to choose from, for example ,FHA, conventional, fixed rate, variable rate, veterans, 203(k) and more.
Yes, choices are a good thing, but it can be overwhelming to try to figure out which type of loan you should apply for.
Choose a Realtor
Everybody knows someone who is a realtor, and people often feel pressured to use a relative or good family friend who “needs the business.” Choosing a realtor this way can be a big mistake that wastes your time and costs you money.
By all means, ask for a referral from a friend who recently bought or sold a home. But be specific about what qualifications you're looking for. A great agent has local knowledge of the market in which you want to buy or sell a home. And he or she knows the ins and outs of real estate dealings. A great agent will be busy. We all get better with experience, and a busy agent is honing skills through practice. A great agent has top-notch negotiation skills and a high level of integrity. You can use a free service like HomeLight, which matches you with some of the top real estate agents in your area.
Interview several agents before you decide whom to work with. Ask lots of questions. Ask them to tell you about what went wrong and what went well in their most recent transactions. Tell them about your situation and assess if they're focused and are really listening to you. Ask for the names and phone numbers of their last three clients. Then call those clients to get real-life customer perspectives.
Check out this article with tips on finding a great real estate agent.
Start Searching for a Home!
With your prequal letter or preapproval in hand, you're ready to tour some properties. You may like the idea of living in a midtown penthouse condo. Or maybe you prefer a single family home with a yard in a quiet neighborhood. As a buyer, there's no reason you should go it alone. Sellers bear the cost of real estate agents on both sides of the transaction, so you can avail yourself of the expertise and experience of a stellar agent at no cost to you.
Narrow your choices by identifying what neighborhoods (or zip codes) you prefer and what kind of home features you're looking for. Equally important, identify what types of properties and features you don't want. Narrow your search to homes that fit your style and preferred location. Don't just look at everything in your price range. This saves time and helps your agent focus your search.
Before and during your home search, save your pennies! The upfront costs of buying a home are higher than many first-time homebuyers expect. You'll need to save up not just for your down payment, but also for closing costs, inspection fees and the cost to move.
In the next installment of this two-part guide, we'll look at the steps you need to take once you've found your dream home.