Buying a home is not just about pricing and negotiation. A large part of the process has to do with how well–or how poorly–a buyer is prepared for making the purchase. This preparation does not need to take a great deal of time, and most of it can be done from the comfort of your current home or office, but it is essential to spend some time getting ready before running off to look at specific homes. That’s why we created this step by step guide to help make the home buying process seem less scary and intimidating.
Know your credit score
The first thing every homebuyer will want to prepare for is credit checks. Knowing your credit score is vital to know which house is and is not within your purchasing means.
The median house price in America in 2020 sells for $300,000. Unless you are financially able enough to pay that price in cash, you’ll need the help of a lender for your mortgage payments. However, no lender would just hand out thousands of dollars without ensuring that their investment is protected, and they’ll receive a fair return on what they give. This is where the buyer’s credit score comes into play.
Your credit score or ‘credit rating’ is a number that describes the likelihood of you returning back any loan you take. This score is reported in what is called the ‘FICO model’ and is shown as a three-digit number between 300 and 850, with 300 being the lowest and 800 being the best score. While the score requirements may vary from lender to lender, generally, a score above 750 is considered excellent, 700+ is good, and 650+ is fair.
In signing up for a home mortgage loan, a score below 650 is considered poor and insinuates credit history problems. The lender is taking a larger risk and suspect such buyers may default on their payment. These types of loans are called “subprime loans” because the credit score is below the prime rate of 700+, and even if you can find a lender to extend you a mortgage, the interest rates will be much higher.
The credit score is determined by various factors like payment history, amounts owed to anyone else, debt to credit ratio, length of credit history, etc. By reviewing your credit report, you can learn about any issues or missed credits and even find out about any errors in the report. Rectifying these problems could boost your credit score and increase the chances of a premium loan with low-interest rates.
Sort out your debt
After reviewing your credit score, you may find you have outstanding debts. These are usually reported once you download your free credit report from one of the reporting agencies. This debt can negatively affect buyers’ credit scores and might prevent them from borrowing a good sum with reasonable fees and interest rates.
Generally, if the total value of your unsecured debts is less than 5% of the purchasing price of the home, you can ignore these debts for the time. However, if they are more than 5% and are high priority loans, i.e., have high-interest rates like car loans, credit loans, or some personal loan, you should focus on paying those down.
The nature of the debt owed can also determine whether you should sort them out first. If most of your loans are long-term with little to no interest on them, e.g., HECS-HELPS loans for education, you can neglect them and move on to the next step.
Plan out your budget
The best way to make sure that buyers don’t end up in financial hot water or become ‘house poor’ when they purchase a home is to properly budget before even looking at any home options. It means list down all your current assets and estimate your total financial worth. This estimate includes any property you may be willing to sell to buy the house, as well as monthly income (which plays a crucial role in dictating monthly mortgage payment value). Once you have this rough estimate, you can use it to determine the range in which to search for a house where you can live comfortably and not have to worry about other expenses.
The best way to do this is to make a list of all your monthly expenses, which now includes a mortgage payment, mortgage insurance, property tax, and homeowner’s insurance. Now divide these total expenses with your monthly income. You’ll end up with a number called debt to income ratio. Lenders check this number, i.e., the DTI, to determine the financial credibility of a borrower. A debt to income ratio is below 43% is considered healthy, although to live comfortably, a number below 36% is better and is also preferred by most lenders.
Research mortgage loan options
Buyers are faced with various mortgage lending options, and it’s best to research them first to know what to expect from each and which option suits them best. Familiarising yourself with the mortgage process can also significantly help in securing a good deal. To determine which mortgage option is best for you, read about them here:
Conventional loans
These are the most famous kinds of loans and are harder to qualify for because of their strict requirements like a high credit score, a more significant downpayment, lower DTI number, potential mortgage insurance requirements, etc. These mortgage loans are also not government-insured or guaranteed. However, once qualified for these loans, they can be less costly than those that are federal government guaranteed. There are two types of conventional loans:
- Fixed-Rate Mortgage. In this type, the monthly payment value of the mortgage and the interest rate on the loan remains constant for the entire duration in which money is borrowed.
- Adjustable-Rate Mortgage (ARM). Buyers have the option to choose a constant interest rate for some time and adjust the rate according to their financial index for the rest of the period with this option.
Federal Housing Administration (FHA) loans
These loans are government-insured, have less stringent requirements, and are therefore easier to qualify for. The significant advantage of these loans is that your down payment can be as low as 3.5% of the purchasing price (depending on your credit score), and therefore you’ll have fewer upfront loans and payments to consider. However, borrowers are also required to pay for Mortgage Premium Insurance (MPI) and must have a study income.
Department of Veteran’s Affair (VA) loans
Veterans can request their certificate of eligibility from their VA office and use it to apply for a VA loan. In this case, the VA does not give out the loan itself but guarantees the loans made by another qualified lender. This enables veterans to obtain loans with favorable terms, which can also include no payment at all.
Pre-approval for a mortgage
In a competitive market with many buyers trying to buy the same property, a preapproval can really make a buyer stand out and give the seller the impression of someone serious. This is because a preapproval for a mortgage is a stamp from the lender, ensuring that the borrower has the credit score, financial requirements, and other credentials required for the loan.
A pre-approval also clearly defines the amount the lender is willing to give to the buyer and therefore provides the seller with a clear idea of how much the buyer can afford to pay. This makes for a smooth dealing and transaction and prevents any jeopardy that might result from getting approved after making a deal for the house (like not qualifying for the required amount). Some buyers opt for a mortgage prequalification; however, there is a difference between prequalification and pre-approval, with the latter being the better option. This is because a prequalification is based on information provided by the borrower. On the other hand, a pre-approval involves research on the lender’s part and thorough verification of the buyer’s credentials and financial history.
Deposit for a down payment
There is a general established rule of thumb that buyers need to deposit at least 20% of the home’s price as a downpayment. However, this is not always the case, and depending on your lender, the downpayment can be as low as 3.5% (like with FHA).
According to the National Association of Realtors, the average down payment was 11% of the house’s value in 2016, and among younger buyers, with lower incomes, it averaged around 8%. However, a 20% payment can divert the seller’s attention to the buyer and make him stand out more since it means a secure financial status. It also has several benefits for the borrower.
- A low overall payment. Paying the maximum cost upfront means less amount of money left on which you’ll have to pay interest over time.
- Lower interest rates. Financial stability reflects a good credit score, and therefore the lender is more likely to invest in the buyer. This will prompt him to offer a lower interest rate than someone who poses a risky credit score.
- No Private Mortgage Insurance (PMI). With a smaller down payment, lenders will require some insurance that the larger some will be paid off over time. This leads to PMI payments, so the borrower has to make a higher payment each month compared to someone who drove with a 20% equity.
Crunch down on extra costs
To figure out the down payment percentage you should go for, sort out your finances, and start saving. The time immediately before applying for a down payment is crucial for homebuyers since lenders will examine recent history for any large financed purchases. Therefore, the most important thing is not applying for additional loans, like for an extra car or other purchases that may hurt your DTI ratio. Check out our money saving tips to learn more about distinguishing between needs and wants, which can make a massive difference in the amount you save for a down payment.
Gather the needed documentation
This is something buyers need to do before even applying for a mortgage loan from a lender. For a background check and insurance, most lenders require a financial history checkup and therefore need all the necessary documentation. Gathering all the papers beforehand can help expedite the mortgage process and make everything run more smoothly.
Most lenders will ask for the following things from borrowers before going through with anything.
- Identification. This can be a driver’s license, passport, or social security number.
- Income verification. This includes:
- the borrower’s tax returns for the last two years
- Pay Stubs
- W-2 forms, i.e., an IRS tax form that reports wages paid to employees
- Federal tax information or 1099 forms
- Financial history & condition. Bank statements, brokerage, or investment account statements for the last two years and proof of sufficient funds for a downpayment.
- Other. A gift letter if your down payment is being paid by someone else and a letter of recommendation from previous landlords (if you were renting before).
Find a trusted real estate agent
An experienced real estate agent can provide useful guidance when shopping for a home, especially for first-time buyers. Although this step is optional, it’s highly recommended.
An agent usually informs the buyer on the current market condition, pulls up records related to similar homes in the area, and points them towards better or more affordable options in the region.
A realtor will also prove helpful when the contract is being decided, i.e., reviewing the offer, providing counter-offers taking into account the property’s condition, etc. The agent takes care of all the research and time-consuming part of the home buying process, saving buyers the hassle of it all.
Open houses and searching the area
Probably the most fun and exciting part of buying a home is house hunting, visiting different homes, comparing their features, mentally making a list of things you like and other things you’d like to change, etc. The best way to search for your dream is to create a wish list of all the things you want in your new dwelling and then visit open houses that match that criteria. Look out for any minor cosmetic makeover the building might need so that you can add that to your estimated cost.
A good practice is to get a home inspection done prior to a definitive agreement to know about any repairs needed and the overall condition and integrity of the home. This way, you will not be faced with any surprises later and will be aware of what exactly you’re getting into (especially regarding significant renovations that would need a huge budget) when the contract is made.
If you do have a tight budget, check out our post on the cheapest place to buy a house. Historically, West Virginia is generally the most affordable state, followed by Mississippi and Oklahoma.
When visiting homes, try to bring your real estate agent along and discuss everything with them before making any decisions. If you find an issue, you can search for better alternatives or propose a suitable solution. However, this does not mean that you should ignore your gut; an agent provides a valuable second opinion that can be quite productive, but the priority is still what you yourself want.
Wrapping it all up
For first time buyers, the entire process can be quite intimidating and very complex to navigate through. A few pointers can simplify the understanding of the process as well as make them more confident in this endeavor. With this article, we’ve tried to achieve precisely that, and hopefully, our efforts have not been in vain. For more information, you can contact your local real estate agencies and discuss the specifics with them at length.