Among the many milestones we use to mark our financial coming of age, few are as exciting as buying a home. I remember signing a raft of papers a few inches thick when my wife and I bought our current home in 2001. The process left me both exhilarated and terrified. Our firstborn would not arrive until Christmastime that year, and I felt as though I’d taken my biggest step into adulthood yet.
Since then, I’ve learned firsthand the joys of homeownership (turning a dank, dingy basement into a family room) and challenges (home repair, home repair and home repair). We’ve also refinanced our home several times over the years as interest rates fell, and picked up valuable knowledge in that arena.
If you’re a first-time homebuyer, or just beginning the process of house hunting, I can sympathize: Just making the cognitive leap from renter to owner can prove daunting. Navigating the mortgage process isn’t a picnic, either, especially if you don’t have someone who can walk you through it.
Before you apply for a mortgage, what’s the first thing you need to do? Let’s review the most important things any prospective homeowner must tackle first.
Determine how much house you can afford
“Look at your monthly budget and figure out what level of payment you’re comfortable with, and how much of a mortgage you’re comfortable with,” says Polyana da Costa, a Senior Mortgage Analyst at Bankrate.com. “That’s very different from the lender telling you what you can qualify for. Just because you can get a $500,000 mortgage doesn’t mean you should get one.”
Money Under 30 has solid advice on how much house you can afford, as well as a home affordability calculator that can help you find a reasonable budget.
Before you get started down the mortgage path, take time to use this calculator, or one like it.
Our calculator gives you a ballpark of the mortgage payment and home value you can afford, but you’ll need to cushion for taxes and insurance which will add a few hundred dollars to your monthly payment.
And you’ll want to leave more of a cushion still.“Leave room for maintenance and for unexpected repairs, even if you’re buying a new home,” da Costa says. “You never know if you’ll need a new air conditioner or general maintenance. As a renter you don’t think about those things; you just call the maintenance guy. But as a homeowner you have to find the money to fix it. It’s not a question of whether it will happen, because it will happen.”
Review your credit and get pre-approved
Once you know whether you’re in the ballpark, it’s time to go out and get pre-approved for a mortgage—a step you’ll want to consider even before you’ve settled on a property. First-time home buyers don’t always appreciate just how much paperwork is needed to get a mortgage, and if you wait until you’ve fallen in love with a house, you could be in for a rude awakening.
“Don’t wait until you get to the lender to check your credit; you don’t want any surprises,” da Costa says. “You don’t want to find a house, sign a contract, then find out there’s something wrong with your credit report and it’s too late to fix it. You want to get pre-approved for a mortgage.”
To get that pre-approval, make sure you have your papers ready to go: your past tax returns for at least two years, W2s, pay statements and bank statements. On the credit report side, pull your credit score and credit reports and keep your fingers crossed. Scores of 680 or better mean you’re a good bet for a conventional mortgage (which has better terms), assuming you can put 5 percent down on a home.
Decide what kind of mortgage you’ll get
If you’re in the 620 to 680 range, you may still qualify for an FHA mortgage, which is insured by the federal government. The good news is that you only need a 3.5 percent downpayment. The bad? You’ll have to deal with the added expense of private mortgage insurance, “which makes the loan much more expensive,” da Costa says. “And you have to pay for mortgage insurance for the life of loan as a result of federal laws.”
She adds: “I always recommend applying with three lenders and get a good faith estimate. Look at them side by side and at least you can compare apples to apples.”
As for conventional mortgages, you have two major kinds: fixed-rate mortgages (where the annual percentage rate of the loan stays the same for 15 or 30 years), or adjustable rate mortgages (where a much lower interest rate is frozen for a period of five or seven years).
Next you’ll need to decide on the mortgage term: 30- or 15-year terms are most common. 30-year fixed-rate mortgage is most traditional type, and offers a big advantage over its 15-year counterpart: a lower monthly payment. But in current market conditions, a 30-year loan will run about a percentage point higher than the 15-year loan.
And with mortgage interest rates so low, da Costa says that many buyers opt for the 15-year loans because of the enticement of paying off the mortgage twice as fast, and saving a bundle in the process: “If you can afford it, you’ll get done quicker and it’s a great deal.”
With adjustable-rate mortgages, interest rates will dip even lower than with a 15-year loan (about half a percentage point), but there’s a catch: You assume full responsibility for any hike in interest rates when the loan expires in five or seven years. “It’s a risky one because if you don’t move and stay in the house, who knows what your rate is going to be,” da Costa says.
But there’s a reverse logic at play, too: If you know you will likely move before the loan expires, you’ll get to use the low rate of the ARM and not risk an interest rate hike on the same property.
With a five-year ARM (also known as a 5/1 ARM), you can take advantage of rates that are right now at about 2.75 percent, compared to about 4.25 percent for a 30-year fixed rate mortgage.
Keep in mind all of your debts, not just the mortgage
There’s one more number to think about as you put all this together and before you apply for a mortgage: your debt to income ratio. “Depending on the mortgage you get, you want to stay under 43 percent,” da Costa says. “And you have to look not just at your mortgage, but the whole debt situation. If you pay just 10 percent for the mortgage that’s one thing, but if you pay another 70 percent to drive a fancy car and pay off your other debts, that’s not good at all.”
All of this may sound like a lot to digest. It is. But landing your first home is a process that will take months to complete, so there’s time to learn. My best advice here is to tap the knowledge of someone who’s been through the process recently and knows their stuff. When Amy and I bought our Chicago home, we had lots of young friends in the same boat who were eager to coach us.
Just as we learned from them, my hope is that I’ve passed something of value to you as you go out house hunting. Crunching the numbers and learning the mortgage ropes may not be nearly as much fun as walking through homes with a perky real estate agent. But you can’t get to that dream home without a solid reality check.