Buying a Home

Buying a house is a big step, but often a smart move. Home ownership enables you to build equity. Equity is the increased value of your investment in the house— that is, the difference between what you could sell it for, and the debts against it (e.g., the mortgage). Also, home ownership allows you to access two important tax deductions: mortgage interest and property tax.

How Much House Can You Afford?

“How much house can I afford?” is probably the first question you’ll think about when you decide to buy a house—especially if you’re a first-time buyer. Like most people who purchase a home, you’ll probably need to borrow money to finance the purchase. Here, then, are the two most important considerations:

• How much down payment can you come up with?
• How much will a lender (e.g., bank) be willing to lend you?

Down payments, in general, range from 5 to 25 percent of the purchase price of a house. The amount you’ll need to put down can depend on several factors, including the selling price, age and condition of the house, your credit rating score, the requirements of specific lenders, and whether you are purchasing your first home.

If you’re selling a house, the money you realize from the sale may provide the down payment for the purchase the new one. If your down payment won’t come from the sale of another house, you will need to take the money from savings. Investments, such as stocks and bonds or stock options from an employer are a potential source of funds for a down payment. Bear in mind that the larger the down payment, the lower the monthly mortgage payment and closing costs will be (see Closing the Deal). In some cases, it may be possible to borrow money from certain types of retirement accounts (e.g., IRAs) to help fund a down payment. It’s a good idea to ask the advice of a tax professional or financial advisor before borrowing from retirement accounts or liquidating long-term investments.

Note that first-time homebuyers and veterans may be eligible for special financing terms. Contact your local U.S. Department of Housing and Urban Development (HUD) office, as well as local city, county, and state housing bureaus, for information about programs in your area (see For More Information).

How much can I borrow? The important question isn’t really, “How much can I borrow?” Rather, it is, “How much can I afford to borrow?” Although many people who purchase a new home feel a financial pinch until they adjust to the new obligation, it’s not a good idea to borrow so much that you feel a tight squeeze. Fortunately, lenders’ primary lending criteria will be how you look financially. The amount you’ll be allowed to borrow will, consequently, depend on the numbers—particularly your net worth and your current gross income.

• Net worth is calculated by totaling the value of all of your assets (i.e., things you own: savings accounts, IRAs, stocks, cars, etc.) minus your total liabilities (i.e., everything you owe: credit card balances car payments, other long-term loans).
• Current gross income is the total of your salary plus any income you receive from other sources (e.g., dividends, interest, disability benefits).

In general, 28 percent is the maximum percentage of monthly gross income that a lender allows for housing expenses. Housing expenses are usually defined as: principal and interest on the loan, property taxes, homeowners insurance, any required homeowner’s association fees, and any required private mortgage insurance. Note that the 28 percent maximum may vary depending upon several factors including gross income and net worth.

Lenders use a second number, 36 percent, as the maximum percentage of your monthly gross income allowed for total debt. Total debt includes housing expenses plus recurring debt: car loans, credit card payments, child support, and all other debts that will not be paid off in a relatively short time (e.g., 6 to 10 months).

Use Chart A to determine the maximum housing expenses likely to be allowed by a lender, based on your monthly gross income. Use Chart B to determine the maximum total debt a lender is likely to allow.

After you know your total monthly debt figure from Chart B, you can estimate how much you have available for monthly housing expenses by figuring out your recurring monthly debt, and subtracting it from maximum total debt number you calculated in Chart B.

What will borrowing cost me? Once you have a general idea of how much you can afford on a monthly basis, it’s time to get a handle on the cost of borrowing. Generally, banks calculate monthly principal and interest payments per $1,000 borrowed.

Here’s how the chart works. Let’s say you purchase a $100,000 home, and you have $10,000 for a down payment and need a mortgage for the remaining $90,000. The bank agrees to lend you the $90,000 for 30 years at 8 percent interest. To calculate your monthly mortgage payments:

• Using the chart, find the monthly rate per $1,000 at 8 percent for 30 years—in this case $7.34.
• Multiply the rate per $1,000 by the number of thousands you’re borrowing. The result is your monthly payment—in this case $7.34 times 90, or $660.

Note that this calculation provides the monthly principal and interest cost—it does not include property tax, homeowners insurance, etc. If you want a more complete picture of the costs of owning a home, you need to know or be able to estimate additional costs, including property taxes, homeowners insurance, homeowner fees, and an estimate of maintenance/repair expense. Many banks, mortgage companies, and other lending institutions provide “cost calculators” on the Internet. Also, a real estate agent can help you make these cost calculations

Working with a Real Estate Agent

A real estate agent can be helpful in the search for a new home. Real estate agents usually specialize in properties in certain geographic areas. They’re likely to be knowledgeable about schools, shopping, recreation, and transportation considerations in those areas.

Generally, the seller pays the real estate agent a percentage of the proceeds of the sale, so there is no cost to the buyer. Keep in mind that this means that the agent works for the seller, which may or may not influence his or her advice. To find a reputable agent, ask family, friends and business associates for recommendations. Interview several agents before choosing one. Ask each the following questions:

• Are you licensed?
• Do you have access to the Multiple Listing Service (MLS)?
• Do you represent the seller’s interest, the buyer’s interest or both?
• How are you compensated?
• How many houses are you prepared to show?
• Will you provide references?

Finding Your Dream Home

Start your home search by checking out potential neighborhoods. The famous old real estate saying—there are three factors to consider when shopping for a home: location, location, location—has as much to do with resale value as with what is right for you. When you choose a specific area, you will want to know about the following:

• Local schools. Even if you do not have school-age children, investigate the quality of schools—it can be an important factor when you resell.
• Municipal services. What services does the municipality provide (e.g., water, sewer, trash removal)?
• Commuting times (e.g., to your workplace) and public transportation alternatives.
• Proximity to entertainment, supermarkets, religious institutions, etc.
• Type of neighborhood. Is there a mixture of families of different ages? Seeing a number of swing sets in neighborhood backyards may appeal to growing families, but can make you think twice if you’re anticipating quiet weekends.
• Property taxes in the area, and any common charges, co-op fees, assessments.

Most people aren’t lucky enough to find everything they’d like to have in a house at a price they can afford. So, to help you keep your priorities in order while you search, draw up a list of the things you must have, and a list of things you’d like to have in a home. For example, you may have to have a certain number of bedrooms because of the size of your family, but you may be able to do without air conditioning initially, if you can add it later. Do your homework. Read the real estate section of your newspaper, go to open houses, and/or retain the services of a real estate agent to learn about prices in your chosen neighborhood(s).

When you have found the home that suits your needs and budget, make an offer. Your obligation to buy the house, however, should be contingent upon the findings of a home inspection and your ability to secure a mortgage.

Check it out. Before you purchase any home, you want to make sure you really know its condition. A house can appear perfect but have serious defects that only a professional can uncover. To avoid unpleasant surprises, hire a home inspector to perform a thorough inspection. Home inspectors identify deficiencies and irregularities, and prepare reports on the physical condition of the structure, including the roof, exterior, plumbing, heating, cooling, insulation, and interior. You may want to be present during the home inspection, so that you’ll learn as much as possible about the condition of your new home. Many mortgage lenders require a home inspection as well as inspections for termites and radon (a gas that can seep into a house through the earth and cause health problems) and remediation of any problems identified.

To find a qualified inspector, ask friends or business associates for recommendations. Many home inspectors advertise in the Yellow Pages, often displaying their certifications and membership in professional organizations. You may want to ask for references.

Closing the deal. When choosing a mortgage lender, shop around. Interest rates vary from lender to lender. Before deciding on a lender, compare the terms of the mortgage as well as closing costs for both 15 – and 30 – year loans at both fixed and variable interest rates.

A fixed-rate mortgage guarantees that the interest rate and, consequently, your mortgage payments will stay the same over the life of the loan. Variable-rate mortgages usually start out at a lower interest rate, which may rise at specified intervals (e.g., one year). Therefore, variable rate mortgages may result in higher rates—and payments— later in the life of the loan. There are several types of variable rate mortgages. Make sure you completely understand the terms of any mortgage loan before signing on the dotted line.

Closing costs. In addition to comparing interest rates, be sure to consider closing costs, which can be a significant expense —running into thousands of dollars. Closing costs are all of the expenses associated with closing the deal—of making the legal purchase transaction. Some closing costs will vary based on the price of the home, and are not directly related to the loan (e.g., insurance, taxes). Closing costs include items such as loan application and origination fees, attorney’s fees, mortgage insurance premiums, transfer taxes, prepaid interest, survey, deed preparation and recording, etc. Note that some closing costs (e.g., loan application fees) may be negotiable, while others (e.g., prepaid taxes) are not.

The Real Estate Settlement Procedures Act (RESPA) was enacted to protect consumers when they buy houses, and to help them be better shoppers for settlement services. RESPA requires lenders to give you estimates so that you can compare loans and services. It also mandates that lenders make certain disclosures (e.g., typical costs, affiliations). When you apply for a loan, the lender is required to give you a Good Faith Estimate of loan-related expenses that you’ll be required to pay at closing. The estimate must be given to you or mailed to you within three days of your application. The lender does not need to provide this information if your application is turned down during the three-day period. Make sure you understand all of the figures on the settlement estimate and on the final settlement statement at closing. If you do not understand specific fees or costs, insist on an explanation

Real estate agents can help you sort through and understand the paperwork involved in buying a house, but they are not lawyers or tax experts. To fully understand the tax consequences of a home purchase, or to understand the legalities involved in the purchase, you may want to consult a real estate attorney and/or tax professional.