If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To learn the basic essential information needed to buy a home, especially including calculating how much you can afford and how much you will need at closing.
Prerequisites: PF104: Creating a Budget & Cash Flow Statement, DM102: Debt Reduction
Handout: Home Buying Considerations
Assignment: Closing Disclosure Statement in Excel | Google Docs (previews in lecture material)
Buying a home is an essential part of the American dream, right?
We certainly bought into that dream in 2006 when we purchased our first little starter home right after my husband graduated from college and got his first job. My husband hadn’t even technically started his job yet and I was making part-time income from an internship while finishing my master’s degree, but they still approved us for the loan without batting an eye (ah, the good old days). Down payments were low (yay), house prices were high (so high-we had no idea!) and interest rates were between 7-8% (we didn’t know any better).
And then, we watched our home value plummet to less than half of our purchase price when the housing market crashed. Now 10 years after the purchase, our home still hasn’t gone back up to what we paid for it and due to making such a low down payment, we are still upside down on our mortgage (what happened to the American dream?!).
We now rent that property out and ignore it in our finances as much as possible (since the rent payments generally cover the mortgage and other costs) but what a bummer! We learned a lot from that home, the least of which was NOT that landscaping is an important consideration when purchasing a home. Specifically, one should check if there are any gazillion year old maple trees that may need to be cut down in the near future. Apparently that sort of thing can cost upwards of $5,000. Now you know….just in case.
We were able to purchase another home at the near-bottom of the market several years later that was probably twice as nice for nearly the same mortgage payment due to the low home values and lower interest rates.
We’ve since sold that home and purchased yet another home that required a major renovation and taught us some valuable lessons about how much it costs to totally renovate a home’s interior (basically, a LOT of money and more than you think is possible going in!).
In the wake of the housing crisis of 2008 and the declining growth of home values, it’s not at all surprising that millennials especially are hesitant to commit to purchasing a home. There is a lot more publicity recently about many younger and older Americans that are choosing to rent, even though they could easily “afford” to buy a home. In addition, there’s certainly a shift from the thinking that if you don’t own your own home you either can’t afford it or are not financially intelligent. It’s a big choice and likely the biggest purchase you’ll ever make by far. It’s certainly not a good choice for every person for a variety of different reasons!
While buying a home may not be for everyone, it can be a worthwhile way to build wealth if you follow some basic principles and know exactly what you’re getting into. There are many financial and non-financial factors to consider. In this class, I’ll only be focusing on the factors that relate to the monetary aspect of buying a home, although I’ve included some other pros and cons of home ownership for the class in the handout (which you can download at the top or bottom of the post).
STEPS TO BUYING A HOME
Let’s start from the very beginning and go through the step-by-step the process for buying a home.
STEP 1: MAKE A LIST OF YOUR HOME NEEDS & WANTS
The absolute first thing you need to do when you start the home-buying process is to make a list of your must-have requirements. These are things that are the absolute most important to you to have in your new home.
This would definitely include the number of bedrooms and bathrooms, but also things like an open layout, a newer home that doesn’t require renovation or repairs if you’re not looking for a project, a small or large yard, etc. A list of many of these types of things is included in the handout for the class.
STEP 2: START RESEARCHING THE MARKET
Even if you plan to hire a realtor or agent, I very, very highly recommend starting to watch the market yourself well in advance of when you start looking to buy a home. An app such as Zillow can allow you to set up and save automatic searches for homes in a specified area. You can identify your needs (number of bedrooms, lot size, price, etc.) so that your search is limited to certain criteria only. This way you can see the prices for homes with your desired features and monitor how fast homes are selling in your location.
Driving around the actual neighborhoods will also help you to narrow down your search even more. You will rule out a LOT of homes just by driving by them.
STEP 3: DETERMINE WHAT YOU CAN TRULY AFFORD AND CHECK YOUR CREDIT
Now that you’ve done your research on the market and know the price range that houses are going for in your area, you already have a very idea of how much you will need to spend to get a home with the features and in the location that you want.
Many (maybe most?) Americans will then go to their bank or mortgage broker to find out if they can “afford” to buy the home of their dreams. However, this isn’t what you’re going to do next, because you want to make sure you know exactly what you’re getting into financially. Trusting someone else to tell you what you can afford is a recipe for disaster. I’ve heard that disaster doesn’t taste good, so don’t follow that recipe, okay?
First, create a monthly budget scenario that includes the total mortgage payment you will be comfortable paying within your budget. This should not be too difficult if you’ve already completed the budget class (PF104) This monthly amount should include principal and interest as well as monthly property taxes and insurance escrow amounts, PMI (if you are paying less than 20% down) and homeowner’s association fees. Also include in your budget a monthly amount for home repairs and utilities based on a new home.
Here’s how to obtain the different components:
- Principal and interest – If you are using Zillow to research properties, you can their built-in mortgage calculator to calculate the principal and interest. Alternatively, you can use the loan amortization schedule from our debt class DM102: Debt Reduction, which will calculate the principal and interest portion of your payment. You will need the amount you’re financing, interest rate and loan term to calculate this payment.
- Property taxes – Property taxes are public information, but the information is more easily accessible in some places than others. The best place to start is a website/app like Zillow to see if they show the property tax history.
- Insurance – If you’ve previously owned a home, you likely can make a good enough estimate of how much an insurance company will charge you for a policy. If you have no idea, you can contact your current insurance company to get an estimate based on the overall home value you’re looking to purchase.
- PMI – Private mortgage insurance is generally required for all buyers that pay less than 20% down on a home. This insures the bank against the increased risk of you defaulting on your loan. For a quick estimate of monthly PMI, go to Mortgage-Info.com. I would strongly recommend that you save 20% down for your home to avoid PMI and make sure you can really afford to purchase the home.
- Association Fees – If you have a very specific location in mind, you can estimate the association fees. You should have a good idea of whether you’ll be paying association fees from the second step, which was researching the market, but just realize that if you do purchase a property with steep association fees, you’ll be able to afford to spend less on the actual home purchase.
- Home repairs – A good estimate for annual home repairs is 1-2% of the purchase price. So for example, if you purchase a $100,000 home, you would budget $1,000-$2,000 annually or around $85-$150 monthly for home repairs. Of course this will also depend on the age of the home and whether the previous owners maintained it regularly.
- Utilities – The size, efficiency and layout of the home as well as your own personal factors will affect the amount of utilities you use on the home. Consider electric, gas, water and trash service in this component.
Next, determine whether the homes in the price range you’ve been researching would make sense with your personal budget. After entering all of this previous information into your budget, if you don’t have enough money left over to cover your other expenses and save 5-10% of your income, you should consider looking at less expensive options. Trial and error, each time starting with the amortization schedule to figure out the mortgage payment portion of the monthly expense is probably the most effective way to come up with a home purchase price that fits your budget.
Buying the maximum value house the mortgage broker says you can afford is a sure way to live on an extremely tight budget, which will likely result in you going into debt when financial times get tough.
In addition to getting your budget in order, during this step you should also obtain a copy of your credit report and credit score. This is an extremely important step for anyone planning to finance a home. Errors are quite common (more common than you’d think!) and you’ll want to make sure you have at least a month or two to correct them.
I personally found an error on one of my credit reports when we went to purchase our most recent home and discovered that my credit score had dropped over 100 points due to a $15 utility bill that went to collections without me ever knowing it. Fortunately, I was able to fix this problem quickly, but other issues may likely take a lot more time to resolve.
STEP 4: SAVE THE CASH NEEDED
If you’ve already been considering buying a home you have likely also already started saving for a down payment. However, it may catch you by surprise how many additional costs there are associated with buying a home.
Some of the costs include:
- Lender charges
- Appraisal fees
- Property tax reimbursement to seller
- Prepaid interest to lender
- Homeowner’s insurance for the first year
- Upfront deposits for your escrow account (property taxes and insurance)
- Transfer taxes
- Title insurance
- Notary fees
- Home inspection
In addition to these costs, lenders will also require that you have a “cash reserve” that covers anywhere from 2-6 months of the mortgage payment in savings.
I’ve set up a spreadsheet that mimics the home settlement form “Closing Disclosure”. This is a new form that came out within the past year, so if you’ve previously purchased a home, you may not recognize it (it replaces the HUD-1 settlement statement). Although there would certainly be a more simplified way to look at these costs, I believe that it’s very important to know the forms (that’s absolutely the same with taxes!). When you’re making the largest purchase of your life, you need to be informed and not blindly accept whatever the lender gives you. This form can be found on the Consumer Financial Protection Bureau website. I’ve filled in an example similar to the one shown on their website (click to see an enlarged pdf version).
If you’ve never purchased a home before, this may be very confusing to you and you may need additional guidance from a mortgage broker or bank to help determine the estimates. If you have purchased a home before, you should pull out your previous settlement statement and take a look at each line item on the buyer side of the statement.
If you already have a good general idea of the costs, you should start filling in this spreadsheet now. Enter as much information about the home and loan as you can in the inputs at the top of the form. These are just rough estimates at this point, but they will allow you to get an evaluate some of the additional costs you will need in addition to your down payment.
After you apply for a mortgage loan (part of step 9), the bank will give you a Loan Estimate (formerly referred to as a Good Faith Estimate or GFE). This will be in a similar format and will allow you to know well ahead of closing how much cash you will be required to bring to the table at closing. If you’ve never bought a home before and/or don’t have any idea of the amount and type of fees you’ll be charged, you will want to ask the bank or mortgage broker (in the next step) to go through them with you.
There are many, many articles all over the web that offer ideas for saving money. Since this post is focused on the other topics related to home buying, I’m going to leave it to you to come up with a plan for saving the cash you need to pay the down payment and closing costs for your home purchase. One tool that I’ve provided previously is an annual goal tracking spreadsheet included in the assignment for class PF101: Intro to Personal Finance & Goals.
STEP 5: FIND A MORTGAGE BROKER
You should now know exactly what you’re getting into and what you can truly afford. When you’ve saved up sufficient cash, it is finally the time to go to a bank or mortgage broker to get pre-approved for the loan. A mortgage broker is someone that offers mortgage loans from a variety of banks, which allows you to compare interest rates and closing costs easily and quickly to help you to get the best loan for your personal situation. They find multiple lenders, but you may want to get loan details from your bank as well. I’ll just be referring to a broker for convenience.
The best way to find a mortgage broker is through recommendations from friends or family, but the internet now also allows us to check reviews on professionals. You definitely want someone that will be honest and upfront about fees and that you will communicate well with.
In order to get your pre-approval for the mortgage, the broker will ask you for a LOT of information. Some of the things you should start collecting in advance include:
- Recent paystubs (a full month cycle)
- Recent bank and brokerage statements
- W-2 statements for the past 2 years
- Personal tax returns for the past 2 years
- Business tax returns and additional information if you are self-employed
- A complete list of monthly debt obligations including credit cards, student loans, automobile loans, other real estate loans, child support and alimony payments as well as the total balance owed
Be prepared to answer (a million) additional questions and provide (a million pages of) additional documentation and signatures.
In this step, you should also analyze your mortgage term options. Fixed rate mortgages are generally the best option for most people and a 15-year option is more ideal than a 30-year option if at all possible. Not only will you pay off your home and gain equity more quickly, but you will also get a lower interest rate. A variable rate mortgage can be an option to consider, but only in specific circumstances, such as when you don’t plan to be in the property very long so it won’t matter if the interest rate rises in the future (although at that point, you should seriously analyze whether it may be more optimal to rent than purchase). If your credit is disqualifying you from receiving favorable interest rates, this may be another reason to wait a little longer before buying a home.
STEP 6: MEET WITH A REALTOR
Using a realtor or real estate agent as a home buyer is optional, but is highly recommended especially for first-time home buyers. There is a lot of negotiation required and they can walk you through the entire process from walking through potential homes to getting the keys at final closing.
Again, the best way to find a realtor is to get recommendations from friends and family. Honesty is important here as well as knowing the housing market in the location where you wish to purchase.
STEP 7: CONDUCT YOUR HOME SEARCH WITH COST ANALYSIS IN MIND
While you are actively conducting your home search, you should begin a spreadsheet to calculate and compare the monthly estimated costs for each home that you are seriously considering. Money is and should be a big factor in this purchase and you’ll want to make sure that the homes you are considering will fit within the budget you created earlier. There are often additional HOA fees or other situations that you may not have already included in your previous analysis.
I suggest copying your monthly budget and creating a column for each home, with the budget items that fluctuate between each home scenario being the mortgage payment (including principal, interest, taxes and insurance), HOA fees, utilities (depending on the size of home), monthly repair cost (depending on the age of the home) and any other applicable items. You certainly don’t want to have a negative cash outflow at the end of the month and you’ll quickly be able to see the impact that buying a less expensive and/or smaller home will have on your monthly finances.
If you are considering major renovations, that will also need to be included in further analysis. That’s a whole additional topic for another day!
STEP 8: PUT IN YOUR OFFER, COUNTER OFFERS, AND REACH AN AGREEMENT
When at last you’ve found your dream(ish) home, you’ve reached the negotiation stage. You’ll submit an offer (through your agent) and likely go back and forth several times with additional counter offers. Make sure to include any special items that are important to you in the sale.
With the offer you submit, you will also include an earnest deposit of around $1,000-$5,000 or more depending on the approximate purchase price and area where you are buying.
The end result of this step will be a completed purchase agreement signed by both you (the buyer) and the seller(s). This can be a lengthy and scary process, but be prepared to walk away if the purchase price gets higher than you are comfortable with.
STEP 9: APPLY FOR A LOAN, CONDUCT YOUR INSPECTION AND APPRAISAL
With your signed purchase agreement in hand, you’re ready to officially apply for your mortgage loan. Your mortgage broker will have you officially fill out a mortgage application and will be required to provide to you with a Loan Estimate (formerly a GFE) within 3 business days of your application. You can shop around and get multiple Loan Estimates if you wish to make sure you’re getting the best loan possible. This form is supposed to be a clear document to help you easily understand the fees and mortgage terms.
Once you’ve decided which loan to go forward with based on this estimate, the mortgage lender will start the process of getting your loan approved and through the underwriting process.
To see an example Loan Estimate, go to the Consumer Financial Protection Bureau website here. This document is much clearer than the previous Good Faith Estimate and your mortgage broker will answer any additional questions you have about the loan process.
Generally your purchase agreement will provide for a specified time in which to obtain a home inspection. While you may think that avoiding the $250-$400+ cost of the inspection is a good choice, it is vital to make sure that everything is in good working order. It can easily save you many times the amount of money you spend if you have a good home inspector. Be sure to be present for the inspection, as they will provide information that will be invaluable to you and give you peace of mind that you’re making a good purchase free of major problems. Any issues that arise during the inspection should be brought up to the seller and resolved before closing.
After the home inspection, the next step will be to arrange for an appraisal. While you as the buyer will not be present during the appraisal, it is a vital step in the process and a cost that you will be required to cover. An appraisal is an independent verification of the value of the home. It protects both you and the lender from purchasing a home at a price higher than its real value. Generally the appraisal comes in right at or close to the purchase agreement price, but it’s not unheard of for a deal to fall through when an appraisal comes in at below the agreed upon price in an inflated housing market.
Additionally, you will also need get homeowner’s insurance in place before closing. Consider getting updated insurance quotes for your bundle of policies (auto, homeowner’s, any other additional policies you have) if you haven’t done so recently.
STEP 10: CLOSING
After the previous steps have all been completed, there is a (long) wait during the loan underwriting process. Generally, there is an average of 30-45 days between the submission of the loan application and the closing date.
You should plan a final walk-through of the home close to the time of the final closing to make sure that everything is still in the condition agreed upon. Be sure to carefully check the interior and exterior of the home. It’s common for sellers to try to leave behind unwanted furniture or paint cans/hazardous items (we learned this the hard way with our first home). Don’t be afraid to speak up!
If you’re considering buying a home, hopefully you have a good basic understanding now of the overall process. It’s great to own your own place and be able to really make it yours. Just make sure that you do your research. Good luck!
EXAMPLE: THE SMITH FAMILY
Because Jim Smith is a realtor, he’s always analyzing the prospect of buying a different home. He decides to do an analysis of one of these less expensive homes to see the difference it will make on their overall budget. An example home in the price range he’s been researching is shown below (shown from Zillow):
Based on the information above, the total mortgage payment would be $731 ($481 principal & interest, $65 homeowner’s insurance, $185 property taxes). Utilities are estimated to be approximately $150 per month and repairs are estimated at $1,500 annually or $125 per month. This would result in more than a $500 savings per month from their current budget.
Next, they need to analyze the closing costs for the possible future purchase. In addition to the $26,980 down payment, their closing costs would be in the range of $7,000 for a total of approximately $35,000 cash needed for the sale (which they would get from the equity in their current home). Click the pictures below for an enlarged PDF version of this example.
Overall, based on the financial factors, this is something that the Smith family should consider. They would not only have less expenses, but also be able to pay off some of their debt with the remaining equity from selling their current home.
Your homework assignment is to analyze a prospective home purchase using the tools provided in this class.
- IMPROVING – Go through each item line by line on a Loan Estimate provided to you and determine a ballpark monthly payment you can afford based on your individual budget.
- INVESTED – Provide a mortgage broker with the details of a possible home you may consider buying and ask them to go through the potential costs of purchasing the property, including closing costs, required down payment based on your credit and any other costs.
- UNSTOPPABLE – Well in advance of the potential purchase, make a plan for saving 20% for a down payment and additional closing costs according to a detailed analysis as shown above.
File your home purchase analysis in your Financial Plan binder under the tab “Special Situations”