What sort of advance financial preparations should you make before buying your first home?
You've read all the headlines about problems in the home real estate market.
You’ve also read that, compared with 12 and 24 months ago, home prices today in dozens of areas around the country are a lot more affordable than they had been.
So you make the decision to buy a house — your first. What sort of advance financial preparations should you make before proceeding?
Here’s a quick guide to the key questions.
Number One: How much house can you really afford to buy, and how do you go about making that determination?
Years ago, the rule-of-thumb answer was very simple: You could afford a house that cost twice your annual household income, assuming you made a standard 20 percent down payment.
Today, the computation is a bit more complex, and down payments can be minimal or even zero. Most lenders and mortgage websites can provide easy-to-use calculators that help you figure out what size mortgage you can afford at current interest rates. Key factors that will affect the results include:
- Your debt-to-income ratios.
As a general rule, many lenders offering mortgages at “prime” interest rates will expect you to spend no more than 28 percent of your monthly gross household income on your housing-related expenses — your mortgage principal and interest, property taxes and insurance.
Those same lenders typically will also expect that your total monthly debts — your credit card payments, student loan payments, car payments PLUS your mortgage payments — not exceed 36 percent.
These can be tough standards to meet, so most lenders have programs designed for first time buyers that will allow you a lot more flexibility on your debt ratios. Sometimes they can go as high as 45 to 50 percent for your total household debt and 35 percent or more for your housing expenses.
Bear in mind, however, that lenders typically will charge you an interest rate that is higher than their “prime” rate in exchange for that flexibility.
- Amount you have for a down payment.
Almost no first-time buyers have the ready cash to make down payments higher than 10 percent these days, and many put down less than 5 percent. Here again, there’s a cost. Whenever you put down less than 20 percent, most lenders will require you to obtain private mortgage insurance or FHA (government-backed) mortgage insurance coverage. These premiums usually are paid along with your monthly principal and interest, and raise your total monthly costs.
- The closing and escrow costs.
First time buyers doing their advance financial preparation work sometimes overlook the settlement fees and escrow charges that come with a mortgage, and can add 2 to 4 percent onto the total expense of buying a house, depending upon the location. These fees — due and payable at the time of closing the loan — range from lender fees to title insurance, local taxes, and the administrative charges for processing and completing the entire transaction.
If you don’t have cash available beyond the down payment, many lenders will allow you to finance most of the closing costs — pay for them over time — in exchange for a slightly higher interest rate. Typically the increase in rate will not exceed one quarter of one percent.
Number Two: How good is your credit profile?
Months — not weeks — before you start shopping seriously for a home or mortgage, you need to check your credit thoroughly. This is an essential step because, in the eyes of a lender, your credit history and credit score will govern everything — how much you’ll be charged in interest and fees, and even whether you qualify for a mortgage in the first place.
The three national credit bureaus — Equifax, Experian and Trans Union — maintain ongoing credit files on more than 100 million Americans. Odds are they each have a file on you. You can obtain a free copy of your credit report from each bureau once every 12 months by visiting www.annualcreditreport.com. The site is run jointly by the three bureaus. You can also purchase copies of your reports any time at each of the bureaus’ websites.
When you obtain your credit files, examine them carefully. Many files contain erroneous or outdated information. Sometimes they confuse one person with another because of similar names or Social Security numbers. Other files are incomplete because creditors fail to report borrowers’ on-time payment histories or only report to one or two of the bureaus.
If you find incorrect or missing information, contact the creditor immediately and request a correction. Under federal law, the bureaus are required to maintain consumers’ files accurately. If a creditor fails to correct misinformation promptly, contact the credit bureau and request that it contact the creditor to resolve the issue.
What is in your files determines your FICO score, and that score almost always will determine the interest rate you are quoted by lenders. Consumers with low scores — especially under 620 — get hit with high rates and fees. If your score is between 700 and 850, you should be quoted the very lowest rates and fees available. (Visit www.myfico.com for helpful guidance on FICO scores and interest rates.)
What if you haven’t had much experience with the traditional world of credit or banking? What should you do if your FICO score is artificially depressed because your credit file is “thin,” making you appear to be a much worse credit risk than you know you are? Happily, growing numbers of lenders now offer loan programs where so-called “non-traditional” credit information — payments such as monthly rent and that are not reported to the national credit bureaus — can substitute for or be added to traditional credit histories to raise your scores.
Number 3: How much of a loan can I be pre-approved for?
Once you’ve got your credit situation in order, the final key step is to get approved in advance for a loan. This is important because the pre-approval process will give you a hard and fast indication of the loan amount you can count on. That, in turn, will provide you an upper limit on the cost of the house you can buy. If the approved mortgage amount is $350,000, and you’ve demonstrated to the lender that you can afford a 5 percent downpayment, that means you are pre-approved to buy a house costing as much as $367,500 (ie., a downpayment of $17,500 and a loan amount of $350,000).
Pre-approvals are essential in today’s market because they tell everyone that you are for real, that you are serious AND financially capable to buy. That’s a written assurance that you can literally take to the bank.
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