M is for Money

This is Part 3 of The First Time Homebuyer: Part 1 and Part 2

The process of buying a home starts years before the actual purchase. Some of the financial preparations, like building up a credit score and saving up a down payment, take time. Let’s take a closer look at each of the steps to getting your finances in order.

Credit Score

The days of easy money for subprime borrowers are gone and the requirements to get a home loan are much stricter now. Prime borrowers, those with good credit, can still get loans. But everyone else may have trouble. The exact cutoff score to be considered a prime borrower varies depending on the agency preparing the score and the lender’s rules. Generally prime starts somewhere around 720 and up, scores between 680 and 720 would be considered Alt-A (not quite prime) and below 680 would be subprime. You can check your score for free using Credit Karma, though the score they give is only a rough estimate. Improving your credit score takes time so start early if you currently have poor credit. Services like Credit Karma will identify the top reasons why your score is not higher, these are the areas to focus on for improvement. If you are already in prime territory then you don’t need to do anything, a score of 800 will land you the same loan as a score of 750.

Down Payment and Closing Costs

The traditional down payment is 20% of the home’s value, this is to give the bank and buyer an equity cushion. These standards were relaxed over the last decade and that in part contributed to the rash of homeowners underwater today. In a backlash many lenders have returned to the 20% down payment rule, though it is still possible to find lenders who will accept 5% or 10% down. The zero down loans of the bubble years are history, you will have to make a down payment. Anything less than 20% will require PMI, private mortgage insurance. The premium for that insurance will be part of your monthly payment until you have 20% equity in the house.

If homes in your desired area average $200,000 you will need $40,000 as a down payment. Add to that the closing costs, which can be another $5,000 to $10,000. This is to cover the various fees, title insurance and other transaction costs associated with buying a house. If you choose to pay points to lower your mortgage rate that is additional cash you have to bring to closing.

Saving up the cash for a down payment and closing is the biggest hurdle to homeownership for first time homebuyers. In high cost of living areas you need $75,000 or more cash for a modest starter home! I suggest you look for lenders that will accept lower down payments or look for down payment assistance programs in your area. You should put down as much as you can, but I understand that 20% can be too difficult in some cities. Parents and family can help with cash but I recommend they transfer the money well ahead of your home search. Money from family is sometimes regarded as a silent loan, not truly your down payment. If the money has been in your bank accounts for some time, no one is going to wonder where it came from.

How Much House can you Afford?

The exact amount you can borrow will depend on your lender’s criteria, but you should set a price based on what is comfortable for your budget. Homeowners have some costs that renters never think of. In addition to your principal and interest payment to the bank, you must have homeowner’s insurance (your lender will require this) and pay property taxes every year. Homes require upkeep and maintenance, so you should save money every month for repairs. The other hidden cost is utilities, many apartment buildings cover some portion of the monthly utility bill. At my apartment I paid for telephone, electric and gas, but I did not pay for water, trash or sewer fees. Our trash alone costs over $30 a month! Also shared walls tend to reduce heat and cooling costs, single family homes can’t benefit from their neighbor’s leaked heat.

Once you have figured out how much monthly payment you can afford use those figures in a mortgage calculator. The current average loan rates are available online, or look at your bank or credit union’s rates. Here is an example: your budget says you can afford $1200/month for a payment, not including the taxes and insurance. If the rate you expect to pay is 5.5% for 30 years, that means you can borrow around $210,000. Add in the down payment you’ve saved and you get the maximum you can afford for a house.

Your debt to income ratio is another way to determine how much you can afford to borrow. Each lender has their own guidelines for the ratio they will accept. Here is how you calculate a debt to income ratio. The monthly payment based on D/I includes property taxes and insurance, you will have to subtract those expenses to determine the mortgage component of the payment. You can then plug the mortgage payment into a calculator to find the amount you can borrow.

First Time Homebuyer Programs

Many communities have programs to help first time buyers with everything from education about the home buying process to down payment assistance. Other first time buyer programs offer loans with small down payments, the government’s FHA backed loans are one such example. These types of assistance programs are located throughout the country, this site is a place to get started. It is definitely worthwhile to check out what aid is available to you. The current recession stimulus also provides an $8,000 incentive in the form of a tax credit to first time buyers, here are the details from the IRS.

Being Financially Ready

You can never be over prepared when it comes to buying a home. It is one purchase that will take years of saving and planning. Even if a home is many years on the horizon, now is the time to set yourself up for the future. The biggest financial decision of your life requires a huge financial commitment.

Part 4 - Mortgage Basics

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