So you have decided to pursue the "American Dream" and purchase a home; congratulations! As you begin this exciting journey, our hope is to share with you some helpful information to make this process as enjoyable and memorable as possible, and not stressful! As you can imagine, there is a lot that goes into buying a home, and below are some helpful suggestions and “rules of thumb” to assist you with your decision making.
1) How much can you afford?
The first step is to get pre-approved, this allows you to know how much home you qualify for, so that you can make a smart financial decision, opposed to an emotional decision. In general, our recommendation is somewhere between 2 to 2 ½ times your annual household income. For example, between you and your significant other, you make a combined income of $200,000, you should look at purchasing a home that is no more than $400,000 to $500,000. The reason you want to stay within this range is to ensure you don’t become “house poor”. What this means, is that all of your discretionary money is going to your home, and not towards other bills, investments, paying down debts, establishing an emergency reserve, etc. Know that in addition to your mortgage, you will have to pay property taxes, home owner’s insurance, utilities, as well as associated costs to maintain your home.
2) How long should you lock in your mortgage?
If you are first time home buyer and recently married and no children, you might consider taking advantage of an adjustable rate mortgage (known as an ARM). The average first time home buyer lives in their first home for about 10 years. An ARM has a fixed interest rate for that particular timeframe…which typically range from 3-10 years. The reason one would select an ARM, is because of a lower interest rate, which equates to a lower monthly mortgage payment. The strategy behind utilizing an ARM is that by the time your ARM expires, and the interest rate goes up, that you have sold your home and have bought a new home. By this time, you most likely have children, have decided on a good school district and neighborhood and with this home, you may want to lock in for 30 years. Of course, if there is not a big difference in interest rates between the two, a 30 year fixed mortgage could be a better option as you know the interest rate is locked in for that entire duration, and may allow for greater flexibility should you decide to sell, rent your home, or stay in the home. Finding an experienced mortgage advisor is key to understanding what is right for you.
3) How much of a down payment should you put down?
Most lenders require you to put at least 5% down, unless you qualify for a physician or VA loan, which then you don’t have to do down payment. The reason you would want to put more money down on your home is to lower the monthly mortgage payment, and potentially a lower interest rate because of more money down. The flipside to this, is that the money you put down on your home is not as accessible/liquid as it would be if you decide to leave a portion in cash. When purchasing a home, there can be a lot of additional expenses, that you might now be aware of up front…such as furnishings, window treatments, unexpected repairs just to name a few. You might be surprised at how little your mortgage payment is reduced by putting more money down. For example, if you purchase a $300,000 home with 5% down, your hypothetical mortgage payment would be $1,444/mo and if you put 10% down, that payment would be $1,368. This reduces your hypothetical payment by $76/mo, however that additional $15,000 is no longer liquid and readily available should an emergency arise.
4) Do your research and homework!
If you are new to the area, it may be prudent to rent for 6-12 months. This not only allows you to focus on the major transition already—moving, but gives you time to get a better understanding of the “lay of the land”. You will come to terms with what side of town you want to live on, how is the commute, how are the schools, etc. Once you figure out where you want to live, especially the particular neighborhood and/or street, drive by at different times of the day and on weekends to see what the traffic is like, are neighbors outside, or are all of the garage doors shut? This can give you a good feel for what it will be like should you choose that particular home/area.
5) Hold off on furnishings and/or major purchases!
Until you have officially closed on your home, and living in it, you should not make major purchases such as furnishing your new home, buying a new car, or financing anything. The reason is because lenders will want to ensure that your financial situation has not changed drastically prior to closing (to ensure that you are within their debt-to-income ratio guidelines). We live in an environment now of tight lending requirements, due to the subprime mortgage crises, and most lenders will pull a credit report the day prior to your closing. If you get above this threshold, you run the serious risk of becoming disqualified for obtaining a mortgage to buy your home.
My hope is that you find this information helpful so that when you do pursue the "American Dream" of purchasing your own home that it is a rewarding and enjoyable experience and not a buyer’s remorse decision.
Written by Erik R. Andrews, CFP®
Associate Partner & Senior Financial Consultant | North Star Resource Group
817909 / 02-2014