Nolo's Essential Guide to Buying Your First Home (11 page)

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Authors: Ilona Bray,Alayna Schroeder,Marcia Stewart

Tags: #Law, #Business & Economics, #House buying, #Property, #Real Estate

BOOK: Nolo's Essential Guide to Buying Your First Home
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U
p to this point, we’ve been able to focus on the fun stuff—finding out all the great reasons to buy a house and imagining what the new place will look like. Now it’s time to take a step into the world of finances—nothing that will require an accounting degree, fortunately. You may be wondering why we’re even bringing up boring financial stuff before you’ve started seriously househunting. That’s what a mortgage broker is for, isn’t it?
But wouldn’t it be horrible to put an offer on a house and begin shopping for a loan, only to discover that you couldn’t qualify for the amount you needed or the terms you expected? Even worse, what if you were able to get a loan, but discovered after moving into your new home that you’d borrowed more than you could handle—at least, without moonlighting?
Don’t Play the Multiplication Game
 
You may have heard of a formula where you multiply your household’s gross annual income by two and a half to find out how much you can afford to spend. This may be fun and easy, but it won’t help you draw realistic conclusions. It fails to factor in important things like how much debt you currently have, the terms of your mortgage, or how much you already have saved for a down payment. If you really want to guess how much you can spend before reading this chapter, you’re better off using a reliable online affordability calculator like the one at
www.nolo.com/calculators
.
 
Getting familiar with your finances before there’s a prospective property in sight—even if you just sit down for an hour or two—will show you how much you can realistically afford to spend and prepare you to choose the best possible loan. This chapter will help you by:
• explaining the costs of purchasing a house
• demystifying the process mortgage lenders use to decide how much you can borrow
• providing simple ways to calculate what you can
really
afford based on your lifestyle and finances
• showing you how to boost your financial profile, and
• explaining what it means to get preapproved for a loan and why you should do so.
 
If you’ve already found a place and are trying to figure out how to pay for it, don’t skip this chapter. A quick look at your finances will still help you decide whether your prospective home’s cost is within your budget and whether you’re likely to get the loan terms you’re counting on.
Beyond the Purchase Price: The Costs of Buying and Owning a Home
 
Buying a house means some new expenses beyond the purchase price. A first-time homebuyer should plan to drop some cash for:
• the down payment
• the loan principal, loan interest, taxes, and insurance
• up-front costs, mostly to close the deal, and
• recurring ownership costs.
 
The exact amounts of these expenses depend on you, the house you buy and where you buy it, and the type of mortgage you get. But even if you can’t predict exact amounts, understanding these expenses and what drives them will save you some sticker shock.
Do We
Have
to Talk About Money?
 
We know, all this talk about numbers makes watching an MP3 download seem fascinating. But if you’re one of those people who never balances a checkbook, this exercise is even more important—unless you think it’s worth thousands not to deal with the hassle. If you pay just half a percent more than you could have if you’d done some research—say, 7% instead of 6.5%, on a 30-year, fixed-rate mortgage for $200,000—you could end up paying almost $24,000 more in interest over the life of the loan.
 
Down Payment
 
You may be plunking down a hefty chunk of change, in the form of a down payment, to buy your home. The amount depends on how much you’ve saved, the terms of whatever loan you get, and the house price. Conventional advice says your down payment should be 20% of the house’s purchase price, but don’t think you’re done for if you don’t have that much: Many first-time buyers don’t.
Tick, Tick, Tick
 
Finding the house you want to buy might not take as long as you think. According to a 2008 survey by the National Association of Realtors®, the typical homebuyer spent ten weeks searching before settling on a house.
 
The main reason to scrape the cash together for a large down payment is to reduce the size of your monthly payments. Also, if you’ve got your heart set on a specific house or price range, but your income isn’t high enough to take out a big loan, a larger down payment can make up the difference. Here are other benefits to making a large down payment:
•
No PMI.
If you pay 20% of your purchase price, you don’t have to pay private mortgage insurance, or PMI, which lenders routinely require of homebuyers who borrow more than 80% of the home’s value, to protect the lender if you default.
•
Smaller monthly mortgage payments.
If you borrow less money, you’ll have less to pay back, leaving you more cash for other things.
•
Less interest overall.
If you borrow less, you’ll owe less in total interest. For example, if you got a 30-year, fixed rate loan for $200,000 and paid 6.5% interest, you’d pay approximately $255,090 in interest over the life of the loan. But you’d pay only about $204,070 over the life of a $160,000 loan with the same terms. The bank would get over $51,000 more in interest just because you didn’t put $40,000 down at the beginning.
•
It’s like money in the bank.
No matter what the market does, putting cash into your home is a low-risk way to use it.
•
Lower interest rate.
Borrowers who take out mortgages for more than a certain amount ($417,000 in most places in 2009, but it is higher in high-cost areas and can change annually) get what are called “jumbo” loans, with higher interest rates. If making a down payment will lower your loan to below that amount, your interest rate will probably drop, too. Likewise, if you’re a borrower with poor credit, you might be able to obtain better loan terms if you fork over more cash at the beginning—the lender figures you’ve got more incentive to keep paying if you stand to lose your down payment when the lender forecloses.
 
Where Will I Get Down Payment Money?
 
If you’re interested in making a down payment but haven’t saved the cash, here are some alternative sources:
•
A gift or loan from family or friends.
If you have a loved one with available cash, you may be able to get a low-interest loan, or even a gift. According to Asheesh Advani, president of Virgin Money, over 30% of first-time homebuyers get help from friends and family—either as a gift or a loan—for the down payment.
•
Withdrawal from your IRA.
You can withdraw up to $10,000, penalty-free, from an individual retirement account (IRA) to purchase your first home. Your spouse or cobuyer can do the same. For more information, see IRS Publication 590,
Individual Retirement Arrangements (IRAs)
, available at
www.irs.gov
.
•
Borrow from your 401(k).
Check with your employer or plan administrator about whether you can borrow from your 401(k) plan. Also ask how much you can borrow (usually, $50,000 at most). For more information, see IRS Publication 575,
Pension and Annuity Income
, available at
www.irs.gov
.
•
Current assets.
If you have other investments, like stocks or bonds, consider cashing them out—but be sure to factor in the taxes you’ll owe.
•
Don’t have a big wedding!
Okay, we’re half joking here. But you wouldn’t believe the number of couples we’ve met who said that, in retrospect, they wish they’d kept the wedding small and put that money toward a house.
 
 
 
Make a 30% down payment.
According to Nigel, “When Olivia and I decided to buy a house together, we were earning nonprofit salaries (low). But our parents were excited to see us settle down and gave us generous gifts. Between that and emptying our savings account, we had about 30% to put down—which convinced the seller to choose our bid from among the many others, because we’d obviously have no trouble financing the rest. Now we have absurdly low monthly payments—less than we’d be paying in rent—and the house has appreciated in value. Also, we’re in a position to help our parents out financially, if they need it.”
However, all these benefits don’t mean you should put your every last dollar into a down payment. There are some perfectly good reasons to make a down payment under 20%, or even no down payment at all. For many people, saving up one-fifth of the price of a house sounds laughable. (Think about it—that’s $80,000 for a $400,000 home.) And when home values are on the rise, waiting to save 20% can prevent potential buyers from building equity
now
, make homebuying more expensive or, in the worst case, pricing them out of the market entirely.
And even if you have the cash for a down payment, you might prefer to use it for other things. For example, when interest rates are low, some people finance their homes with low-interest loans, then use their cash to fund other, more lucrative investments.
 
Borrow it all and then some.
Ben was about to get a promotion. “I was excited,” says Ben, “until I realized that I’d no longer qualify for the government-assisted, low-interest loan I’d been counting on—my salary would be too high. I decided to buy a house before the raise took effect, but I didn’t have any cash for a down payment. Luckily, I was able to borrow 103% of the purchase price, using a special mortgage that let me put the extra 3% toward energy-saving improvements to the home. My income increased after I got the promotion, and then I got married. Now, with our combined income, we can even afford to make prepayments on the mortgage. And in the five years since I bought the house, its value has doubled.”
Principal, Interest, Taxes, and Insurance
 
Ever heard of PITI (pronounced “pity”)? It stands for principal, interest, taxes, and insurance, all of which must be factored into your homebuying plans. Here’s the breakdown on these expense items:
•
Principal.
The amount you borrow from the lender and must pay back, month by month.
•
Interest.
A percentage of the overall borrowed amount that the lender charges you to use its money. The exact rate varies widely.
•
Property taxes.
Taxes vary by state and sometimes by local area, but expect to pay between 2% and 4% of the house purchase price each year, if the place you live fits the national average.
•
Homeowners’ insurance.
Coverage for theft, fire, and other damage to the property (required by your lender) and usually for your liability to people injured on your property or by you. Average rates run upwards of $600 per year.
 

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