home :: buyers :: buying your first home
Understanding your finances and buying your first home

by Marshall Brain

Home ownership is an important part of the "American Dream," and is a significant way for a person or family to express its individuality and independence. For many people home ownership marks an "arrival" in the same way that graduation or a first child does.

The purchase of a home is probably also the most complicated financial transaction in which a person participates during a normal lifetime. The first time you undertake a home purchase, the complexity of the transaction can be particularly frustrating because there are a number of unknown rules and procedures that you are generally forced to learn through "the school of hard knocks." We know a number of people who simply gave up the first time they tried to buy a house because too many unexpected things happened during the process. They ended up waiting perhaps six months or a year and then starting over again. It can be that difficult.

The purpose of this article is to help you to understand the home buying process so that you can approach it from a position of understanding rather than confusion. In this article you will learn about the different types of homes available, the financial limits that banks apply to you when you try to get a home mortgage (and which therefore control the type or size of house you can afford), the extra and often unexpected costs that you will incur during the closing process, and some of the hazards to watch for as you go through the transaction. Once you have finished this article you will prepared to go forth and do battle with the banks, Realtors, lawyers, and loan officers who stand between you and the home of your dreams.

Imagine that you would like to buy a new television. In America just about anyone can drive down to the local discount store, pick out a TV, and purchase it with a credit card in about 10 minutes. The process is easy, well understood, and accepted by everyone.

Now imagine that you want to buy a new car. This transaction is a bit more complicated but still relatively straightforward. If you have the cash for a car in the bank then you can:

  • Drive to the dealer
  • Pick out the car
  • Haggle on the price
  • Sign a contract
  • Write a check
  • Call your insurance agent to bind coverage

You can drive the car off the lot the same day. If you have to get a loan for the car then it might take a day or two to contact a bank and arrange for the loan (provided that your credit history is good), but you can still drive the car away with relative ease.

Now imagine that you want to buy a house. In general the process is going to take at a very minimum a month, and more typically between three and six months. There is also a fairly good probability (perhaps 25%, depending on your situation) that, once you find a home you like and wish to purchase, you will be unable to buy that particular home and will have to start over again. A typical question for the first time buyer to ask at this point is, "What do you mean that I may not be able to buy the house that I pick out?" As you go through this article you will begin to understand that there are a number of things that can go wrong if you are not prepared (and sometimes even if you are…). There are three fundamental things that complicate the home buying process:

  • Each home is a large, distinct, immovable, one-of-a-kind object with a distinct one-of-a-kind seller who happens to live in it. This fact means that human emotions and personalities play a much larger role than they do in most other common financial transactions
  • No normal person has enough cash to buy a home, so you are forced to go to a bank and ask for a loan whose size may be measured in the hundreds of thousands of dollars. No bank is going to undertake a loan of this size lightly.
  • All homes rest on a piece of land, and with that land is associated a certain amount of government red tape including the deed for the property and sizable taxes on the home. The process of transferring ownership of a home is not nearly as simple as it is for other objects that we commonly purchase.

Having said all of this, you can expect that any home purchase will involve at least the following steps, provided that everything goes smoothly:

  1. Make the decision to purchase a house
  2. Get your financial affairs in order
  3. Decide on the type of house, the location, and the price range you can afford
  4. Talk to a Realtor and start looking at houses
  5. Find a house that you like
  6. Make an offer on the house
  7. Negotiate a price
  8. Shop for and select a mortgage company
  9. Apply for a mortgage
  10. Wait for approval on the mortgage
  11. Wait for the closing
  12. Attend the closing and sign all the paperwork
  13. Move in to your new home

In the following sections we will discuss each of these steps so that you can understand each one.

Step 1: Make the decision to purchase a home

The decision to purchase a home is not a small one, and involves a number of variables. Some of the considerations that you should keep in mind are listed below:

  • Are you able to commit to a specific location for a period of several years? If your job or lifestyle requires you to change location frequently, then you should not purchase a home. There are two reasons for this. First, a home is not very liquid. It can take months or years to sell a home when you need to move. Second, when you sell your home a Realtor will charge you a 7% commission. That means that in many locations you will have to hold the home for several years so it can appreciate in value or you will lose money when you resell it.
  • Are you qualified to obtain a mortgage? Step 2 will help you determine whether you are currently qualified for a mortgage. If not, you can begin the process of becoming qualified by saving for the down payment, improving your credit history and paying down existing debt.
  • Are you financially, physically and emotionally prepared to maintain the home? Owning a home is different from living in an apartment complex. In an apartment complex the grass is mowed, the buildings are repainted and appliances are fixed by the owner of the complex. When you own your own home you have to do these things yourself or pay someone else to do them. If you are not interested in painting, mowing and fixing, then a house if not for you (although a town house or condo might be — see Step 3). You will also have to pay significant property taxes and insurance premiums once you own a home.

Keep all three of these considerations in mind as you are deciding whether or not to buy a home. On the other hand, you should also keep the following advantages in mind:

  • A house offers you a way to accumulate wealth. When you pay rent on an apartment, that money buys you nothing but living space. By spending about the same amount of money each month to pay the monthly payment on a mortgage, you instead build wealth. If you have a 15 year mortgage, then after 15 years of payments you have accumulated an amount of money equal to the value of your house. In addition, the value of your home will normally appreciate at some rate, with the minimum rate being equal to inflation. Therefore, if you buy a home for $100,000 then after 15 years you will have accumulated $100,000 through your mortgage payments, and in addition the home will have a value of $156,000. Instead of accumulating nothing by paying apartment rent for 15 years, you accumulate $156,000.
  • A house offers significant tax advantages. You gain two important tax advantages though home ownership. First, interest paid on a mortgage is tax deductible. This means that the effective interest rate on the loan is reduced by your income tax rate. In addition, when you sell a home you are allowed to roll the money generated from the sale into a new home without paying any taxes on the appreciated value (i.e. capital gains) of the home. A home is the only investment that works in this way under current tax laws.
  • A fixed rate mortgage stops the "rent increases" that you would see at an apartment complex. Your monthly payment will remain the same until the loan is paid off.
  • The price per square foot for a house is sometimes lower than the price per square foot for an apartment, depending on the area.
  • A house lets you express your individuality. When you live in an apartment you take what you get. You generally cannot repaint or renovate an apartment. When you own a home you can do whatever you want.
  • A house offers privacy. Your home is your castle, so you don't have to worry about people running overhead or playing their stereos at 3:00 AM.

As you can see, home ownership has important advantages and disadvantages, and the decision to purchase a home therefore should not be made lightly.

Step 2: Get your financial affairs in order

Before most people can purchase a home, they must get a loan. The most common form of loan used to purchase a home is called a mortgage. In a mortgage, the borrow pledges to repay the loan as specified, and the lender is given the right to seize the property should payments ever be interrupted. A mortgage deed, issued by the lender and recorded at the county tax office, contains an accurate description of the property and the payment terms of the loan.

Because a mortgage is usually for $100,000 or more, banks tend to be fairly particular about the people to whom they grant a mortgage. In general a bank will require you to demonstrate five things before giving a mortgage to you:

  1. You must have cash on hand for a down payment. Generally an amount equal to 10% of the home's purchase price must be available. In addition, you need to have enough cash on hand in order to cover closing costs as well. Closing costs are the fees you must pay to all of the people and organizations involved in the purchase of a home.
  2. You must have a job with a reputable employer that pays a steady annual income.
  3. You must show that the amount you are borrowing will not overburden you financially. In order to confirm this banks use two standard test. The first test, which could be called the allowable monthly housing cost test, ensures that your monthly mortgage payments will not exceed 28% of your gross annual income. The second test, which could be called the allowable total monthly debt payment test, ensures that your total monthly payments for all debt including your mortgage payments do not exceed 36%. These ratios are good things because they help people to avoid overextending themselves. For example, if you bring home $2,000 per month and had to make a $1,500 mortgage payment each month, it is virtually guaranteed that you would either starve to death or default on your loan. The first test tries to prevent this from happening. In the same way, if you have a number of outstanding loans for cars, boats, furniture, etc. and tried to load another large loan on top of the pile, then it is also likely that you would eventually default. Test 2 guards against this problem.
  4. You must have a clean and strong credit history
  5. You must have an acceptable balance sheet and net worth.

It is possible to obtain certain government—backed mortgages that bend some of these rules. For example, an FHA mortgage (a mortgage backed by the Federal Housing Authority) will generally lower the down payment requirement. In general, however, you can expect any mortgage company or bank to follow these rules fairly closely.

You meet the second requirement by having a steady job with a predictable income. You will need to be able to get confirmation of employment from your employer when it is requested by the bank. You will also have to supply tax returns for three preceding years to show your income history.

You meet the third requirement by looking at your current financial situation and figuring out the maximum amount of money you can borrow based on the test.

If you find that you are way off base when you look at the ratios, then you can do two things: 1) you can plan on accumulating a larger down payment or buying a less expensive home, and 2) you can reduce existing debt.

You meet the fourth requirement in two ways. You build a clean credit history by paying your bills on time. You obtain a strong credit history by obtaining and repaying other loans, like credit cards, car loans, etc. If you have never obtained and repaid a loan prior to attempting to get a mortgage, it is likely that the bank will frown on this fact. It is therefore important to build a credit history by obtaining and using credit cards, obtaining and repaying a car loan, etc.

A bank will check your credit history by obtaining a credit report for you from a credit reporting company. You can and should obtain your own copy of your credit history ahead of time and make sure that the report you receive is accurate and contains no errors. If you know that you have a spotty or poor credit history, you should work to repair the damage. The best way to do this is to talk with a credit counselor. The Fannie Mae Foundation (a private company chartered by Congress) can provide you with help finding credit counselors and other mortgage information. Call 1-800-699-HOME for further information and assistance.

You meet the fifth requirement by presenting to the bank a net worth statement. The bank is primarily interested in your existing assets (to demonstrate financial strength) and your existing debts.

Please Note:

As you are getting your finances in order, you may wish to talk with your bank or a mortgage company and get their opinion on your financial health. This will save you the embarrassment and frustration of applying for a mortgage and being rejected after spending a significant amount of time finding a home you like. Many mortgage companies will pre—approve you for a certain mortgage amount, and going through this process can be very beneficial. Once you are pre—approved, you will know exactly how much money you can spend on a new home, and you will also save yourself the hassle of getting approved once you find a home you like.

Step 3: Decide on the type of house, the location, and the price range

There are at least six different types of housing you can purchase in most markets:

  • A house — A house is a detached single-family dwelling. It stands by itself on its own piece of land and you own and maintain both the house and the land. This is what most people think of when they think of "buying a house," and it is the most common type of property on which to obtain a mortgage.
  • A Duplex (triplex, etc.) — A duplex is a detached multifamily dwelling. In a duplex there are two units (in a triplex three, and so on) that share a wall and the same piece of land. You purchase the entire duplex and the land it sits on in the same way that you purchase a house. Then you can live in one half and rent the other. The rental income can go a long way toward paying a mortgage payment.
  • A town house — A townhouse is normally part of a row of connected units. You own the portion of the building you live in and its land. However, each owner becomes associated with some sort of collective or management company that maintains the grounds and the exterior of the buildings much like an apartment complex would. You pay a monthly fee for this service. The advantage and intent of this arrangement is that the exterior appearance of all units is maintained.
  • A condominium — In a condominium you own an apartment - like unit but not the land underneath it. A management company owns the land and the building your condo exists within. You pay a monthly fee to the management company to maintain the building and the grounds.
  • A co-op — In a co-op you purchase shares in a corporation that owns the building and land. Ownership of these shares gives you the right to live in an apartment in the building. Because all owners own shares in the corporation, they act as a board that can lightly or severely restrict the freedom of individual owners. Presumably this is done for the benefit of the majority. For example, in a co—op you may not be able to rent your unit, there may be pet restrictions, and when you sell your shares the sale will be subject to board approval of the buyer.
  • Manufactured housing — Also known as mobile homes, double-wides, etc., manufactured housing is treated by the marketplace more like a car than it is like a house. Mobile homes depreciate in value over time like cars do (rather than appreciating like a house), so you generally obtain a standard loan (like a car loan) rather than a mortgage. Manufactured housing is not the subject of this article.

You can choose to live in any type of housing, although in general the topics addressed in this article focus on the purchase of a house.

Step 4: Talk to a Realtor and start looking at houses

There are two ways for you to search for a house. You can either look in the paper or in magazines advertising houses for sale by owner and you can purchase a house directly from the owner. This route has the potential to be less expensive, because an owner who sells his or her house does not have to pay a 7% Realtor commission. The disadvantage of this approach is the fact that it can be harder to find a home that you like because of a more limited selection, the difficulty in scheduling visits to each home.

The more common way to search for a house is to use a Realtor. Realtors have the following advantages:

  • Access to a large selection of houses
  • Entry to those houses at any time with a pass key
  • Experience with neighborhoods
  • Understanding of price distributions, taxes, problems, etc. across localities

Use whichever technique feels more comfortable. If you use a Realtor, take time to shop around and find someone whose style and market niche matches your own. One good way to do this is to seek recommendations from friends at work. Since you have a choice, choose a Realtor with extensive experience, and do not allow the Realtor to rush you.

Step 5: Find a house that you like

After searching for a period of time you will presumably find a house that you like in a reasonable location with a price that you can afford. It may take several months of searching to find such a house. At the moment you find it, make an offer immediately. It is not uncommon for a good house at a good price to be purchased by someone else if you hesitate for too long. This is the most common way to lose a house that you really like.

There is a funny thing that happens to many people right after they make the offer. It is commonly known as buyer's remorse. It is the feeling that you have just done something extremely stupid, and often occurs right after you sign your name and hand over the deposit check. Buyer's remorse is a natural human emotion. You can combat it to some extent by making up a written list of advantages and disadvantages for the house as part of your decision—making process. If this list is sound and true, then when buyer's remorse kicks in you can refer to the list and reassure yourself that you did the right thing. Or maybe not. Just be aware that the phenomena is common and be prepared for it.

Step 6: Make an offer on the house

You make an offer to purchase a home by signing an offer to purchase form and writing a check. The check acts as a deposit and represents your commitment to following through with the purchase should the offer be accepted. This money is normally referred to as earnest money. The check will be cashed, and the money will be placed in escrow. An escrow account is simply a bank account managed by a neutral third party, generally the Realtor or a lawyer. Should you be unable to follow through on your commitment to purchase, you will lose your earnest money. Should the offer not be accepted, the money will be returned to you. The amount of earnest money you will be asked to give varies, but generally is 1% of the purchase price. This money is applied to the purchase price at the closing if the deal is successful.

A standard offer to purchase is a single sheet of paper. On one side are a number of blanks where you fill in your name and address, the offer price, the amount of earnest money, and any conditions or contingencies on the offer. On the back are a number of standard condition paragraphs. For example, many localities require a termite inspection or bond on any house that is sold. There will be a standard paragraph covering this condition. Should the house fail to pass a termite inspection the offer will be nullified and your earnest money will be returned to you.

You can also add your own condition and contingencies. One common condition added by most sellers is "subject to loan approval." That way, if you are denied a mortgage you get your earnest money back. Another common condition is "subject to a satisfactory home inspection by a licensed inspector." You, as the buyer, will have to pay for the inspection ($100 to $500), but you can use the results of the inspection to request repairs to the house prior to purchase. The seller pays for these repairs. You can stipulate that the seller will pay certain closing costs (this is important because it can save you a lot of money - see step 12). You can, in fact, add any conditions that you like (contingent upon sale of an existing home, contingent upon repair of the roof, contingent up removal of dead trees in the yard, etc.), but at the same time the seller has the option of rejecting them.

The most important part of the offer to purchase is the offer price. The seller places the house on the market with an asking price. You have the option to offer the asking price, or more, or less. If you know that you have three competitors and you really love the house, you may have an incentive to offer more than the asking price, but generally you will offer less. The amount that you offer depends on your personality and your negotiating strategy.

Step 7: Negotiate a price

The seller will either accept your offer, reject it, or make a counter offer. If you receive a counter offer you have the right to accept it or make a counter counter offer. At this point you negotiate with the seller until you reach a price and terms that are agreeable to both parties. If you do not reach agreement, the offer is eventually rejected, your earnest money is returned to you, and you get to start over again. This is the second way that you can lose a house that you like.

Step 8: Shop for and select a mortgage company

There are a number of good reasons to talk to a mortgage company prior to searching for a home (see Step 2). If you do not then at this point you must start the process. Search for a company that has good rates and that seems to understand you and your financial situation. Ask several different banks or mortgage companies for quotes — the rate differences can be amazing. You local paper will often publish a list of banks with the lowest rates in the area.

Step 9: Apply for a mortgage

There are two different types of mortgages: fixed-rate and adjustable-rate (also known as ARMs). Fixed rate mortgages come in 15-year and 30-year formats. Adjustable rate mortgages come in many different forms, but the most common form starts at some rate and then adjusts itself every six months or year depending on changes to the prime rate.

Adjustable rate mortgages generally start with a interest lower rate, but carry the sometimes-significant risk that your monthly payment will rise if interest rates rise. Fixed rate mortgages are guaranteed to maintain the same monthly payment over the life of the loan.

Once you have chosen a mortgage company and a mortgage type, apply for the loan by filling out the appropriate paperwork and supplying all of the requested information.

Step 10: Wait for approval on the mortgage

Approval may take several days or weeks, depending on the mortgage company. You may be asked to supply additional information during the process.

As discussed in Step 2, much of the nail-biting than accompanies the mortgage-approval process can be eliminated by getting your mortgage pre-approved. See Step 2 for more information and talk to your mortgage company before starting your search for a house..

Step 11: Wait for the closing

At the time your offer is accepted by the seller, you and the seller will negotiate a closing date. With the mortgage approved all that you can do is wait for the closing date, prepare to move, and hope that nothing goes wrong.

Step 12: Attend the closing and sign all of the paperwork

Finally the closing day arrives. This should be a day of rejoicing because on this day you will become the proud owner of a new home. Unfortunately this day is instead one of frustration and myriad small details unravel. It is not exactly clear why this unraveling is so common, but it is definitely the case.

The closing normally occurs at the office of a lawyer. At the closing you will be required to pay quite a few fees, so bring your check book and make sure you have plenty of money in your account (the lawyer will normally provide you with a total closing cost prior to closing day, but be sure to have at least $1,000 over and above that cost available just in case).

The costs that you may be expected to pay at the closing may include the following, depending on how closing cost payments are negotiated when you make your offer to the seller:

  • Loan origination and/or processing fees
  • Points on the loan (points are a front-end interest charge assessed by the lender. The more points you pay, the lower your monthly payment because you are paying your interest early. Each point represents 1% of the mortgage's value. It is not unusual for a lender to require you to pay two to three points at closing, and it is preferable for tax reasons to pay them yourself with a check rather than wrapping them into the mortgage.)
  • Up to one month's worth of mortgage payment, depending on the closing date
  • The amount of the down payment (perhaps 10% of the home's purchase price)
  • Lawyer fees
  • City and county Taxes
  • Homeowners fees (for town houses, condos, etc.)
  • Title search and title insurance fees
  • Surveying fees
  • Deed registration or filing fees
  • Homeowners insurance fees (paid either prior to or at closing)
  • And so on

The total figure can add up to thousands of dollars. Some banks will let you roll these fees into the mortgage, but many will not and in that case you will have to have the cash available. You will also sign at least 15 pieces of paper.

Step 13: Move in to your new home

Presumably this part is easy, and once you have moved in you can sit down on your couch and you can congratulate yourself. After several months or years of hard work you have successfully bought your part of the American Dream!