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.
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:
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
Having said all of this, you can expect that
any home purchase will involve at least the following steps, provided that everything
- Make the decision to purchase a house
- Get your financial affairs in order
on the type of house, the location, and the price range you can afford
to a Realtor and start looking at houses
- Find a house that
- Make an offer on the house
- Shop for and select a mortgage company
for a mortgage
- Wait for approval on the mortgage
for the closing
- Attend the closing and sign all the paperwork
- Move in to your new home
following sections we will discuss each of these steps so that you can understand
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
- 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
- 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.
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.
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.
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.
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:
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.
- You must have a job with a reputable employer
that pays a steady annual income.
- 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.
- You must have a clean and strong credit history
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
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.
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.
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.
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.
4: Talk to a Realtor and start looking at houses
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:
to a large selection of houses
- Entry to those houses at any
time with a pass key
- Experience with neighborhoods
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
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.
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
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
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
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.
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).
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
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
amount of the down payment (perhaps 10% of the home's purchase price)
- City and county Taxes
fees (for town houses, condos, etc.)
- Title search and title
- Surveying fees
- Deed registration
or filing fees
- Homeowners insurance fees (paid either prior
to or at closing)
- And so on
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.
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!