A little over a year ago, my wife and I tried unsuccessfully to purchase a home in Florida.
We came very close, about 3 weeks away from closing with a signed contract, but ultimately problems with the home proved to be the deal-breaker. We decided to give it a rest when planning our wedding became a major time-suck.
In retrospect, that decision saved us a lot of money in lost equity and repairs. Hindsight is fantastically 20/20. But our dream to own a home is far from dead.
Through the experience, we learned about the home-buying process in detail. For the first time, we understood first-hand what exactly was required to search for, select, finance, and purchase a home. Today’s post is (mostly) about the “finance.”
The experience of buying a home is a lot like adolescence. You have dreams–you want to go places, do things. You think you know what it takes to get there. But in the end, it takes a parent to keep you on track and set appropriate limits. You might not always agree with them, but in the home-buying process, like in adolescence, trying to fight against authority rarely succeeds.
As I mentioned, we’ve been around the block once before. We spent a good part of four months searching for homes, and made about 3-4 offers during that time period. With one home, we came within weeks of a purchase.
That was then. Looking at how things have changed, we’ve evaluating our options once again. We’re looking at all of the factors I’m about to describe, as well as one very important choice: home or lot.
As many of you know, I’m an architect by day (and sometimes night). Aside from being unsatisfied with almost every house we go to see during the selection phase, I have a strong desire to design my own home, “eventually.” Everything will not turn out perfect, but it will be my home.
So it turns out the choices for us are:
- Buy a home we’re happy with now, and set aside the goal to build our own home for the future.
- Purchase a lot and continue renting, and begin construction on a new home.
- Purchase a lot and a condo, and look at custom home construction as more of a long-term project.
It’s not an easy choice by any means. Buying a home now gives us room for an expanding family and something we’ve wanted for a long time. But the dream of our own design may never materialize…
On the other hand, buying a lot and designing something gives us a lot of options to stage construction and control both the costs, and the time line. And it forces us to realize the dream.
Ultimately, the choice may also come down to market timing–buying and locking in the price of a lot now may be much more accessible than trying to go after a home.
So that’s our story…now let’s take a look at all the components of what it actually takes to buy a home (or a lot, on a smaller scale).
Cash, A Lot of Cash
One of the biggest challenges to first-time homeowners is coming up with the amount of cash required to close the deal. That’s why the government stepped in and created the FHA, and why 0% and 5% down loans were so popular before the recession made them almost impossible to get.
Some of the things your cash stash will have to cover?
- Deposit: When you make a serious offer on a home, it’s usually prudent to include a deposit check to show the commitment to your offer.
- Down payment: Between 5-30% these days, depending on the bank, the area you live in, you financial situation, and your risk level.
- Closing Costs: Fees, expenses, and charges, oh my. While your bank will usually give you an estimate before closing, these are hard to know going into the deal, and they depend on many factors like location and home price.
- Escrow Costs: If you’re going to be putting your yearly taxes and insurance in escrow (your bank divides the estimated yearly bill and you pay into the fund monthly), they may request that you pre-fund the pot with a few months of payments.
- Taxes, Insurance: On top of escrow payments, your first year of taxes & insurance may actually be due at closing.
- First Months: Most banks will also require at least a few month’s worth of mortgage payments in your checking account at time of closing.
- Initial Expenses: I have yet to see someone move without spending a dime. You’ll have initial, and often unexpected, costs associated with moving and preparing your new home for occupancy.
You can see why many people have trouble coming up with the initial cash–the list is long and expensive.
How has the economy changed the cash you’ll need? While it’s true that as a percentage of cost, you need more money than ever (banks are requiring more down, more up front), as prices continue to fall the scales seem to balance out.
It’s (Mostly) About The Income
Besides the need to have a lot of cash, your income is probably the most important determining factor in how much house you can afford.
No-income-verification loans are a thing of the past. You’ll need to show steady income over the last several years, in the form of pay stubs and tax returns. Bless you if you’re self-employed–you’re in for a ride as well. Not only that–based on what I’m hearing, working in a “high-risk” industry will also tag your application. It’s hard to be “perfect risk” these days.
So how do you know if you’re earning enough, and what the bank says you can afford? The standard in the past was to apply a series of ratios to your income to determine how much of your income could be used for servicing your home and debt. These “classic” ratios are (to my understanding):
- 28% front ratio: the percentage of your monthly income you can spend on housing costs, including taxes, insurance, and association dues.
- 35% back ratio: the percentage of your monthly income you can spend on all debt payments (calculated based on minimum payments), including child support.
During the housing boom, lenders were approving applicants with 35%+ front ratios and 50%+ back ratios. Is it really a surprise that many of these applicants are now having trouble meeting their obligations to the bank?
So how can you figure out what your bank will say? Well–you can ask them. In your preliminary calculations, assume the “classic” ratios. If you make $4,000 a month of gross income, that means you can afford about $1,120 in housing costs and an additional $280 in debt payments ($1,400 total).
Massaging Your Credit
In the “big three” of home buying, credit is the other factor in being able to secure a home loan. When you hear the word “sub-prime” being throw around, people are simply talking about loans that were made to less-than-optimal credit holders.
What’s considered optimal these days? Credit scores of 700+ are a good start, but many banks will be as strict as requiring the golden goal of credit–760 and above.
I’ve written about the various components of your credit score before–paying bills on time being a significant portion and one you can’t change “overnight.” That’s why if you plan to buy a home, you have to take the “big ship” approach to preparing–small changes long ahead of when you think you’ll need the effects. It takes a long time to turn the credit ship.
While credit history and credit score are big components of your application, your active credit will be as well, for the reasons I talked about in the income section. Having a higher level of current debts will increase your ratios and prevent you from taking on the home loan you’d normally qualify for. So make sure that while you care for your score, you also consider paying down consumer debt–which should help your score in the process.
Pre-qualifying and pre-approval used to be optional ways to make your home search look more legitimate and give you additional bargaining power when making offers to buy.
I don’t believe that’s the case right now, with two big changes:
- Realtors and sellers are looking for reassurance that buyers have reviewed their financials with a bank and have any chance of getting approved.
- Banks who issue pre-quals/approvals are backing out on their offers in the application process when they really evaluate your application. Bummer.
What can you do? Find a bank that will treat you honestly (no really, I’m not kidding, heh) and have an open conversation. Lay out your own situation in black and white terms and don’t try to exaggerate your own realities. The more information your banker has to work with up front, the more likely you are to get an accurate pre-approval that actually means something when it comes time to close.
And make sure you do get that pre-approval before you go out searching for a home. When the right one comes along, you want to be sure you can afford it and have the documents to back up your offer available immediately.
As little as three years ago, real estate prices were climbing at an incredible pace. The word on the street was “buy now or you’ll miss out.” The common consumer felt rushed and pressured into getting whatever they could get their hands on.
The recession caused the opposite to be true. The word on the street was “don’t buy, prices are going to keep tumbling.” And down they went, month by month. The common consumer felt scared to enter the market for fear that their new home would continue dropping in value.
What’s the story today? Much of the caution is still out there, but more and more people are dipping their feet into the pond to test the waters. Generally speaking, prices continue to fall even as the number of sales start to pick up. That’s good news for the real estate industry, but still bad news for home buyers.
Trying to time the market perfectly is not so much an exact science as it is an art. By definition, only one person in the world will buy at the true “bottom” of this mess. Everyone else will hopefully fall somewhere close. If you’re in the market to purchase now–it’s probably a good idea. If you can’t afford it yet–I think you’re in luck, too. I seriously doubt we’ll see any kind of run-up with the kind of trigger fear and inventory out there right now.
No discussion of today’s economy and home buying would be complete without a discussion of jobs. After all, income is a big determinant of your loan approval, but after you close on the house–you’re on your own. If your income drops and your payments stop going out, the bank’s coming after you.
If you’re not currently working (or one of you isn’t that previously was), this might be a no-brainer. You simply need to wait until the economy resolves itself and you get back on your feet. It’s hard to buy a home with limited income.
If you are working, things are a little harder, ironically. You have the odd and unpredictable job of trying to figure out the likelihood that you’ll continue working and do so at the same or similar level of salary and for the next few years (assuming it takes that long to re-build a good savings cushion after dropping for your down payment).
Trying to predict the future, as far as I know, is beyond my own abilities. So we’re left with guessing, and the importance of leaving yourself options – enough breathing room to make changes and react when things head south. Giving yourself options is so important that I’m writing an eBook about it. Not kidding.
Putting it All Together
This list might seem overwhelming to the first-timer, but it’s really not all that complicated. The rule of thumb I’ve always kept in mind is: Get your finances in tip-top shape, and you’ll probably get a loan. If you would lend to you, the bank might too.
Remember the golden rule of loaning money–banks like people who don’t need the money, not those who do. Obviously, most of us can’t buy a home for cash, so we all need the money on some level. But if you’re desperate for a loan, it will show, and whatever you’re trying to hide will very likely be a bright red flag in your file.
If you’re looking to buy a home in today’s opportune real estate market, more power to you! May the winds of bank lending be favorable.
11 thoughts on “The Path to Home Ownership”
Great post, Wojciech! We took the homeownership plunge this year, and the timing was both great and bad.
My daughter was born in February and we were starting to outgrow our 2 bedroom apt (I work at home in the 2nd bedroom), so we were casually looking. A townhouse that had been under contract came back on the market more than 10% cheaper than its last listing price, and its price fit into our budget. Of course, I wasn’t completely aware of the high closing costs — another 3 or 4 percent — but we made an offer and it was accepted.
A few weeks later, I got laid off. It wasn’t fun. A new baby, a one income household, and now a mortgage. But we had emergency funds built up, and were able to take advantage of the extra $8,000 first time homebuyer credit. I would have rather used it to finish paying off my school loans, but when you need it, you need it.
Now I’m recently re-employed and waiting to pocket as much money as I can to prepare for any other emergency — and household related problems. They happen, and we’ve yet to have a big one … so I know it’s somewhere down the line.
I’m glad to hear things worked out and you’re back on your feet. It’s a good thing you had some money stashed away, too!
The closing costs were unexpected for us too, and it definitely affects your readiness to buy. Sometimes, we’re so eager to jump the gun that as soon as we have a down payment, we go for the kill.
People forget that houses need to be painted, A/C’s replaced, roof leaks repaired, etc…
And as a two time home buyer, both at 0% down do everything in your power to have 20% down before you even think about buying that house. Don’t be lured into the “If I don’t now, I never will” house fever. If I had been smarter in my earlier years I’d be in a much different place then I am now with no equity on a house with two mortgages.
Thanks Paul! Part of the reason I like the two-step approach (land & build) is because it would let us put a lot of equity into the land before even having to start construction (potentially even paying it off completely).
A great post. Thank you for walking through your past experiences so we all could learn from it. You mention banks throughout the post. What is your take on mortgage brokers? Did you only go to a bank? If so, why?
We looked at several banks (3-4) as well as a mortgage broker. We had good and bad experiences with banks, and a generally good experience with the mortgage broker. In the end, the loan was being processed through a bank.
I really don’t have an opinion either way on brokers, and I think they can be a great way to find a wide range of financing options and walk you through the process. However, I am concerned about who pays their bills at the end of the day and whose interests they are protecting. If we went that route, I would be sure to do my research and pick the product I think is right for me (with their help, of course).
Excellent post, Wojo.
One suggestion: Whenever possible, before closing on your house, I would recommend setting aside 3 to 6 months worth of mortgage payments in a special account to handle periods of job loss or extended illness. It’s a whole lot easier to save the money and establish this emergency fund *before* you buy your house.
Len Penzo dot Com
I completely agree, Len. It’s much easier to live “ahead of the curve” that to try to catch up to it all the time. Patience is difficult, but important.
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