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Buying your first home: What you need to know

At a glance:

You've decided to take the plunge into home ownership. When this is your first experience with the maze of issues involved in homeownership, the whole process can seem intimidating.

There is a lot to learn and a lot to do, but if you take each step one at a time, you will increase your chances of becoming a satisfied homeowner. One thing you should have is an overview of the nuts and bolts involved in becoming a first-time homebuyer.

How much house can you afford?

The idea of buying your first home can be intoxicating and intimidating at the same time. You are embarking on a journey down an unfamiliar road, so the first consideration is what you can afford to spend on a house.

How can I afford a home?

Consider this from a couple of different angles:

  • How much of a monthly payment can I afford?

  • What savings do I have available for a down payment?

  • How do I plan to cover other expenses such as the earnest money deposit and closing costs?

Some housing-related numbers you should know

The rule of thumb for monthly payments is that they shouldn't exceed 25 to 30 percent of your monthly gross income. Monthly payments include your mortgage principal and interest, real estate taxes, mortgage insurance, and homeowners' insurance, so be sure to include these if you are running your own numbers.

As for down payments, they range from nothing to 20 percent or more, with most buyers falling in between these two extremes.

Manhattan has some of the most expensive zip codes to live in. (Graphic: David Foster/Cashay)
Manhattan has some of the most expensive zip codes to live in. (Graphic: David Foster/Cashay)

Here are some other useful percentages: your total housing costs shouldn't consume more than 32 percent of your gross monthly income.

When you've been renting, it has been easy to underestimate the ongoing costs involved in homeownership, which range from simple and fairly inexpensive matters such as calling the plumber to unclog your sink to the budget-busting cost of putting on a new roof.

And your total debt load — including car loans, student loans, credit card debt, etc. — shouldn't exceed 40 percent of your gross monthly income.

What the numbers will look like

So, if you and your spouse have a combined gross income of $50,000 a year, the numbers work out like this:

  • Monthly payments between $1,041 and $1,250

  • Total housing expenses not to exceed $1,333

  • Total debt load not to exceed $1,667

These are important numbers, because they are the ones that lenders will come up with when you start asking about getting pre-approved for a mortgage. A mortgage pre-approval means that a lender has checked you out and made a commitment to offer you a mortgage for a certain amount based on your financial situation.

What is a FICO score and why is it important?

Just because you want to buy a home doesn't mean that a lender is eager to loan you money. Lenders look at your past history in handling your finances, which is where the FICO score comes in. By the end of this article, you will be able to identify a good FICO score and how it was determined.

What your FICO score is made of

The FICO score boils your credit history down to a three-digit number that instantly tells a lender whether you are creditworthy. This score dictates what terms — if any — you will be offered in a mortgage. Pioneered by the Fair, Isaac Corporation, this score and similar ones used by other credit reporting services rely on the following factors:

  • How much you owe compared to how much you originally borrowed

  • Your payment history

  • How long you've had credit

  • What types of credit you have

  • New credit applications

Past payment history and outstanding debt are the two biggest factors in computing a FICO score. If you've consistently made loan payments after the due date and are using a large percentage of the credit available to you, that's bad. However, if you missed a car loan payment once three years ago, don't fret. Smaller blemishes, especially if they aren't recent, aren't enough to derail your FICO score.

The score favors borrowers who have a mix of different types of credit, including installment loans such as car and student loans, as well as credit cards. The longer you've had credit, the better. If there is a record of a number of different applications for loans or credit cards in the recent past, that will count against you.

Why you should have a good FICO score

The average FICO score falls between 600 and 800, with the median close to 720. The overall range is 300 to 850. Your FICO score makes a huge difference in terms of what interest rate you are offered on a mortgage. For example, a consumer with a FICO score more than 720 could get an interest rate nearly 2 percentage points below a consumer with a score below 620.

That 2 percentage-point difference translates into a much more painful payment — on a $200,000 loan, it would be about $300 a month. One way not to get gob-smacked by a poor FICO score when you're in the mortgage lender's office is to pay a small fee to get yours in advance.

Through Fair, Isaac (www.myfico.com) you can obtain a copy of your FICO score plus credit reports from the three major credit reporting bureaus for a small fee.

Hiring a broker or buying a home on your own

The decision to hire a real estate agent when you're buying a home isn't the no-brainer it once was. In the early 1990s, the question was, Which agent should you go with?, while the question now is, Do you even need one?

The comforts of going with a realtor

When you are new to the world of home buying, signing up with a realtor can be comforting. You know that the realtor is experienced in navigating the complexities of the home-buying experience and that he or she can save you some time by going through your area's Multiple Listing Service (MLS), selecting homes that meet your needs and scheduling appointments to view them. The MLS is a database of homes available for sale in a particular area.

Things to remember about using a real estate broker

If you decide to go the realtor route, don't pick just anyone. This is business, not friendship, so you want the best because it will cost you money — not directly, but the commission will be built into the price of the home you ultimately buy. While brokers' commissions are more subject to negotiation than they used to be, 6 percent is still standard in most areas, with the buyer's and seller's agents splitting that take. Before you sign a contract with an agent, interview several. Ask about their experience with the type of home you're interested in, their customary commission rates, what services they provide, how long they've been in the business, how many homes they've sold in the past year, etc. Read the contract closely before you sign it — there may be clauses that bind you to this agent for a specific period of time and other things that you may not like.

You could also go it alone

The alternative to going with a realtor is the do-it-yourself route, where you figure out what you can afford on your own, scour the local paper and Internet for suitable homes, and go shopping.

The Internet is a great place to shop for homes because many "for sale by owner" (FSBO) homes appear on these sites, with photos and information about the house that will help you narrow your list of homes you actually end up viewing.

You can save money buying an FSBO home because the traditional commission isn't built into the asking price, but there is only so much you can expect to save, because the seller wants to come away with more profit. Should you choose this route, don't skimp on crossing the I's and dotting the T's in terms of legal issues — it may be wise to spend the money and hire a competent real estate attorney to make sure all your paperwork is in order.

How to find suitable homes you can afford

When you make the decision to buy a home, it's as if blinders are lifting. As you drive to work, or the store or the gym, you notice all the realtor and FSBO ("For Sale by Owner") signs that are all over town.

The prices, the options, the floor plans and everything else can make you dizzy, so refine your wants and needs and what you can live without before you actually start looking. And this is NOT Valentine's Day, so don't fall in love with a particular house.

Be especially careful if you are working with a realtor, as they have a tendency to "up-sell" you into a house that you may love but can't really afford. There's nothing for them to lose by this endeavor, because the higher the house price, the more they make in commissions. Just remember — you will be the one paying the mortgage and the associated bills.

What do you really want in a home?

When house-shopping, must-haves are all well and good, but don't get too picky. While it is fine to reject the house with the orange shag carpeting, you can't expect everything to be exactly the way you want it. Make a list of what you are looking for and consider these issues as you work on it:

  • Number of bedrooms

  • Number and type of bathrooms

  • Size of yard

  • Style

  • Overall floor plan

  • Garage

  • Finished or unfinished basement

  • Porch

  • Closet space

  • Laundry area

  • Size and style of kitchen

  • Special features such as fireplaces, wood floors, vaulted ceilings, etc.

Location, location, location

Don't neglect the type of neighborhood you're looking for — if you've got small kids and end up in a subdivision with older folks, your kids will be bored and your neighbors less than tolerant of their youthful antics. Think about how long a commute you are willing to put up with and how convenient grocery stores, schools, gyms, parks, etc., are to the home.

Be as specific as you can with your preferences

If you're working with a realtor, you're paying him or her to find you suitable homes. So the more specific you are in articulating your wants, needs, and overall lifestyle, the better the job the realtor can do in matching your personality to the appropriate house. If you are on your own, the Internet is a great place to start looking, as is the local paper's weekend real estate section, and any for-sale homes you notice in neighborhoods that you like.

The purchase and sale agreement

When it comes to buying a home, once you get to the purchase and sale agreement, you're almost there. Your feet feel like they've walked through every house in town and you have finally found one that fits your budget and contains most of your must-haves. It is time to make an offer, a process that deserves careful consideration and comes with some legal strings attached.

The purchase and sale agreement is legally binding

When you make an offer in writing, you need to decide what price you want to offer for the home, whether your offer will be contingent upon anything (such as a home inspection), and what deadline you want to set for a response. Your offer is always accompanied by a binder payment — also known as earnest money — which is usually in the form of a check for $1,000 or so.

Read the purchase contract carefully before signing it, as this is a contract that is binding in court. If you don't like some of the terms or want to be sure that your interests are protected, ask for a copy of the contract and retain an experienced real estate attorney to review it for you.

What is in the purchase and sale agreement?

The seller may decide to accept your offer, reject it, or make a counter-offer. Once you have agreed on terms, it is time to review and sign the formal purchase and sale agreement, which typically contains:

  • The approximate closing date

  • What property — such as drapes, appliances, and lighting fixtures — is included

  • The real estate agent's commission

  • The amount of the buyer's deposit and where it will be held — usually in escrow (by a third party) — until the closing

  • The amount of the mortgage that the buyer needs to finance purchase of the house

  • Inspections that the buyer may want to make, such as a general home inspection and other inspections for radon, termites, etc.

  • Cost adjustments to be made at the closing, which can include points, property taxes, etc.

  • What happens if either the buyer or seller backs out of the deal

  • Any special conditions or contingencies, which could include the seller fixing a problem with the house, the buyer obtaining financing, a satisfactory home inspection report, or other items.

The purchase and sale agreement isn't always final

Most buyers breathe easier once the sellers sign the purchase and sale agreement, because the process is formalized and is in motion. However, it isn't uncommon for closing to be delayed due to one issue or another, such as a delay in the mortgage company processing your application or some other snafu. Occasionally, deals do fall apart at the closing conference table.

The closing is when ownership of the house passes from the seller to the buyer, so until the closing process is complete, the house isn't yours.

Paying careful attention to the purchase and sale agreement and other details of your purchase can mean the difference between a successful conclusion to your house-hunting journey and putting you back on the streets, starting all over again.

Summary of buying your first home

The decision to buy a home is one of the biggest ones you will ever make. Before stepping into the housing market, it is important to figure out how much house you can afford and whether your FICO score qualifies you for a competitive mortgage rate.

Savvy home buyers take some time to think about whether they should hire a realtor or handle the process themselves. Both alternatives carry potential risks and rewards. The final step in transforming your dream into reality involves crafting a careful purchase and sale agreement and moving the deal through the closing.

There are few experiences that equal the thrill of taking possession of your new home. By carefully working your way through the process, you will increase the likelihood that actually living in your new house will meet your pre-purchase expectations.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips our Buying/Selling a home section

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