Purchasing a home is often far-and-beyond the largest financial commitment that we will make, and one not to be taken lightly. In most cases, the purchase will involve a substantial down payment and the need to borrow a large sum of money to complete the purchase. Add to this the time, energy and stress that invariably accompanies a major purchase, and it’s easy to see how the pleasurable pursuits of visiting open houses and contemplating design schemes are quickly replaced with the cold reality that credit scores, mortgage applications, and cooperative board packages provide. Keeping your Cortisol levels in check requires a detailed plan of action that progresses through every important phase of the home-buying process.
Phase 1: Building the foundation
At this initial stage, it’s important to ensure that you have built the proper financial foundation, and it doesn’t get more basic than checking your credit. While an abundance of credit-monitoring options are available, reviewing the raw data that is used to compile your credit score is a critical first step. The Fair Credit Reporting Act requires each of the three major credit reporting agencies- Experian, TransUnion, and Equifax- to provide a free copy of your credit report, at your request, once every twelve months. Get started by requesting a copy of your reports and carefully review them. If you find errors, the Federal Trade Commission website provides an excellent step-by-step guide detailing how to dispute them.
Understand the score
The information contained in your credit report is the foundation of your credit score. While there are several credit scoring methodologies in use, the FICO score dominates the market and is used by the overwhelming majority of banks to assess your risk as a borrower. The FICO methodology is proprietary, and thus secret, but the following components and weightings have been published by the score’s provider and serves as a guide for how your score is determined.
- Payment history: this comprises 35% of your score and focuses on the repayment of past debt. The score considers revolving debt (credit cards) and installment loans (mortgages and other loans paid over a period of time). The formula is slightly tilted toward installment loans, though paying all of your bills on time is essential to maintaining or improving your score. In contrast, bankruptcies, liens, judgments, settlements and late payments can have a detrimental effect on your score.
- Amounts owed: also referred to as credit utilization, this category comprises 30% of your score. Calculated as the percentage of available credit being used, the FICO score favors borrowers who use a small portion of the credit available to them and penalizes those that consistently utilize the maximum amount of credit on offer. The score considers revolving debt (credit cards) and the amounts remaining on installment loans, the number of accounts with a balance and the mix of revolving and installment debt. Maintaining low credit card balances and paying them on time helps to ensure a healthy credit utilization ratio, as do increases in your credit limit that remain unused.
- Length of credit history: this category makes up 15% of your FICO score and focuses on how long your credit or installment accounts have been opened. This category considers both the average length of time the accounts on your credit report were opened, and the length of time that the oldest account on your report has been opened. While this component works against those with a limited credit history, the consistent and responsible use of credit can help build your credit profile. In contrast, those with a long credit history should be careful when canceling credit cards that have been opened for a long time.
- Credit mix: the specific combination of credit cards, retail accounts, and installment loans comprises 10% of your FICO score. Though not a significant factor in your score, a balance of revolving debt and installment debt with a history of on-time payments can help improve this part of your credit profile.
- New credit: this category comprises the final 10% of your FICO score and includes the opening of new credit accounts (revolving or installment), which can have a detrimental effect on your score. Soft inquiries, such as checking your credit report, or having your credit checked by a prospective employer are not considered in your FICO score. Those making credit inquiries to a bank- i.e., rate shopping, should note that all such inquiries made within a short window of time count as a single inquiry and should not materially impact their score.
There are different versions of your FICO score, and new ones are added to accommodate the needs of lenders. Mortgage lenders tend to rely on the classic versions of the score with the familiar range of 300-850. A FICO score of 750 or higher is considered excellent and will help ensure you obtain the most favorable terms possible on the type of loan you apply for. A critical part of your foundational planning should include steps to enhance and maintain a favorable credit profile, as a small difference in rates can have a dramatic effect on your cost of borrowing.
Phase 2: Save baby save
Put some money in the bank because you’re going to need it. In many cases, a down payment of 20% of the purchase price is required to avoid the need for private mortgage insurance. Those qualifying for loans through the Federal Housing Administration (FHA) can put down as little as 3.5% and may benefit from their more liberal underwriting guidelines. These benefits, however, do not include waiving PMI. The Veterans Administration (VA) also provides loans and these come with a slew of benefits, including zero down payment in some cases, and no PMI.
Availing yourself to programs that help circumvent the need for a large down payment can be a boon to those that qualify, but the need to maintain a healthy cash position extends beyond funding a down payment. A cash cushion will be necessary to help you pay closing costs, which on average cost between 2% and 4% of the purchase price, but can vary based a variety of factors.
From a practical perspective, lenders look favorably upon those with a healthy cash position when it comes time to extend credit. The extra cushion demonstrates your budgeting prowess and may help allay concerns about running into financial difficulty after the loan closes. For conventional loans, plan to maintain 3-6 months of mortgage payments in cash. Jumbo loans, larger loans that do not conform to the guidelines of Fannie Mae and Freddie Mac, require correspondingly larger cash reserves. In the case of jumbo loans, a range of 6-12 months of mortgage payments may be needed.
Finally, consider the reality that new homeowners may incur a slew of unexpected costs. Hiring a good home inspector may help you steer clear of purchasing a money pit, but even routine costs related to maintenance and upkeep can easily run into the thousands of dollars. Budget adequately for unexpected repairs to your new home, as well as any costs related to moving, furnishing and designing your new abode.
Phase 3: Know how much you can afford
In certain locations, average home prices have become increasingly disjointed from local wages, resulting in a lack of affordable housing. The story is quite different in other places, where prospective buyers face much lower barriers to homeownership. Regardless of location, it’s important to have an understanding of just how much you can afford to spend on housing each month, without torpedoing your budget. There are two schools of thought on this topic: housing ratios and budgeting.
Residential real estate financing relies on ratios of your income to expenses when evaluating whether a borrower will qualify for a loan.
- Housing Expense to Income Ratio: measures the future monthly housing expenses (loan principal and interest plus taxes, insurance, association fees and other ongoing housing-related expenses) as a ratio of your gross monthly income. To calculate this ratio, add up your housing costs (ignoring current rent or mortgage if your current home will be sold and the loan repaid at closing). This is the numerator. Now add up your total monthly gross income, plus or minus alimony. Divide your monthly housing-related expenses by your gross monthly income and multiply by 100. The ratio should be at or below 28%.
- Debt to Income Ratio: this ratio seeks to measure total expenses to income, so it expands upon the housing to income ratio by including your total monthly debt. Numerically, it is the sum of your total debt payments (housing costs, minimum credit card payments, loans, child support and alimony) divided by your total monthly gross income. The debt to income ratio should fall at or below 36%
Maintaining an accurate and up-to-date budget often provides some unintended benefits, and is especially important when contemplating a major purchase. In compiling your budget, use after-tax monthly income, as this accounts for tax withholding, workplace insurance benefits, and retirement plan contributions. Ideally, an allocation of 30% or less of your after-tax income should be your target. Although a budget will generally yield a conservative result when compared with the housing and debt-to-income ratios, the power of budgeting is that it uses after-tax numbers, which is consistent with how people actually spend their money. A simple, but helpful, rule of thumb is to allocate 20% of your income to savings, 30% to housing and the remainder to cover non-housing debt repayment and living expenses.
Phase 4: Setting parameters and neighborhood reconnaissance
Now that your foundational planning is underway, it’s time to begin your fact-finding mission. Before you hit the bricks, however, it’s helpful to begin thinking about what your new home must have, and where you are willing to be flexible. Your reconnaissance missions will help confirm whether your must-haves are compatible with your budget.
Consider the type of home you’d like to own, whether an apartment, freestanding home, or townhouse and what size it needs to be to accommodate your needs. If you’re planning a family you may opt for additional space, while empty-nesters may seek to downsize.
Location is a critical factor in any real estate purchase, so take time to identify what’s important to you in a neighborhood and what you’re willing to live without. Families with young children may opt for a suburban location with excellent schools, while urban living is a goal for many others. Take time to evaluate neighborhood amenities, transportation options, geographic features, and the proximity to your office and other places where you’re likely to spend significant amounts of time. Visit several neighborhoods at different times of day, and spend some time visiting the parks, shops, and restaurants that you may get to know well if you become a resident.
The size and age of a home, number of bedrooms, and special architectural features are often a source of conflict that may be mitigated with some planning. The charms of a pre-war coop may yield to the convenient layout of a more modern building. A fixer-upper may be ideal for those with skills in construction and design- and an abundance of free time- but intolerable to the overworked Urbanite that has little interest in becoming the next HGTV star.
Taxes, maintenance, insurance, and upkeep are also important considerations and are all too often overlooked. In fact, many first-time home buyers spend little time evaluating these costs before settling on their dream home. Before you become enthralled with that spacious split-level Victorian overlooking the lake, think about the property tax bill, flood insurance, and the army of landscapers that will be needed to keep the crabgrass at bay.
Phase 5: Mortgage basics, and pre-approval
Unless you have very deep pockets- or someone with very deep pockets has taken a shining to you- if you’re a first-time home buyer, you will probably need to secure a loan to purchase your dream home.
Extolling the niceties of a 7/1 ARM is not the objective of this endeavor. Understanding mortgage basics and the types of loans and lenders that are most suitable to your needs is. To help focus your energy, consider how much you’ll need to borrow, how long you are likely to own your new home, and whether you are eligible for special loan programs such as those available through the Federal Housing Authority (FHA) or Veterans Administration (VA).
Loan sizes come in two sizes: conforming and jumbo, and it’s helpful to know which one you’ll be shopping for. As the name suggests, conforming loans are those that fall within the limits established by Fannie Mae and Freddie Mac. Fannie and Freddie, as they are known, are the two government agencies that purchase mortgages that are then bundled together, securitized and sold to investors. For 2018, in most locations, the maximum conforming loan limit for a single-family home is $453,100. In higher-cost markets, such as New York and San Francisco, the limit increases to as much as $679,650. These are evaluated and adjusted for inflation each year. A jumbo loan is a loan that exceeds the conforming limits and is thus not bundled and sold to Freddie Mac or Fannie Mae. The underwriting standards for these larger loans are generally more stringent because of the additional risk involved.
Another important consideration is whether you want a fixed-rate or an adjustable rate loan. As the name suggests, a fixed-rate mortgage has a set interest rate and the monthly payment will remain consistent for the life of the loan. While the monthly payment remains stable, the amount of your payment allocated to principal and interest will change over time. In the early years of the loan, the lion’s share of your payment will be allocated to paying loan interest, with a larger percentage being allocated to principal repayment as the loan draws closer to maturity. Thus, the amount of mortgage interest you pay will be higher in the early years of the mortgage and will decline over the life of the loan.
Adjustable rate mortgage loans (ARMs) have an interest rate that is subject to change at established intervals. The loan will often begin with a fixed rate of interest that is lower than a comparable fixed-rate loan but will be subject to an adjustment every year after the fixed period expires. For example, a 7/1 ARM with a 5/2/5 cap carries a fixed rate of interest for the first seven years and has fixed principal and interest payments during that term. Once per year, beginning in year eight, the loan is subject to an adjustment. The loan includes a cap, which ensures that your rate cannot exceed a stated maximum. To finish our example, in year eight the interest rate can increase by a maximum of five percentage points above the initial rate, and every year thereafter the rate can adjust by a maximum of two percent. The interest rate, however, can never increase by more than five percent over the life of the loan, which represents the loan’s cap. Adjustments to the rate are based on the changes in an underlying index, such as the London Interbank Offer Rate (LIBOR).
Adjustable rate mortgages may be appealing to those seeking a lower initial interest rate and plan to sell their home, refinance or repay the loan if the rate is subject to a material adjustment. The average length of time that a homeowner remains in their home is approximately ten years so a seven or ten-year adjustable rate loan may be a compelling option for some buyers. Fixed-rate loans provide a stable interest rate and reliable payments and are often the default option for many buyers. Keep in mind that you pay for that stability with a higher rate of interest.
A final consideration concerns whether to opt for a government-insured loan or a conventional loan. The conventional loan has no underlying insurance and represents the majority of the loan marketplace. Federal Housing Administration (FHA) and Veterans Administration (VA) loans are government-insured loans that are available to borrowers that meet specific guidelines. FHA and VA loans have lower down payment requirements and liberal underwriting guidelines, which can help borrowers with less than stellar credit or minimal liquidity to buy a home. An FHA or VA loan may sound like a great deal, but each loan has its own unique set of pros and cons. A seasoned mortgage professional can help you sort through your options.
Understand the difference between pre-qualification & pre-approval
Now that you’ve done your mortgage research, it’s time to begin the process of obtaining a loan pre-qualification or pre-approval. Depending on where you are in your decision-making process, one may be preferable over the other. A pre-qualification is simply an estimate of how large a loan you may qualify for based on a cursory review of your finances. A pre-qualification may be beneficial for those that are in the process of accumulating additional funds for a down payment- or otherwise would like a gut check as to whether the loan terms that they think that they will qualify for are likely to come to fruition. Serious buyers will generally opt for a mortgage pre-approval letter.
A mortgage pre-approval is a letter from a lender indicating the amount of loan you can qualify for and is issued only after an evaluation of your financial history. A pre-approval letter signals that you are a serious buyer and have a mortgage lender that has evaluated your finances, and is willing to work with you to secure a loan. It’s important to note that a pre-approval is not a guarantee that you’ll qualify for a mortgage, and there is no rule that says that you must apply for a mortgage with the same lender that issued your pre-approval letter. It’s generally wise to speak with several lenders in advance and understand the type of loans available so that you can cull the field of lenders to a manageable few. A mortgage broker- i.e., one that works with many lenders- can be a valuable resource on this front.
Phase 6: Shopping!
Now the fun begins. Armed with your mortgage pre-approval letter, monthly budget and the information gleaned from your reconnaissance missions, it’s time to get your home shopping on.
Before you begin, there’s one additional decision to be made: namely, whether to hire a real estate agent or go it alone.
A large majority of home buyers do opt to work with a real estate professional to help them in their search. Agents can help address some of the issues of asymmetrical information that can plague real estate transactions- i.e., they know more about the home buying process and can provide guidance on pricing and whether that neighborhood or home you love is all it’s cracked up to be.
While a good real estate agent can be well worth the price, one with misaligned incentives can make an already stressful process unbearable. The key to hiring a real estate professional is to understand their incentives and help ensure that they align as closely with yours as possible. Begin with a discussion about whether the agent in question is a listing agent, a buyers agent, or both.
Simply put, a listing agent represents the interests of the seller while a buyer’s agent represents your interests. And in some cases, the same agent may wear both hats. An exclusive buyer’s agent represents only the buyer’s interests and is the sort of relationship you should look for when seeking professional guidance. A buyer’s agent can help identify appropriate properties, including some that you may not have had access to without their assistance. In terms of incentives, the buyer’s agent is paid a portion of the commission, often splitting it with the seller’s agent. The buyer’s agent’s incentive is to turn you into the buyer of a home, but not the buyer of a specific home. In contrast to a seller’s agent or dual agent, the incentives of the buyer’s agent are more closely aligned with yours.
At this stage, you are a very well-prepared buyer and your thoughtful pre-game preparation is likely to pay dividends. In your search, focus on properties that fit within your established parameters. Avoid condemning a property because of ugly carpet, outdated fixtures or other cosmetic issues that may be easily remedied. Your sights should, instead, be set on structural problems, shoddy electrical wiring or a roof that dates to the Reagan administration.
Ask your agent if they’ve visited the homes they are showing you and request an MLS printout of comparable properties in the area. Be prepared to take notes during your tour and limit the number of properties visited to a manageable few.
When you identify a home that you’d like to buy, put forth a well-informed offer. First, consider whether the property is likely to receive multiple offers and is fairly priced. If you’re planning to buy a desirable property in a desirable neighborhood proceeding with a low offer may work against you. Rely on your buyer’s agent for assistance with formulating an offer, that’s part of the value they provide. If you’re buying a fixer-upper or operating in a buyer-friendly market, a low initial offer price may be entirely appropriate.
Be prepared for multiple offers. If you like the home and it’s attractively priced, there’s a good chance that someone else will be bidding on it. Review your budget and the anticipated costs associated with closing to determine your highest offer. Don’t shy away from multiple offers, but be prepared to walk away if the price materially exceeds your budget.
If your offer is rejected, expect the seller to issue a counteroffer. If the seller counters at full price, continuing to negotiate may still be fruitful. You may wish to stack the deck in your favor by telling the seller why you want the home and give them a reason to want to sell the home to you. Real estate transactions can be fraught with emotion, and presenting a compelling narrative to support the purchase just might help you secure the keys to your new abode.
If your offer is accepted, the process moves to the final phase.
Phase 7: Closing
When your real estate agent delivers the good news that your offer has been accepted by the seller the real work begins.
A contract for sale will need to be drafted and reviewed by your real estate attorney. If you don’t have an attorney, ask your buyer’s agent, mortgage banker or professional advisors for a referral. Among other things, the contract should set forth whether a home inspection is allowed and the time frame for conducting it. If the contract includes an inspection contingency, the buyer may be able to back out of the contract or renegotiate the sale price. The devil is in the details, so be sure you fully understand the terms of the contract.
Assuming the home inspection does not turn up any major defects, it’s time to contact your mortgage banker or broker and settle on a loan type and prepare to lock in an interest rate. It’s generally best to do this thirty to forty-five days before your closing date. In addition, ask your lender for a detailed list of closing costs and review them. Be prepared to question charges for incidentals such as photocopying and parcel delivery that are not agreed upon in advance.
As you move through this process, your buyer’s agent and attorney should work with you to schedule a final walk-through and finalize a closing date. The final walk-through affords you the opportunity to make sure everything is in working order. If you find anything that is broken or missing, you may be successful in negotiating a closing credit.
The closing date is where the home buying process reaches its conclusion. The process will be facilitated by a closing agent, who is a neutral third-party and whose job is to ensure that the proper documents are signed and the contract is properly consummated. Depending on your location and specific situation, your attorney or buyer’s agent may attend the closing, and some states require that an attorney be present at closing.
At closing, you’ll sign a mountain of documents and exchange large sums of money. Have a good breakfast. Be sure to ask your attorney for a checklist of items that you’ll need to bring with you and what you’ll be expected to sign. If you have questions related to anything you are signing, do not hesitate to ask the closing agent or your attorney for an explanation. Decide in advance how the property will be titled (individual name, joint tenancy with right of survivorship, tenants-in-common, etc). If you’re uncertain of how your new home should be owned, consult with your accountant, financial planner or attorney to discuss the advantages and disadvantages of each.
When the closing is completed, you’ll leave the closing agent’s office with a slew of documents, sore wrists, and the keys to your new home. While the work is not entirely complete, you’ll move on to a more familiar process of moving into a new home. Good luck with that.
John Male CFP®, RICP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
9 East 40th Street, 5th Floor
New York, NY 10016
T| (212) 221-7067 Ext. 113
F| (585) 625-0830