How To Get Started Buying A House
There is a lot to consider when it comes to buying a home. How much can I afford? How much should I put down? What questions should I ask my agent and the seller? How do I get preapproved? The list goes on.
These are all good questions that I will unpack in due time. Disclaimer up front that I am not a certified real estate professional. However, I do have experience with a few different home purchases in a few different ways (I’ll elaborate later). The more prepared you are, the less stressful the whole ordeal will be. I think a good starting point is a really high-level view of the home buying process. So let’s hop in.
The Home buying Process
At a most basic level, buying a home is a transaction between two parties where one side is exchanging their house for something of value from the other side, usually cash. There are always two primary parties involved: the buyer (party trying to buy the house) and the seller (party trying to sell said house). Simple enough so far.
In reality, there are many other people involved in portions of the process. Some of these people are on the “buyer’s team,” others are on the “seller’s team,” and still others are on “neither team.” Here’s a list of many of the other players that can be involved in the game:
- Buyer’s Agent
- Seller’s Agent
- Lender
- Inspector
- Appraiser
- Title Company
- Real Estate Attorney
- CPA
Know that not all of these people are a part of every house purchase but it’s helpful to be aware of these various people and what they do. As I walk you through the homebuying steps, these players will pop their heads up throughout.
Step 1: Understand Your Budget
This step is critical. Buying a home, especially your first one, is an emotional thing! My wife and I will forever cherish our first little home with its high ceilings, curved archways, and original wood trim. It’s perfectly normal to let your emotions be involved in this process. However, you need to balance your emotions with rational thinking and practical planning because you want to ensure that you make a decision that you can live with for a potentially long time. Here’s the situation you want to avoid:
Avoid becoming house poor.
When your housing expense is disproportionately high compared to your income, it can put considerable pressure on your finances and emotional well-being. That is being house poor. Buying the $5 Starbucks latte will not sink you. It’s poor financial decisions on bigger ticket items like cars and houses that can put you in a bad spot. But you’re going to be smart about your life instead.
When I say you need to understand your budget, I’m really talking about two distinct aspects. First, there is the upfront cost to actually acquire the house. Following that, you must consider the ongoing financial obligation to pay off the loan and costs associated with maintaining your house (such as your monthly mortgage payment). Let’s delve into both of these areas.
How Much Can I Afford Per Month On A House?
I’ll start with looking at monthly costs first because that will impact how much money you need to put down to buy the house. A really important piece of the puzzle is knowing your debt to income ratio (DTI).
Debt to income takes all your monthly debt payments divided by your gross monthly income. Gross meaning the money you earned before taxes. When you do this, you’ll likely (hopefully) come up with a number less than 1. DTI is stated as a percentage so convert the decimal to a percentage by multiplying by 100. That might not make any sense at all so here’s an example:
Let’s say you make $4,000 per month before taxes (gross). Let’s also say per month you pay $150 for student loans, $200 for a car loan and $100 on credit card debt (hopefully not). That would put your total debt payments at $450. Take the $450 and divide it by the $4,000 of income and that makes your DTI equal to 0.1125 or 11.25%.
Why does this matter? DTI matters because most lenders set a limit of what they are comfortable lending to you based on that ratio. In general, lenders are comfortable with you borrowing up to an amount that would put your DTI ratio at around 45% (sometimes more or less than that). So if you want to estimate the max amount you could borrow per month for a house, take your income multiplied by 45% and then subtract that number by your current debt payments. Back to our example:
You know your income is $4,000. Multiply the $4,000 by 45% which gives you an amount equal to $1,800. This is roughly the total debt payment per month a lender would be comfortable with you having based on your income level. Keep in mind though, we haven’t factored in your other debts. You need to subtract the $450 of other debts from the $1,800 to get to a good quick and dirty estimate of what monthly house payment the lender would be comfortable with you paying. In this example, that amount is $1,350.
Now it’s important to note that this amount is just what the lender is comfortable with. This does not mean it is the right payment amount for you to be paying each month. Conventional wisdom suggests that your total housing expense should be somewhere between 25% – 35% of your income depending on who you ask. The $1,350 housing payment in our example would be 33.75% of the $4,000 monthly income. Definitely on the higher side of the advisable range but that’s up to you to decide for yourself. Let’s stop for a moment and talk about what makes up a monthly housing or mortgage payment.
What Makes Up Your Mortgage Payment (PITI)
Another acronym for you: PITI. PITI stands for principal, interest, taxes, and insurance. These are the core components that make up the mortgage payment. I’ll touch on each briefly.
Principal is the remaining amount of the loan itself. So if you took out a $200k loan, the initial principal is…$200k. You pay that down over time back to the lender.
Interest is additional money you pay to the lender as a reward for them lending you money. There is always a risk to lending out money to people, so the lender wants to be compensated for that risk. Over the life of a loan, you usually pay more interest than principal early on and then more principal than interest later. Lenders want to get paid first.
Taxes are assessed by local governments to pay for all the public services you use. Real estate taxes are calculated and paid on a yearly basis but lenders will collect payments monthly and hold the money until the taxes are due.
Insurance is similar to taxes in the sense that its paid annual/semi annually. The lender will collect monthly payments and hold it in an account (called an escrow account). The two types of insurance that could be included in that insurance number are homeowners insurance (which you need) and primary mortgage insurance (PMI) which I talk about in a later section.
Other Monthly Cost Considerations
While the PITI payment is what the lender is primarily concerned about, you still have to factor in other costs of owning a home. It would be naive to think “the monthly payment for owning this house is similar to my current rent so I’ll be fine.” First off, there are utility costs which includes items such as electric, water, and gas. That’s a couple hundred dollars right there.
Then there is the cost to furnish the place. Maybe you already have furniture from renting but do you have tools/equipment to maintain your house? Again additional costs there.
Even if you have all of those things, have you considered the cost of fixing issues that must be corrected? A major plumbing issue, roof damage, electrical problem, etc.
Do not be too discouraged by all those costs. My goal is not to scare you off but instead I want you to be prepared and have a realistic picture of the costs associated with home ownership. Yes, there will be costs that arise but that’s where you can lean on friends and family to help you out. Maybe you have a friend who’s super handy and you can offer to make dinner for an hour of their time. Instead of purchasing all new tools, find someone giving them away, or just borrow from a friend as needed. Get creative!
How Much Money Do You Need To Put Down On A House?
One of the most frequently asked questions about buying a house is “how much money do I need to put down?” The answer is it depends. Sorry that’s a cop out. I’ll elaborate.
I’ll change the question to how much should I put down? The answer to how much you need to put down could be zero. There are many ways to play the real estate game but not all ways are a good fit for every situation.
For most people, they are going to put down somewhere between 3% – 20%. There are pros and cons to every place along that spectrum. You’ve probably heard someone say “you need to put down 20%.” The main reason for this is that typically speaking, if you put down less than 20%, you may be required by your lender to pay for private mortgage insurance (PMI). Basically, you are deemed riskier to the lender since you have less of your own money in the house.
The cost of PMI varies but its typically a small percentages of the loan balance. Just as a ball park estimate, think $20 to $500 per month. Obviously a wide range but its very dependent on the house you buy. If you do put down less than 20%, you are not stuck paying PMI forever depending on the type of loan you get. Often, once you get your equity in the house to be greater than 20%, you can get the PMI removed. Guess now is a good time to talk about equity.
What Is Equity In A Home?
Equity is the difference between the remaining balance on your mortgage and the value of your home. The balance on your mortgage is the remaining principal and interest. The value of your home is a little more vague but it’s the amount that your house would sell for under “normal” conditions. The remainder is equity. We like equity. Quick equity example to reinforce the babbling:
You buy a house for $200k and put $20k down as a down payment. This means your beginning loan balance was $180k. Assuming you bought the place for what its worth and not at a discount from grandma, the value of your home or fair market value at the purchase date is the $200k you paid. Your balance on your mortgage related to the home is $180k and the remaining $20k is equity.
Now jump ahead 2 years. You’ve paid down some of the balance on your home so now the total mortgage balance is only $160k. You also bought in an up and coming area so now your house is worth $225k (that’s what you could sell it for). So 2 years later when you take the fair market value of $225k less the loan balance of $160k, that means your equity in the house has now grown to $65k.
Down Payment Vs Closing Costs
I’ve talked some about down payments but it’s important to bring up that there are other costs related to purchasing a home. We call them closing costs. Remember earlier how I said there were/can be a lot of other people involved in the homebuying process? Well they like to get paid too.
There can be a number of closing costs for both the buyer and the seller. We are focused on buying a home here but I’ll just mention that traditionally, the seller pays the commission fees for both the buyer’s real estate agent and the seller’s real estate agent. So you likely won’t have to pay your realtor as the buyer.
Often the largest closing cost line item to the buyer is related to the cost of getting a loan. Your lender will throw various fees at you that can be quite material depending on how big your loan is. You also might need to pay real estate taxes to the local government at closing. There’s also the title company. We will get into depth on them in a future post but the title company is the final piece of the puzzle. They verify that the property can actually be sold by who’s selling it and they act as the middle person for the final steps of the process. When it’s all said and done, closing costs can end up being several thousand dollars. A rough estimate range for closing costs is 2% – 5% of the purchase price of the home.
Know that many costs are negotiable. There’s also a number of assistance programs out there for first time homebuyers that can help with the down payment and or closing costs. Do not fret, I will provide all of this information to you in due time. Congrats on making it through step 1. Stay tuned!
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