Section 01 Budgeting for a new home
Figure out how much house you can afford
Before you start the house hunt, you’ll need to narrow down your price range. Knowing what’s feasible for your budget and income will help you focus your search on homes you can afford.
To help you start crunching the numbers, it's first important to know your debt-to-income ratio (DTI). This is how much you spend on debt payments each month (things like student loans, credit cards, car loans and — hopefully soon — a mortgage) divided by your monthly pre-tax income. So if your debt payments total $2,000 a month and your gross income is $6,000 a month, your DTI would be 33 percent.
Not only does your DTI show you what percentage of your income goes toward debt, but it’s also a figure used by mortgage lenders to determine how well you may be able to manage your monthly financial obligations — the higher your DTI, the riskier you appear to a lender.
Most financial pros recommend a DTI of 36 percent or less to improve your chances of being approved for a home loan or to get better loan terms. Many also advise that you spend no more than 28 percent of your gross monthly income on housing expenses. For example, if you make $6,000 a month, your monthly mortgage payment should be no higher than $1,680.
Using these benchmarks can help give you a sense for how much you can afford when you’re buying a home.
Prioritize your must-haves
Once you’ve identified a target price range, it’s important to think carefully about what you really want in a home. Put simply, what are your must-haves, and what are your nice-to-haves (the features that you'd like in a home but don't truly need)? Consider elements such as the number of bedrooms and bathrooms, square footage, school district, proximity to transportation and community amenities.
Your real estate agent can help you identify your key homebuying criteria as well as what trade-offs you may be willing to make between your list of musts and wants.
Another factor to consider is how long you plan to stay in the home, which could impact what you’re looking for. For example, are you shopping for a starter home — i.e., a smaller home at a lower price point, where you plan to stay for about three to five years — or a forever home, where you can put down roots and live long term?
Assess the full costs of homeownership
A number of expenses will impact your budgeting for a new home. Let’s start with the four that will make up your monthly mortgage payment: mortgage principal, interest, taxes and insurance (also known as PITI).
Your mortgage principal is the amount of money that you borrow from a lender to purchase a home. Every month a portion of your mortgage payment goes toward paying down your principal. As you pay down your principal, you gain equity in your home.
Mortgage interest is what a lender charges you to borrow money, and even a small difference in your interest rate can have a significant impact on your monthly payments as well as how much you pay over the life of your loan. Say you got a 30-year, fixed-rate mortgage of $300,000 at 4 percent interest. The principal and interest you’d pay each month comes to about $1,432. At a 5 percent interest rate, your principal and interest would go up to $1,610.
Property taxes can vary significantly depending on where you live and can change from year to year as your home value goes up or down. Currently, median property taxes range from 0.18 percent to 1.89 percent of a home's assessed value. You can find the latest property tax rates by state or county on Tax-Rates.org.
There are two types of insurance that may be included with your mortgage payment: homeowners insurance, which protects your house and its contents from fire, theft and other disasters; and mortgage insurance, which protects the lender against default (i.e., you’re unable to pay your mortgage).
Homeowners insurance is a good thing to have in case something goes wrong, and many lenders require it. If you put less than 20 percent down on a conventional loan, you’ll typically be required to pay private mortgage insurance (PMI). Homeowners insurance premiums can range from about $650 to more than $3,000 per year. PMI rates usually range from 0.55 percent to 2.25 percent of your loan amount per year, according to a report from the Urban Institute. If you do have to pay PMI, you can typically get it removed once you have 20 percent equity in your home.
In addition to your monthly mortgage, you may have to pay homeowners association (HOA) fees or condo fees for things like property maintenance, shared community features (e.g., concierge, gym, swimming pool) and landscaping.
Also, don’t forget about all the regular housing costs you’ll be responsible for, some of which you may not have had to pay as a renter. These can include utilities like gas, electric and water; trash and recycling pick-up; and internet and TV. These costs can vary widely depending on where you live, but here’s a rough idea of how much you can expect to spend:
a year for natural gas
a year for electricity
a year for water
a year trash and recycling pick-up
per month for cable and Internet
Section 02 Getting a mortgage
Choosing the right mortgage is crucial when buying a home, so you want to get familiar with how mortgages work. Get a firm handle in our guide to key mortgage terms and understand what your loan options are.
First, let’s take a look at two primary categories of mortgages and how they differ in terms of interest rates.
With a fixed-rate mortgage, the interest rate does not change over the term of the mortgage (usually 15 years or 30 years). This means it’s a great option if you want predictable mortgage payments for the life of your loan. A 30-year term will mean a lower monthly payment. While the payment for the same loan amount will be higher with a 15-year term, this type of fixed-rate loan means you gain equity in your home faster.
With an adjustable-rate mortgage, also known as an ARM, your interest rate will be variable over the life of your loan. You’ll have a set rate for an introductory period, usually anywhere between three and 10 years. After that, the interest rate will adjust on a set schedule. For instance, if you get a 7/1 ARM for 30 years, your rate will be fixed for the first seven years and will adjust every year thereafter for the next 23 years.
ARMs generally offer lower rates for their introductory periods vs. a fixed-rate mortgage, so if you know you’ll move before the introductory period is over, an ARM could save you money when buying a home.
Now let’s look at four of the most common types of home loans.
Conventional loan. This is a mortgage from a private lender that meets the funding requirements set by Fannie Mae and Freddie Mac, two government-sponsored enterprises that buy and guarantee mortgages on the secondary market. Typically, you need a credit score of 620 or higher and a down payment of at least 3 percent to qualify for a conventional loan.
FHA loan. Federal Housing Administration (FHA) loans, which were established during the Great Depression, are aimed at low- and moderate-income households. Down payments can be low as 3.5 percent, but you need a credit score of 580 or higher to qualify (although borrowers with a credit score of 500 to 579 can qualify by making a 10 percent down payment). The drawbacks: FHA borrowers must pay a one-time upfront mortgage insurance premium (UFMIP) of 1.75 percent at closing, as well as an ongoing monthly MIP, which can range from .45 to 1.05 percent of the loan amount.
VA loan. If you are an active or retired military member or a veteran’s surviving spouse, you may be eligible for a mortgage from the U.S. Department of Veteran Affairs. VA loans allow for a 0 percent down payment and offer low interest rates, and you don’t have to pay private mortgage insurance.
USDA loan. Loans from the U.S. Department of Agriculture Rural Development are offered to qualified borrowers (income limits apply) in towns with small populations. They offer relatively low mortgage rates and upfront fees, and annual mortgage insurance premiums are also lower than FHA loans. Borrowers can put as little as 0 percent down.
Prepping your finances
You’ll need to do a little prep work before applying for a mortgage. Start by checking your credit score, since mortgage lenders will look at your credit score (most likely your FICO score) to determine what your mortgage rate should be. Generally, borrowers with a credit score of 740 or higher qualify for the best mortgage rates.
You’re entitled to a free copy of your credit report from each of the three major credit bureaus (Equifax, Experian and TransUnion) at AnnualCreditReport.com. Your credit report doesn’t include your actual score — for that, you’ll have to pay a small fee — but it shows your credit history, including any blemishes like missed debt payments. There are also a number of free ways to get your score; in fact, many banks and credit card companies provide it to customers as a free service.
If your credit score isn’t quite where you’d like it to be, keep in mind that improving it could take several months or years, depending on your score. Be sure to make all your payments on time; in some cases, you may want to reach out to a nonprofit credit counselor to discuss how to raise your score. (You can find one at NFCC.org.)
Once your credit is in a good spot, you may be wondering how to apply for a mortgage. First, you should get a mortgage pre-approval — a written commitment stating that a lender will provide you with a loan of up to a certain amount as long as your loan passes underwriting. You’ll have to provide a lender with a lot of paperwork, including:
- Recent pay stubs that display your year-to-date income
- Two years of federal tax returns
- Two years of W-2 forms
- Proof of funds for the down payment, such as a bank statement
- Recent statements for all your assets, such as checking and savings accounts, as well as any investment accounts, such as CDs, IRAs and other stocks or bonds
- Residential history for the past two years, including landlord contact information
One factor that will greatly affect how much money you’ll end up borrowing is your down payment, or how much cash you’re putting down upfront. It’s usually referenced as a percentage of the home’s sale price. For instance, a 20 percent down payment on a $300,000 home is $60,000.
Ideally, you’ll have at least a 20 percent down payment; otherwise, your lender will likely require you to pay private mortgage insurance, which would be tacked onto your monthly mortgage payment. PMI typically costs between 0.55 percent and 2.25 percent of the original loan amount per year. So, for a $300,000 mortgage, PMI would cost between $1,650 and $6,750 annually.
If you’re short on cash for a down payment, you can apply for down payment assistance. According to Down Payment Resource, a national database of homebuyer programs, there are more than 2,300 down payment assistance programs in the U.S. that provide grants and no-interest loans you can use as a down payment.
Budget for closing costs
Closing costs are fees paid to the service providers who are involved with completing your home purchase, such as mortgage lenders, title companies, underwriters and real estate attorneys. Closing costs will typically run somewhere around 3 percent of a home’s purchase price. So, for a $300,000 home, you’d pay about $6,000 to $15,000 in closing costs.
Here are some typical fees that make up closing costs:
- Discount points, or mortgage points (Mortgage points are fees paid to your lender to lower your mortgage’s interest rate. Each point usually costs about 1 percent of the total loan amount.)
- Loan origination fee
- Underwriting fee
- Home appraisal fee
- Home inspection fee
- Title search fee
- Title insurance fee
- Prepaid property taxes
- Prepaid interest
- Recording fees for the deed and mortgage
Section 03 Shopping for a home
Once you've narrowed down your price range, it’s time to start the house hunt. Is working with a realtor a good idea? While it may be tempting to go it alone, the answer is likely to be yes, especially if you’re a first-time homebuyer.
First, understand the differences in how real estate agents label themselves. Broadly, a real estate agent is anyone who is licensed to sell, buy and rent real estate. A real estate broker is someone who has taken more coursework that gets deeper into the business of real estate and has passed additional licensing requirements in their state. A Realtor is someone who specifically belongs to the National Association of Realtors and adheres to its standards. While any of these professionals can help you buy a home, choose someone with the level of experience and credentials you’re comfortable with.
In a typical real estate transaction, there’s a buyer’s and a seller’s agent involved. A buyer’s agent provides a range of services, such as helping you find potential homes, write and negotiate offers, and negotiate a home inspection and repairs. Usually working with a buyer’s agent won’t cost you a penny, since the home seller typically pays for the commission.
Your real estate agent can also be an invaluable resource when you tour homes, whether you do a virtual home tour or visit in person. They can help you narrow down and balance which features you really need versus what you want and can give you insight on local housing trends in your desired neighborhoods.
Attending an open house
When you attend an open house, you’ll want to make the most of your visit. Here are some things to watch for when you’re touring the property.
Ask for a list of recent home improvements. How long has it been since appliances, garage doors, countertops, etc., have been replaced?
Peek behind windows and furniture for signs of damage. While small cracks are fairly normal, large gaps or cracks could indicate an issue with the home’s foundation. Discoloration or soft spots could also indicate water damage.
Take note of smells. Mildew or mustiness could be a sign of mold. (Some open houses may try to use fragrances to cover this up.)
Listen for noise pollution. Are you near major traffic that could keep you up at night? Are you near businesses that stay open late or draw crowds?
Making a bid
After you’ve found “the one” and you’re ready to make a bid, your real estate agent will help you put together an offer, including the offer price, the earnest money amount (the portion of your down payment you put down as a deposit) and what contingencies you want to include. These details will be finalized in the purchase agreement you and the seller will eventually sign, after which the home is considered “under contract.”
Contingencies are provisions that must be met in order for the sale to take place. Common contingencies include performing a home inspection, securing mortgage financing and requiring that the home appraise for the purchase price.
Waiving contingencies can make your offer more attractive, especially in a hot real estate market, although it means you’re taking on some risk. Many agents also recommend that buyers always keep a home inspection contingency. That’s because if a home inspector were to find problems like a leaky roof, faulty plumbing or cracks in the foundation, you could ask the seller to make the repairs in order for the sale to go through. If the seller says no, you’d be able to walk away without losing your earnest money.
Trying to win a bidding war? Don’t underestimate the power of appealing to the seller’s emotions. Write a personal letter to the homeowner expressing what you love about their home. If you know they raised kids in that home, explain how you’re looking to do the same. You can also use the letter to highlight common goals — for instance, if you know the seller wants to close on the home quickly, let them know you’re willing to be flexible on the closing date.
Section 04 Closing on your home
The closing, or settlement, is where you sit down and sign a pile of paperwork to make your purchase official — where you’re actually buying your home. There are typically several other people present as well, including the buyer’s and seller’s agents and attorneys, a lender’s rep, a title company rep and the closing agent. At the end, you receive the keys to your new home.
Here’s what you can expect to review and sign at closing.
A deed of trust or mortgage
This puts a lien against your home as collateral for your loan.
Mortgage and promissory note
These will include the details of your loan repayment terms and what happens if you can’t make payments
This includes the details of your loan terms and itemizes all the closing costs. You should receive it at least three business days before closing.
You’ll bring the following items with you to closing.
A government-issued photo ID (your name on the ID must match the name that will appear on your property’s title and mortgage)
A copy of the purchase agreement
Funds to cover closing costs, including the remainder of your down payment. Although you can use a cashier’s check, some lenders may require you to send the money via wire transfer.
Proof of homeowners insurance
Speaking of homeowners insurance, you need to make sure you have enough coverage in place before you buy your home. A typical homeowners insurance policy will cover theft or damage to your home. It can also protect you if someone sues you after getting hurt on your property.
There are also other types of supplemental homeowners insurance you may want to consider adding to your policy, like flood insurance, earthquake insurance, home-based business insurance, condo insurance and a rider for valuables. Umbrella insurance can also protect you if you’re brought into a lawsuit that falls beyond the coverage offered by your homeowners or auto insurance.
Finally, buying a home is a major life change, which makes it a good time to review your life insurance. It's important to make sure you have enough coverage so that, should something happen to you, your family can continue to stay in the home they know and love.
Section 05 Conversation starters with an advisor
How much home can I afford?
How will buying a home affect the rest of my budget?
Where can I find the cash for a down payment?
Should I make a 20 percent down payment?
Am I ready to buy my forever home or should I buy a starter home?
How much insurance coverage will I need after I buy a home?