Homebuying 101

Here’s the honest truth about renting vs. buying: Each will probably make sense at different times in your life.

You may feel a lot of pressure from people who say you need to buy a home ASAP. But the smartest time to buy isn’t based on market conditions — it’s when you’re ready.

4 Reasons You Might Want to Buy

There’s a strong correlation between homeownership and wealth. The average homeowner’s household wealth is $231,420; for renters, the average is just $5,200, according to 2016 Federal Reserve data.

Of course, this discrepancy raises cause-and-effect questions. After all, wealthier people are the ones who can actually afford to buy a home. And homeowners skew older, meaning they’ve had more time to build wealth.

That said, here are four key advantages to buying a home.

4 Reasons to Keep Renting

If you’re renting a home, you have plenty of company: As of 2016, more households were headed by renters than at any time since 1965, according to U.S. Census data. Rising housing prices, coupled with rising debt — looking at you, student loans — have put homeownership out of reach for many, particularly younger people.

Housing is typically your largest expense. That’s why, even though your rent payment is buying you a place to live, making that payment can make you feel as if you’re throwing that money away. But here are some reasons renting can make sense.

At first glance, a mortgage payment can look ridiculously cheap compared with what you spend on rent. But there are tons of costs you may not be aware of when it comes to homeownership.

Let’s pretend you’re purchasing a $200,000 home. You put 10% down.

You mortgage the remaining $180,000 over 30 years. Your interest rate is fixed, meaning it won’t change, at 4.5%. You’ll owe $912.03 each month in principal (the amount you borrowed) and interest (the fee you’re charged to borrow money).

That’s probably a fraction of what you’d pay to rent the same $200,000 home. Ready to sprint to the nearest lender? Stop right there.

Taxes and Insurance

Taxes and insurance are frequently rolled into your mortgage payment, which is why you might hear the acronym PITI — principal, interest, taxes and insurance. Here’s what that entails:

So let’s go back to your hypothetical $200,000 home and $180,000 mortgage. Here’s what your monthly payment looks like with taxes and insurance rolled in.

Mortgage payment — $912.03

Property taxes — $195

Private mortgage insurance — $150

Homeowners insurance — $90.25

Total — $1,347.28

Other Costs of Homeownership

But wait! That’s not all. Here are some other costs to consider:

Where Does Your Mortgage Payment Really Go?

When you make your first mortgage payment, your balance will only go down by a teensy amount. That’s because most of your early payments are going toward interest rather than principle. The majority of your mortgage payment will go toward interest for the first 10 years or so of the loan.

The good news is, every month throughout the amortization schedule, i.e., the lifespan of the loan, you’ll pay a little more toward principal and a little less toward interest as your balance goes down.

How Much House Can You Afford?

Lenders will scrutinize your debt-to-income ratio, which is the percentage of your gross household income that goes toward debt payments.

While you might be able to get approved for a mortgage with a debt-to-income ratio of 50% or even more in some cases, many experts recommend you follow the 28/36 Rule, which is that you shouldn’t spend more than 28% of your household’s gross monthly income on housing expenses, and your debt-to-income ratio should be no higher than 36%.

That means if your monthly income is $5,000 before taxes, your mortgage, property taxes and insurance shouldn’t exceed $1,400. Your total monthly debt payments — including mortgage, car loan, credit cards and student loans — shouldn’t exceed $1,800.

A down payment is often the No. 1 hurdle for first-time homebuyers. Most likely, saving up for one will be the financial equivalent of a marathon — and the first steps should start long before you start shopping for a home or a loan.

How Much Should You Put Down?

Traditionally, you needed a 20% down payment to purchase a home. But the 20% down payment requirement has pretty much gone the way of flip phones and the Macarena.

The median down payment for first-time homebuyers is just 6%, according to the National Association of Realtors. Some programs that we’ll discuss later let you put as little as 3% down, or 0% if you’re a veteran.

Even though you probably won’t need to put 20% down, there are a lot of advantages to doing so, including:

• You’re more likely to get approved for a mortgage because lenders know when you have a significant amount at stake, you’re less likely to default.
• You’re less likely to end up underwater in your mortgage, which is when you owe more on your home than it’s worth. Being underwater can complicate things if you need to sell.
• Lower interest rates. Because you’re starting out with a substantial investment, lenders assume you’re less likely to default. That means you’ll pay less money over the life of the loan.
• Lower monthly payments, because you’re borrowing less money.
• You probably won’t need PMI.

Let’s be honest, though: Saving 20% for a purchase as large as a home is really, really hard. Making a lower down payment isn’t necessarily a bad thing. In addition to getting you into a home quicker, it can help you keep cash liquid for emergencies, or put more money toward investments or retirement.

But even 3% to 5% of a home’s value is a substantial chunk of change. Here’s where to find the cash.

How to Save for a Down Payment in 6 Simple Steps

Saving for a down payment is a long-term goal that might take several years. So you might not know what your budget will be when you get started. That’s OK. The most important words of advice we have are: Just. Start. Saving.

Down Payment Assistance Programs

Down payment assistance programs are most commonly offered by state and local housing authorities, but you can also get them through cities, counties, nonprofits, your employer or labor union, or even directly through your lender.

Assistance can come in the form of grants, loans, tax credits and more. It can only be used for a primary residence.

Most programs have income limits based on household size and require you to contribute toward the down payment. There’s usually a limit on the price of the home — typically, it’s a percentage of the median home price in your area. You’ll also probably have to take a course about homebuying.

About 63% of assistance programs are for first-time homebuyers, but guess what? You may still qualify for first-time homebuyer programs, even if you’ve owned a home. The Federal Housing Administration defines a first-time homebuyer as someone who hasn’t owned a primary residence in at least three years.

Your profession could also help you get assistance. About 14% of down payment assistance programs are for people who work in a profession that serves the community, like education, health care and law enforcement or veterans.

The U.S. Department of Housing and Urban Development has a list of local homebuying programs that’s a great place to start your research.

Should You Raid Your 401(k) or IRA for a Down Payment?

We hear alarm bells whenever someone asks if they should borrow from a 401(k) or individual retirement account (IRA). After all, that money is meant to grow over decades. Borrow from these accounts and you miss out on compound growth. That said, here are the rules if you’re considering using retirement funds for a down payment.

You also need to start getting your credit in shape before you start talking with lenders or hunting for homes.

Your first step is to check your credit reports. You’re entitled to a free credit report from each of the three bureaus every 12 months. To get yours, go to AnnualCreditReport.com.

Here’s what shows up on your credit report:

What you won’t see on your credit reports are your credit scores. But you can get your credit score and a “credit report card” for free from Credit Sesame. It breaks down, in layman’s terms, exactly what’s on your credit report, how it affects your score and how to address it.

Because it simplifies everything, you should be able to spot any errors. For instance, if you find an “unpaid” credit card that you know you paid, or a bill in collections you know never existed, you can dispute the incorrect information and correct your credit score.

We’ll get into the credit score requirements for various programs and mortgages later, but for now, let’s just say many require at least a 580 score. To get the best interest rates, you’ll need a score of around 760.

If you spot errors on your credit report, you may be able to improve your score quickly by disputing the information with the credit bureaus.

Otherwise, improving your credit won’t happen overnight. The most important thing you can do is to make your payments to creditors on time.

Almost as important: Keep paying down your debt without taking on new debt. While you’re doing that, ask your credit card company to increase your credit limits. This will lower your credit utilization ratio, or the percentage of your credit that you’re currently using. Lenders typically like to see credit utilization lower than 30%.

For a complete guide to credit scores, check out TPH Academy’s Credit Scores 101.

If you have a down payment saved and your credit is in decent shape, you might be ready to contact a lender. You could talk with the bank you already do business with. Or you could contact a major mortgage lender like Quicken Loans or SoFi.

You could also hire an independent mortgage broker to shop around and find the mortgage that works best for you. You’ll pay your broker about 1% of your loan amount for the convenience, but that won’t happen until closing.

Types of Mortgages

Understanding the different types of mortgages is one of the most head-scratching, migraine-inducing parts of buying a home. Here’s a quick primer for those who aren’t fluent in mortgage speak.

Prequalification vs. Preapproval

If you’re just starting the homebuying process, you might want to get prequalified by a lender. To do so, you’ll provide information to the lender about your income, assets and debts, along with your credit score, and the lender will estimate how much you’ll qualify to borrow.

But preapproval is when it gets serious. With prequalification, you’re self-reporting most of your financial information. When you get preapproved, you’ll have to provide LOTS of documentation, such as:

• Two years’ worth of tax returns.
• Copies of your W-2s, 1099s and two most recent pay stubs.
• 60 days’ worth of bank statements.
• Most recent quarterly 401(k) statement and two months’ worth of statements from your IRAs, brokerage accounts and certificates of deposit (CDs).
• Name and address of all your creditors, along with the account number, loan balance and minimum payment.
• Current mortgage statement if you already own a home.
• Documentation of 12 months’ worth of rental payments, plus contact info for your landlords from the past two years if you’re a renter.
• Divorce records.
• Bankruptcy and foreclosure records.

Your lender will also perform a credit check, which will show up on your credit reports as a “hard” inquiry.

Applying with a co-borrower? Sorry, but your lender will base its decision on the lower set of scores.

When you’re preapproved, your lender will provide you with a letter that says you qualify for a specific mortgage amount based on your financial information.

Having a preapproval letter gives you a huge edge when you’re shopping for a home. It means that you’re approved to borrow a certain amount as long as your financial situation stays the same and the home’s value holds up on appraisal.

Note: For the purposes of this course, we’re assuming that you’re going the traditional financing route and working with a lender to secure a mortgage.

But as many as 40% of home purchases are cash sales. These buyers are often investors or retirees who paid off their mortgage and are downsizing. The bad news is, sellers almost always prefer a cash offer to one that involves a mortgage.

If you have a decent amount saved, you may be able to pay cash, particularly if you’re buying a foreclosure or short sale.

You might not have to choose between getting a mortgage or paying cash. Seller financing or rent to own are two ways to finance a home without a mortgage.

If you have a preapproval letter in hand, you’ve made it past a huge hurdle. Now it’s time for the fun part: shopping for your home. Woohoo!

What Does a Real Estate Agent Do?

If you’re not serious about buying a home soon, you probably don’t need a real estate agent yet. You can always visit open houses and call listing agents about homes that interest you without an agent. When you’re ready to buy, ask friends, relatives and co-workers to recommend an agent.

You’ll work with a buyer’s agent, also known as a selling agent. Their job is to help you find homes that fit your needs and your price range. A seller’s agent, also known as a listing agent, works on behalf of — you guessed it — the seller. They help the seller with pricing, showing and marketing the home, as well as negotiating offers.

When you find homes that interest you, your agent will go with you to tour them. When you find a home you like, they’ll help you make an offer, and they’ll negotiate on your behalf. They’ll even guide you through the paperwork blizzard that follows.

Your real estate agent will almost always get paid by commission. That means if you don’t close on a home, they don’t get paid.

The House Hunt

You can look for houses the old-fashioned way — by driving through neighborhoods, looking for “for sale” signs. Your real estate agent can also help you in your house hunt.

Real estate websites like Zillow, Trulia and Redfin are increasingly popular starting points in the home search. They’ll let you search for listings by city, neighborhood or ZIP code. You can filter the results by price range, number of bedrooms and bathrooms, and more.

Many will also let you filter by the type of home you’re looking for. Here are some common options you’ll find:

Single-family home: A house that isn’t attached to any other structure. You have your own yard and entrance, and your house is the only home on the property.

Condominium: An individually owned unit within a multifamily community where you share the common areas, like yards and amenities. Multiple condo units are often in a single building, meaning you’ll share walls and a roof with your neighbors, although detached condominiums do exist.

Town home: A town home is an individually owned house that usually has at least two stories. It’s attached side by side to other homes, meaning you’ll share at least one wall, but you won’t have another residence above or below you. Town homes often have small private yards and sometimes even individual garages and driveways, but you share some common areas with other residents.

Once you’ve narrowed down some possibilities, start by doing a little homework. Type in the addresses for the properties that interest you to the county property appraiser’s website to find out the home’s assessed value and how much the seller paid for it.

Next, you can check out the residence during an open house, or your agent can contact the listing agent to schedule a showing.

House hunting can be fun, but you have to keep your emotions in check — no falling in love until you’ve signed all the fine print.

When you’re looking at homes, you can never ask too many questions. Ask about the age of the roof, the home’s foundation and when the appliances were last replaced to get a sense of whether major repairs could be on the near horizon.

Also, request a copy of recent utility bills from the seller. Unusually high bills could be a red flag that major repairs are needed, or they could push a home out of your budget.

You’ll also want to ask questions about the neighborhood. Ask if there are any major projects in the works that could affect the home’s value. You’ll want to find out if there are foreclosures nearby, because these can negatively impact neighborhood property values. To find out the scoop on the neighborhood, don’t just take the seller’s word. Ask the neighbors, who are more likely to be upfront about the area.

All the tips above are for if you’re buying an existing home. But what if you’re building your own home or buying a home pre-construction? You still need to play detective. Research the builder to make sure they have a good reputation. The Better Business Bureau is a good place to start.

If you’re buying in a pre-construction community, you’ll probably tour a model home. Be sure to ask lots of questions about what features are standard and which ones are pricy add-ons. If possible, check out other communities the builder has constructed in person, and talk with people who live there to see if they’re satisfied.

Ready to Make an Offer?

Before you make an offer, you need to educate yourself about the local market. Your agent and real estate websites can help you figure out whether it’s a buyer’s market or a seller’s market.

If it’s a buyer’s market, there are more homes for sale than potential buyers. That means you’ll have more time to make an offer, and the sellers are more likely to negotiate.

But you don’t have time to dawdle in a seller’s market, which means buyer demand is higher than the supply of available homes. Sellers in this market are likely to field multiple offers. If the market is super hot, you’re likely to find bidding wars, which is when two or more potential buyers compete against one another by gradually upping their bids.

Generally, when there’s more than six months’ worth of inventory, it’s considered a buyer’s market, whereas it’s a seller’s market when there’s less than six months’ worth.

To figure out how much inventory is available, use a real estate website like Zillow to find out how many homes are listed for sale in an area. Then, check out how many homes in the same area sold within the last month. Divide the number of homes for sale by the number of homes sold in the last 30 days to calculate how many months’ inventory is available.

For example, if there are 20 homes for sale and five sold in the last month, there’s a four-month supply. It’s clearly a seller’s market.

Before you make an offer, your agent will probably contact the listing agent to find out if there are other offers.

Your agent will help you figure out how much to offer. The sellers can then take your offer, accept another offer or get back to you with a counteroffer.

Even if the seller accepts another offer, it might not be time to give up just yet. A ton of things can go wrong before closing, so it could be worth it to submit a backup offer.

If you and the seller agree on a price, you’ll hand over what’s called an earnest money deposit that’s typically 1% to 2% of the purchase price to show that you’re committed.

A title company will hold the money in an escrow account, and the home will be listed as pending rather than for sale as you get ready to close. The deposit will eventually go toward your down payment and closing costs.

You’ve found your dream home. Your offer has been approved. But wait! It’s not time to pop the bubbly just yet. There are still a few things standing between you and homeownership.

Home Inspection

Your next step is to hire a licensed home inspector, who will scour the home for defects.

The most common problems they find are things like faulty wiring or plumbing, poor ventilation, clogged gutters, mildewy basements or missing roof shingles, according to the National Association of Realtors.

If the inspector finds serious defects that weren’t disclosed, you can take back your offer or renegotiate. Sometimes the seller will agree to make repairs.

You want to tag along for the inspection. After all, you’ll get to know everything that’s wrong with your new house! Just don’t panic if the inspector finds minor flaws. (Spoiler: They always will, and usually, it’s not a deal-breaker.)

The knowledge will come in handy when you actually buy the place. Be sure to get a copy of the inspection and keep it in your records.

Find the Best Mortgage Rates

At this point, you’re still not committed to any lender — even if you’ve been preapproved. Getting quotes from multiple lenders puts you in a better bargaining position, says the Consumer Financial Protection Bureau. If you’ve been preapproved by one lender but a different lender offers you a better rate, show the first lender the lower quote, and ask them to match it.

Better Mortgage is a good option if you want to save time shopping. The company bills itself as an online mortgage lender that’s built like a tech company — fast and innovative. It emphasizes speed and efficiency. It can quote you an interest rate in seconds once you type in your ZIP code, credit score range, down payment amount and the price of the house you want to buy.

Getting one additional quote before locking in a rate and buying a home could save you $1,500 over the life of the loan, according to Freddie Mac.

Shop Around for Homeowners Insurance

The bank that lent you the money will require you to insure the home you’re buying.

Homeowners insurance covers the cost of repairing or rebuilding your home if it gets damaged by fire or the kind of natural disaster insurers call “acts of God” — earthquakes, lightning, etc. It typically won’t cover damage from flooding or hurricane winds, so you may need to purchase separate insurance policies for those, depending on where you live.

To find affordable insurance, shop around. You may also be able to save money by raising your deductibles, making certain upgrades, and buying your home and auto policies from the same company.

Finally… Closing Time

Yes… It’s time… You are now about to sign the mortgage papers and officially become a homeowner.

At closing, it will be you versus a mountain of paperwork. Expect to sign your name. Again. And again. And again. Your real estate agent and a loan officer from your bank will be there, along with your mortgage broker, if you hired one.

Expect total closing costs to run anywhere from 2% to 5% of your purchase price. This covers everything from having a property appraiser assess the value of the home to having a title company do a title search to make sure nobody else has a claim on the property.

You may be able to negotiate with your seller to cover some or all of the closing costs. Or you could ask the sellers to add closing costs to the purchase price. That way, they get the same amount of money, and closing costs will be rolled into your mortgage.

You’re still reading, so we’ll assume we haven’t scared you away from buying a home. But before you start on your homebuying journey, we have one final question for you.

Why do you really want to buy a home?

If it’s because everyone else is doing it or you’re afraid of missing out, stop right there. Ditto for if you’re counting on making a quick profit by reselling in a couple years.

But if you want to buy a home because you feel ready — both financially and in terms of life priorities — you have our approval.

Just remember: Whether you opt to buy, rent or couch-surf for life, what matters is what works for you.