Critical Financial Steps When Buying a Home

In my lifetime, I have bought six houses, and sold five. I currently live in the sixth, which was new construction, which was an adventure unlike purchasing an existing home, But the principles of buying a home are the same, whether you are purchasing a new home, or an existing home.

1. Understand why you want to buy a house
Purchasing a home is a major decision that shouldn’t be taken lightly. It’s important to define your personal and financial goals before proceeding. Think about factors such as whether you’re craving more stability, whether it makes sense financially and whether you’re prepared for the responsibility of maintaining a home.

You should explore some resources on Renting vs. Buying before you make the decision. I posted a article with a couple of good videos on this subject, and bankrate.com as an informative article here. 

2. Dig Into Your Credit Reports and Credit Scores

Your credit score and history are the first things all lenders will look at to decide whether or not to consider offering you a mortgage, so you need to check your credit to make sure you’re in good standing with all your debts. Numerous sites offer free credit reports and free estimated credit scores. Your bank may offer this service.

When you pull your report, first check out your score, which will be a three-digit number that generally ranges from 300 to 850. Most lenders look for a score of at least 600 to 640 to offer you financing, but some will make exceptions for buyers in the high 500s. This estimated score will give you a good idea of where you stand, but keep in mind that lenders have their own scoring models, so your official score will vary.

After checking your score, you’ll want to dig deep into your credit report to find any old unpaid debts that could affect you. Forgot to pay that old electric bill six years ago? That's probably on your report as an old collections account and will impact lenders’ willingness to approve you.

You also want to check for accounts you don’t recognize and dispute them if you believe they are fraudulent.

Your credit scores will affect how much you pay for a mortgage. There is a ton of information over at myFICO. The chart below shows and example of payments on a $300,000 30-year fixed mortgage,  

3. Fix Any Outstanding Issues with Your Credit Report(s)

If you found any outstanding debts, even ancient ones, it is worthwhile to track down the creditors and call them. It may sound strange to call a debt collector yourself, but hear me out.

Once you get the collector on the phone, find out what the debt is for, how much you owe and if there is a discounted settlement to pay it off in full. If the collector offers you a settlement to pay it off in full and leave it as a $0 balance, take it. If the creditor offers a payment plan only, you will want to pass, as this could renew the debt on your credit and make it look more recent than it actually is. The collection account will remain on your credit after paying it, but lenders are more likely to forgive an older collection account with a $0 balance than one you still owe money on.

You will also want to type up quick explanations of any collection accounts, even those with a $0 balance. Remember, the mortgage underwriting process involves a human element, and these explanations go a long way in easing an underwriter’s mind.

4. How Much House Can You Afford (Should You Afford)?
I was once told that I should have bought the biggest and most expensive house my budget would allow. At the time I had purchased a 2,000 square foot house in nice neighborhood for just me and my wife. The mortgage payment with taxes and insurance was only 15% of my income. It worked out just fine. The advice was bad. 

You have wants and needs in mind for your new home, but can you really afford to pay for a home that checks of all the boxes? This is often the most difficult part of the home buying process.

Many so-called “rules” govern much you should spend on a home, but most financial gurus like Dave Ramsey recommend a conservative approach that’ll keep you from getting too deep in debt. Ramsey suggests limiting your mortgage payment to 25 percent of your take-home pay or less. Sure, your realtor and bank will likely base everything off your pretax pay, but you must pay that mortgage from the cash that hits your bank account after taxes.

Using this approach, if your household take-home income is $4,000 per month, you should limit your monthly mortgage payment to $1,000. There are numerous mortgage calculators on the internet, but Dave Ramsey’s calculator is one of the easier ones to use, plus it helps you estimate taxes and insurance, which you need to include in your 25-percent budget.

Based on your $1,000-per-month budget, you can afford up to a $171,500 home on a 30-year mortgage with a $10,000 down payment at 4.125% interest.

Keep in mind, with this strict budget you may run into the unfortunate reality that it doesn’t align with your wants and needs. This means there are sacrifices you must make like mothballing that man cave or scraping the she shed to stay within your budget.

Another factor to keep in mind is that besides the mortgage payment, there are other costs to home ownership. You should estimate maintenance expenses (1 percent of the home value per year is a good rule of thumb to start with) and utilities. You total housing budget should not be more than 35% of your take home pay. 

Part of the process of determining how much house you can afford is the down payment you'll need. This can vary from 3% for a VA or FHA loan, to 20% for a conventional. A rule of thumb -- again -- is the larger the down payment you can afford, the better off you are.

For those who don’t have that much saved, there are other options backed by the federal government. Borrowers who get a loan insured by the Federal Housing Administration, called an FHA loan, need just 3.5 percent down in many cases. Loans guaranteed by the U.S. Department of Veterans Affairs and the Department of Agriculture, known as VA loans and USDA loans, respectively, require no down payment.

Casey Fleming, a mortgage adviser with C2 Financial Corp., recommends finding a qualified loan officer in your area to help you determine the best option.

“Being willing to buy with less of a down payment gets you into your new home faster, but putting more down lowers your costs,” Fleming says. “The right decision for any particular person or family is highly personal.”

5. Gather Up all Your Records

Eventually you'll need to provide a lender with documentation, such as income, bank accounts, income tax records, etc. If you're a veteran, you'll need a copy of your DD-214. When you do apply for a loan, these records will make it easier. 

If you're self employed, you'll need some type of profit and loss statement, as well as those income tax returns.

Why is printing out a few bank statements so tedious? It’s not the printing. Instead, it’s all the analysis these statements will go through. The underwriter will tear through every page of your bank statements looking for red flags and asking for written explanations.

That $10 your Aunt May gave you for your birthday last month won’t raise any suspicions, but that $3,000 check you deposited from selling your car sure will. After printing out your statements, just do a quick scan to see if there are any irregular large deposits or withdrawals and type out quick explanations ahead of time. Your lender will appreciate your initiative.

I downloaded all my statements, which were in PDF format, and when I selected a loan officer, it was easy to upload them on her web site.

6. Get Prequalified for a Loan 
When you are about 60 to 90 days from buying your home, or just before you start lookng, it's time to take the first big leap and get prequalified for a mortgage. This is an important step, because it assures your realtor and any seller that you are a serious qualified buyer, as well as your own self-assurance that you can proceed. But first you have to find out what kinds of mortgages you can qualify for. There are more types of mortgages than anyone cares to count, but the most common ones are conventional, adjustable rate, Veterans Affairs, United State Department of Agriculture and Fair Housing Administration.

You can do a little light reading to see what you may qualify for, but you will want to speak with a mortgage professional to highlight your best options. Many people qualify for low-rate FHA mortgages, but its mortgage insurance requirements and other regulations offset lower down payment and interest rates they offer. A mortgage professional will quickly identify these details and steer you in the right direction for your financial situation.

To get prequalified, simply apply online through one of the countless mortgage lenders online or call a few local lenders. They will pull your credit and do a quick check of your finances to see if you qualify. If you qualify, the lender will tell you your spending cap, which will likely be way above the 25 percent budget you set earlier (many use a 35 percent rule). Don’t let the amount you are approved for dictate your budget — future you will appreciate if you stick to the 25 percent rule.

One thing to keep in mind about a prequalification: It does not guarantee approval.

7. Choose a Lender and Get Approved

When you are about 30 days from officially buying a home, pick a lender. At this point you should be looking at homes you might want to buy. You want to start this process so that if you are in a position to make an offer, it won't be held up because of financing problems. And of course, any offer letter should state that it is contingent on suitable financing. Sure, you may have gotten a prequalification letter from one or more lenders, but that doesn’t marry you to them. Feel free to shop around for the best rates.

You may be scared to shop for rates because each lender must pull your credit when giving you a rate, and inquiries generally hurt your credit score. According to MyFico, you can shop for rates for 14 to 45 days, depending on the scoring model, and all the inquiries in that span will count as just one inquiry. So feel free to shop around. I shopped five lenders on my last home purchase, and it only showed up as one inquiry, and did not affect my credit scores, nor my final loan approval.

Keep in mind, you are shopping for more than just the lowest payment. You also want to consider the interest rate, closing costs and many other variables. One way to keep this all in check is to ask the lender for a quote that includes the total cost to finance the home. This will add the price of the home, closing costs, interest and all other fees to give you the complete cost of the house over the course of the mortgage.

Once you find a lender with the best overall deal for your financial situation, apply and get your preapproval letter. This is the official approval that basically means as long as nothing changes in your financial situation, you are good to go.

8. No New Debts
When house shopping, it's common to get a nasty case of the I-want-its and rack up debt buying furniture and other items for your new digs. Make sure you pump the brakes on that desire, as one of the key terms to your preapproval is no new debts that cause significant change your financials.

No, a $200 couch on an existing credit card will not raise any red flags to the lender, but a $10,000 bedroom suite on a brand-new credit account may be enough to kill the deal. Even worse, a new $60,000 truck to put in that fancy three-car garage you plan to have — that will certainly raise a stink.

So, keep your shopping to the window variety and make tons of lists of what to buy after you close on the house.

9. Don't Forget Insurance
The mortgage company sees your house as collateral on the big loan it’s about to give you, so it expects you to insure that collateral against damages. Before you close, shop around for homeowners insurance. In most states you have virtually limitless options, so call a handful of them and find out which offers the best total package at a fair price. Sadly, in some states prone to natural disasters, like Florida, you may have few options.

Compare apples to apples, though, so make sure you have standardized deductibles and other coverages for the insurers to quote you on. Also, get every quote in writing so you have a record of it and to keep the insurer from changing anything at the last minute.

Once you choose your insurer, sometimes you can opt to pay the premium yourself up front or have the mortgage company pay it via escrow. In most cases, the mortgage company is going to want to pay it out of your escrow.

10. Collect Your Cash for Closing
Just days before your scheduled closing date, you will receive the update you’ve waited months to hear: “You are clear to close.” This means you have jumped through every hoop, wiggled every left elbow, twinkled your nose just right and kept your credit clean enough to buy your new house. But there is one last step: cash to close.

Cash to close is the amount of money you must bring to the closing table to pay all your prepaid items to get the house. These can include your down payment, initial escrow funding, unpaid taxes, closing costs and much more. When you get the clear to close, the mortgage or closing company will give you the final amount of cash you need to close, and it will give you several options to pay it. These options generally include a cashier’s check, certified check or a wire transfer.

Regardless of which option you choose, have that cash ready to go well before closing. So, if your savings are in several areas, pull the cash needed to close into one account so you’re not bouncing around various accounts and making multiple checks or transfers. Only transfer the exact amount needed to close, as this makes it easier to explain to the bank if it suddenly requests an updated bank statement at the closing table.

Your next step will be to get a realtor and go find a house. Even with new construction, a realtor can be good to have.

My last home purchase was new construction, an adventure in home buying that is quite different from purchasing an existing home. Still, the advice of a realtor was essential. And the builder paid her commission.