The 10 Steps to Buying a House
"You should take all of the information on this website and boil it down into a ten-step plan for success." That was the challenge issued to me by one of our writers. This article is the result. In this lesson, you'll learn about the ten basic steps to buying a house. You can use this as a starting point for your continued research. Follow the links provided to learn more about each step.
Step 1. Set a Budget and Start a Housing Fund
When you walk into a lender's office or speak to them on the phone, you should already have a budget in mind. In this context, I'm talking about your housing budget. This is the amount you can realistically afford to pay toward a mortgage each month. There are all sorts of fancy mortgage calculators online to help you determine your budget. But you don't need them. All you need is a piece of paper, a pen, and a regular calculator.
Here's what you need to do for this step:
Write down everything you spend money on each month. Your car payment. Your credit card bills. Your groceries. Your entertainment expenses. Everything. You can leave out your rent, or your current mortgage payment (since it will be replaced by your new mortgage payment). You're trying to find out how much money you spend each month, for everything other than your rent or mortgage payment. These are your non-housing expenses. Write this number down.
Next, subtract your non-housing expenses from your take-home pay. Don't use your gross monthly income for this. You want to use your net income, after taxes have been withheld. Remember, we're trying to create a budget here. So you need to use the amount you actually take home after taxes. Using your gross income will only distort the process.
Write down the number you're left with, after subtracting your debts from your income. That's the absolute most you should spend on a monthly mortgage payment. In fact, a smart home buyer won't even come close to this number. She will leave some extra breathing room for financial emergencies. The further your mortgage payment falls below this number, the safer you'll be.
It's possible to get approved for a mortgage loan that's too big for you. It happens a lot actually, as evidenced by the number of home foreclosures in the U.S. This is why it's so important to have a budget on paper before dealing with lenders.
This is one of the most important steps when buying a house. That's one of the reasons it's at the top of the list. It's also up top because it makes sense to do this step first. This article follows a logical sequence of events. You want to know how much you can comfortably afford to spend each month, before you apply for a mortgage. Otherwise, you might get approved for a monthly payment that's too big for you.
The lender does not care about your long-term financial stability. They're going to sell the loan into the secondary mortgage market, which takes it off their books entirely. So why would you trust someone like that to determine your financial comfort-zone? You shouldn't. You should do it yourself. It's the first and most important step to buying a house.
See also: How much house can I afford to buy?
You should also start a housing fund at this stage in the process. The sooner the better. A lot of first-time buyers are shocked by the amount of money they have to pony up when buying a house. There's the down payment to consider. Unless you use a VA or USDA loan, you'll be making a down payment of at least 3.5 percent.
Closing costs are another major expense when buying a home. They can easily add up to $5,000 or more. If you're buying a higher-end home, your total closing costs could be well over $10,000.
Step 2: Check Your Credit Reports & Scores
This is another critical step when buying a house, and it's something you should start doing today. Your credit score can make or break your chances of getting a mortgage loan.
In the past, lenders didn't put too much emphasis on credit scores. If you made enough money, you could qualify for a loan. And then came the housing crash of 2008. Today, lenders are doing everything they can to reduce their risks. One of the ways they do this is by scrutinizing the borrower's credit score.
In this context, I'm talking about your FICO credit score in particular. This is the one used by most mortgage lenders. So it's the only one you should be concerned with at this point. Your FICO score is computed based on the information within your credit reports. So you want to review both of these things.
- When reviewing your credit reports, you're primarily concerned with accuracy. Make sure there aren't any errors or inaccuracies. If there are, dispute them ASAP (here's how). You can get copies of your reports for free by visiting annualcreditreport.com.
- You should also check your FICO credit scores to see where you stand. The scoring range goes from 300 to 850. Higher is better. You'll probably need a score of at least 640 to qualify for a mortgage loan. You might be able to qualify for an FHA loan with a score below that. You can purchase your scores through MyFICO.com.
Many first-time buyers skip this step entirely when buying a house. "Why do I need to check my credit?" they say. "The lender will do this for me." True. But the lender is not your financial advisor. They are selling something, and you're buying it. You are on opposite sides of a business relationship. The last thing you want is for the lender to know more about your qualifications than you do (such as your credit score). You can't negotiate from a position of ignorance.
Step 3. Choose the Best Type of Loan
FHA. Conventional. ARM. Fixed-rate. You've got quite a few choices to make when it comes to mortgage loans. Making the right choice now can help you avoid problems later on. The good news is that many of the so-called exotic mortgage products disappeared in the wake of the housing crisis. Today, we are left with the traditional workhorses of the lending world. So the mortgage market is not as confusing as it was a few years ago.
You have two choices to make at this stage:
- Do I want a fixed or adjustable-rate loan?
- Do I want so use a conventional or government-backed mortgage?
The first step is to choose the type of interest rate you want to lock in. A fixed-rate mortgage loan has the same interest rate for the entire life of the loan. An adjustable mortgage (ARM), on the other hand, has a rate that will adjust periodically with some predetermined frequency. Most of the ARMs in use today are actually "hybrid" loans that start with a fixed rate for the first one to seven years. After that the rate begins to adjust, usually every year.
You're better off using a fixed-rate mortgage if you're going to be in the home for a long time. If you think you'll only be in the home for a few years, an ARM loan could be a good way to save money. Technically speaking, you can use an ARM loan for any length of stay -- but it gets risky when you stay beyond the first adjustment phase. That's when the rate starts to fluctuate with market conditions. Usually, this means the rate will rise from one period to the next. And your monthly payment will rise along with it.
Here is some information that will help you weigh the pros and cons:
Fixed vs. adjustable-rate mortgages
FHA and Other Government Loans
In this step to buying a house, you'll also have to choose between conventional and government-backed mortgage loans. Government loan programs include VA, FHA and USDA. A conventional mortgage is made in the private sector with no form of government backing.
If you're a member of the military, you should seriously consider using a VA loan when buying a house. You can buy a home with no money down using this option. What's not to like about that? The qualification process is easier than a conventional loan, too.
If you're not a member of the military, you can get a government-backed mortgage in the form of an FHA loan. This program is incredibly popular among first-time buyers. It's not limited to first-timers, but it appeals to them for several reasons.
The standard down payment for an FHA loan is smaller than a conventional loan (as little as 3.5 percent), and the qualification process is easier. It's not a rubber stamp though -- you'll still have to be approved by a lender in the private mortgage market. They'll scrutinize your credit score, income and debts. Still, with all other things being equal, it's easier to qualify for an FHA loan than a conventional mortgage.
Here's a comparison piece that highlights the pros and cons:
FHA vs. conventional mortgage loans
Of all the steps to buying a house, this is one of the most important. I would put it in the top two, in terms of importance (right up there with the budgeting process of step #1). Research is the key to success. You should learn all you can about the four types of loans we discussed above -- conventional, government-backed, fixed- and adjustable-rate. Once you get a grip on the pros and cons of these mortgage products, you'll have an easier time choosing the right one.
Note: This is the first in a two-part series on buying a home. In the second part, we will pick up with the mortgage pre-approval process. We will also cover house hunting, home appraisals and closing.