What Every First-Time Homebuyer Should Know

Becoming a homeowner is a big decision. Money Girl explains how to prepare your finances, figure out a budget, work with real estate pros, and even when it’s best to step back and wait to buy a home.

THE QUICK AND DIRTY

If you have stable income, good credit, and savings for a down payment, you’re in a good position to buy a home you can afford. But if not, waiting to become a homeowner may be your best financial move. Here are 10 things every first-time homebuyer should know:

1. Credit is a critical factor for paying less.
2. Lenders evaluate your debt-to-income ratios.
3. Your savings must include a healthy down payment.
4. Your mortgage payment includes multiple expenses.
5. Never house hunt without a mortgage preapproval.
6. Real estate agents work to your advantage.
7. Negotiations begin with your purchase offer.
8. Unsatisfied contingencies allow you to ditch a deal.
9. There's work to do before the closing.
10. Reasons for postponing homeownership.

Becoming a first-time homebuyer is exciting, but it's a journey that you need to prepare for carefully so that it helps your financial life and doesn't hurt it. Getting to the closing table involves many steps you should consider before you leap into homeownership.

This episode will cover 10 things every first-time homebuyer should know. You'll learn how to prepare your finances, find the right mortgage, work with real estate pros, and even when to step back and wait to buy a home.

Tip #1: Credit is a critical factor for paying less

The first step in your journey toward homeownership should be checking your credit reports and correcting any errors. Mortgage lenders review your credit reports and one or more of your credit scores to evaluate you.

Good credit scores indicate that you're more likely to repay a loan on time than if you have poor scores. They can make the difference between being approved or denied for a mortgage and the terms you get.

High credit scores allow you to get approved for a loan with a competitive interest rate, which can save you thousands or even tens of thousands of dollars over the life of your loan.

Let's say you have excellent credit, with a FICO score of 760 or higher. If you get a 30-year, fixed-rate mortgage of $250,000 with a 2.5% APR, you'll pay just over $100,000 in interest over the life of the loan.

If you get the same loan but have a credit score of 659, you could end up paying close to $160,000 total. That means you spend $60,000 more on interest over the life of the loan.

To get the best mortgage rate possible, check your credit reports from the three national credit bureaus: Equifax, Experian and TransUnion. You can get them at each of the bureaus' websites or access all three at the official credit site, AnnualCreditReport.com.

Once you receive your reports, look for errors, such as incorrect account balances, payment dates, or personal information. If you find any problems, dispute credit report errors on the credit bureau's website. If there are incorrect account payments or balances, contact the creditor in writing to ask for a correction.

Since credit disputes can take months to clear up, review your reports at least six months before you plan on applying for a mortgage. Unfortunately, any valid late payments or accounts in collections remain in your credit file for seven years. But the good news is that over time they have a diminishing effect on your credit scores until they eventually fall off your reports.

One way to show lenders that you're a good credit risk is to pay off any past due balances before applying for a mortgage. However, making a payment can restart the statute of limitations in some situations, allowing a creditor to sue you. So, if you have an old debt, it's best to consult with an attorney.

Tip #2: Lenders evaluate your debt-to-income ratios

Once you've reviewed our credit and cleared up any incorrect information, look at your debt-to-income ratio or DTI. Lenders use DTI to evaluate your financial ability to repay them.

To calculate your DTI, add up your monthly debt payments and divide that figure by your gross monthly income. For example, if your monthly debt payments total $1,650 and your gross monthly income is $6,400, your DTI would be about 26%.

Most lenders require a DTI of no more than 40%, which includes the new mortgage payment. And typically, lenders require that the new mortgage payment add up to less than 30% of your income.

If your DTI exceeds the lender's limits, you may need to pay down some of your debt to be approved. However, it will depend on the lender's underwriting requirements. So, it may be worthwhile to pay down some debt before applying for a mortgage.

Tip #3: Your savings must include a healthy down payment

You'll need to save for a down payment because conventional lenders don't finance 100% of a real estate purchase. The down payment typically ranges from 3% to 20% of the home's purchase price, depending on the type of loan you apply for and the lender's requirements. Putting down as much money as possible allows you to get a lower interest rate and loan balance, which translates into a lower monthly payment.

If you don't have enough for a down payment, you may qualify for assistance through the following:

• Department of Housing and Urban Development (HUD)
• Federal Housing Administration (FHA)
• Department of Veterans Affairs (VA)
• Department of Agriculture and Rural Development
• Local homeowner programs

In addition to a down payment, you typically owe the following expenses at closing:

• Loan origination fee
• Appraisal fee
• Home inspection fee
• Mortgage discount points (allow for a lower interest rate)
• Property survey fee
• Title insurance fee
• Deed recording fee

It's possible to negotiate some of these closing costs with the seller and reduce your upfront expenses. However, in case you can't strike a deal, be sure to have enough saved.

Tip #4: Your mortgage payment includes multiple expenses

The costs of buying a home aren't limited to repaying your mortgage. Your monthly payment may also include:

Private mortgage insurance or PMI, which protects your lender if you default on the loan. It's required when you get a conventional loan and pay less than a 20% down payment. A typical PMI payment ranges from 0.5% to 2% of the original loan amount annually. It gets added to your mortgage payment but can get canceled automatically when your loan reaches 78% of your home's purchase price.

Local property taxes vary considerably depending on where you live. While the U.S. average is close to $3,300 per year, Alabama homeowners pay the least, less than $800, and New Jersey residents pay the most, more than $8,400 on average.

Homeowners insurance is required by mortgage lenders if you have catastrophic damage by disasters, such as fire, windstorm, and hail. Average premiums vary depending on your credit and your home's location, value, and amenities but could be in the range of $800 to $3,500 per year.

Homeowners association fees or HOA fees are required in some planned neighborhoods to pay for shared amenities (such as a clubhouse, pool, park, or dock), insurance, and maintenance. They range from a few hundred dollars per month to thousands, depending on the community where you live.

In addition to these monthly costs for your home, don't forget about ongoing home maintenance and repairs. These may include landscaping, pool maintenance, tree trimming, or unexpected repairs for broken appliances or home systems (such as plumbing and electrical).

A good rule of thumb is to budget at least 1% of your home's value each year to help cover maintenance and repairs. For instance, if you have a $260,000 home, you'd need to set aside $2,600 annually or about $215 per month.

Tip #5: Never house hunt without a mortgage preapproval

A mortgage preapproval allows you to begin working with one or more lenders to shop their offers and find out how much home you can afford. They look at your finances in detail, including your credit history, debt, income, employment or self-employment history, and savings for a down payment. A preapproval includes the interest rate and maximum loan you can get, typically for up to 30 to 60 days.

Getting preapproved is a critical part of establishing your budget before you begin house hunting. Additionally, it tells a real estate agent and seller that you're a serious and qualified buyer.

But note that just because you get preapproved for a loan amount doesn't mean you should borrow the maximum. Instead, use a mortgage calculator to make sure you can afford the total monthly expenses for a given home.

Tip #6: Real estate agents work to your advantage

Having an experienced real estate professional on your side can help you find hidden listings, negotiate for the best deal possible, and take care of many required details to get to the closing table.

In general, when a seller contracts with a brokerage firm to market their property, they agree to pay a real estate commission, such as 6% of the selling price. If the buyer has their own agent from a different brokerage, the two firms split the commission. With this arrangement, a buyer has no out-of-pocket cost to work with an agent.

However, you may elect to work with and compensate a buyer's agent, who has a fiduciary duty to you. They may charge a flat fee or a percentage of the sale to show you properties, including listings that you wouldn't otherwise know about, and provide local market knowledge and negotiating skills. This expertise is always terrific but can be critical in a seller's market like we see now.

Tip #7: Negotiations begin with your purchase offer

Depending on the market, you may be able to negotiate a home's listing price. The first step is to find out if the price is above market value. Again, this is where an experienced and reputable real estate agent can help. They should provide you with comparable properties, known as comps, showing recent listing and selling prices in the same or similar neighborhoods.

If homes are selling for more than their listing prices, your negotiating power may be limited. Discuss options with your agent that may allow you to stand out from other buyers, such as being flexible on a closing date, writing a letter to the seller explaining why you're the best buyer, or picking up some of the seller's closing costs.

To make a formal offer on the home, you or your real estate agent can prepare a purchase contract. It includes details such as:

• Property legal description
• Purchase price
• Earnest money deposit
• Terms of possession
• Proposed closing date
• Seller's deadline to respond
• Contingencies, such as mortgage finances, home inspection, survey, and termite report

Tip #8: Unsatisfied contingencies allow you to ditch the deal

Having contingencies written into your purchase contract is vital so you can walk away from the deal if you find something you don't like, such as an aging roof, termite infestation, or mold, and get back your earnest money.

You can also include other negotiations in your contract, such as asking the seller to pay some of your closing costs or requesting that specific furnishings or light fixtures remain in the home. Again, your negotiating power depends on the market and the seller's temperament.

Once you make an offer, the seller can accept it or make a counteroffer. If they take a contract as-is, you move forward to work through each contingency. But if a seller counters, the deal is officially dead — unless you accept it. Or you can make a counter counteroffer, and so on.

When you have an accepted offer, the first contingency you'll need to work on is getting the contract to your lender. They take care of many contingencies, such as ordering a home appraisal and survey. You or your real estate agent can order inspections and work with other professionals, such as contractors.

If your home inspection shows problems or potential problems, you can request that the seller repair them or reduce their selling price. They may not agree to either, which is why including contingencies in your contract is so important. If you're not satisfied with an inspection, you can have your earnest money returned and walk away from the deal without penalty.

Tip #9: There's work to do before the closing

If you have a signed agreement with a seller, get financing, and work through contingencies in your purchase offer, congratulations! You've come a long way and are probably anxious to close the deal — but there's still more work to do.

At least three days before your home closing is scheduled, your lender is required to provide a closing disclosure, which details the terms of your loan, projected monthly payments, and closing costs. Review it carefully and ask questions about anything you don't understand.

Also, schedule a final walk-through, which is your last chance to inspect the property and make sure nothing changed since you saw it last. Check on the completion of any negotiated repairs and make sure all appliances and fixtures are still in the home as agreed.

On closing day, you can either meet in person or do a mail-away transaction using a notary for documents you're required to sign. At any point, don't hesitate to contact your lender if you have questions or need help. Once both parties sign the papers, it's time to celebrate — you're now a homeowner!

Tip #10: You may want to postpone homeownership

There are many benefits of buying a home, including:

• Having predictable monthly payments
• Paying less than renting, in many markets
• Owning an asset that should appreciate over time
• Getting a tax deduction for mortgage interest and property taxes
• Changing the décor or renovating as you like
• Having more exterior spaces, such as a porch and yard

However, becoming a homeowner isn't for everyone. If you have poor credit, low savings, or lots of debt, it could be a significant barrier. While having some debt won't prevent you from getting a mortgage, it can make it more difficult to qualify or cause you to pay a relatively high interest rate.

As I mentioned, becoming a homeowner means you must be prepared for unexpected expenses that could wreak havoc on your budget. In addition to your down payment, consider saving at least three months' worth of living expenses in an emergency fund before leaping into homeownership.

If you're thinking about relocating for work or family, you probably should wait to buy a home until your plans get settled. A good rule of thumb is not to buy a home unless you're confident that you'll live in it for at least three to five years. That gives you enough time to recoup your purchase costs.

Buying a home is a big step, and only you know if you're ready to take it. However, if your income is stable, your credit is good, and you have savings, you're off to a great start. Having your finances in order can save huge amounts on your home loan and monthly payments, leaving enough in your budget to reach other critical goals, such as investing for retirement.