IF YOU'VE NEVER BOUGHT A HOUSE BEFORE, much of the jargon and terminology could prove daunting. After all, who would give "discount points" or "5-1 adjustables" the slightest thought unless they absolutely had to? We've arranged this short primer on the basics ofbuying a home as a series of questions and answers that try to address the basic issues with which every home buyer must grapple.
1. "I've Heard a Lot of Horror Stories. Should I Work With a Real Estate Broker?"
The first thing you need to know about real estate brokers is that they typically work for the people selling the home - not you. The standard practice is for the seller to hire a broker, who then takes over marketing the home and seeking out potential buyers. For this, brokers usually are paid around 6% of the sale price, which gives them a built-in incentive to find the seller the highest price they can.
That sounds simple enough. But as you begin to drive around town with seasoned agents, you'll quickly find that they act like they are, in fact, working for you. So don't get too cozy. You will probably be tempted to tell an agent the highest price you are willing to pay for a house or the size of down payment you can afford. Don't. The agent is obligated to pass those details on to the seller, which could hurt you in any negotiation. Also, don't feel obliged to buy a home through one particularly helpful broker. Use several
to have the widest selection of possible homes. (See
10 Things Your Broker Won't Tell You for more on whatto watch out for from real estate professionals.)
You don't need to use a broker at all if the house you want is being sold by an owner himself. Indeed, you'll have a lot more room to negotiate on price if the broker's 6% fee is absent from the equation. It's also not that difficult to sell your house without a broker, though it is a significant commitment of timeand energy -- one you may not be willing to make. Check out Going Solo for more information on what you can expect.
Are all brokers bad? Of course not. A good agent can be very helpful, if only because he or she has accessto a large database of listings in your neighborhood of choice. Agents can also recommend schools, local contractors, and mortgage brokers. (Although, you shouldn't rely too heavily on their advice; they've been known to take kickbacks.) And they can often help steer you through the home buying process, while smoothing out bumps in the negotiations. Remember this, too: An agent's fees are always negotiable. Are you and a seller at loggerheads over who's going to that damaged furnace? Maybe it should come outof the broker's fee. In the past few years, so called "buyer's brokers" have become more popular in certain parts of the country. Unlike traditional real estate agents, they work for -- and are often paid by -- the buyer. They are supposed to help assure you get the best deal. They can be invaluable if you are moving to a town or part of the country you are unfamiliar with or have little time for house-hunting. Like a regular brokerthey are a font of listings. The problem is, their terms often require that you use only them for a set time period. That's fine if you trust the broker and just want someone to screen homes for you. But it can leave you hamstrung if you'd like to go out and do some looking on your own or if you
want to use a number of brokers. Also, compensating a buyer's broker can be tricky. Paying by the hour adds up, but paying a percentage of the purchase price gives a broker the wrong incentive: Getting you to pay the highest price returns the most to him. Sometimes, a buyer's broker will settle for splitting the fee with the broker who has the listing. BACK TO THE TOP
2. "Why Are There So Many Mortgage Options, and How Will I Ever Decide Which One Is Right for Me?"
The answer to the first question is easy enough: Mortgage products proliferate because lenders, hungry for business, are trying to rope you in any way they can. That certainly makes mortgage shopping confusing, but it also means you can probably find a mortgage tailor-made to meet your needs. What Kind of Loan Should I Get? can help familiarize you with thedifferent types of loans available and which might be right for you.
At the most basic level, mortgages come in two categories: fixed rate and adjustable. In both cases "rate" refers to the rate of interest you pay the bank for the privilege of borrowing its cash.
Fixed-Rate loans: A fixed-rate mortgage is so called because its interest rate doesn't change over the life of theloan, no matter what rates do on the open market. Manypeople feel more comfortable with a fixed rate,because they know their monthly mortgage payments will remain steady over the years, making at least oneaspect of their monthly cash flow predictable. Thedownside is that you pay for that comfort: Lenderscharge a higher rate of interest for fixed-rate loans.Why? Because they figure that if interest rates shootup, they lose the opportunity to make more money onthe funds they are lending you.
The standard fixed loan lasts for 30 years, but if youcan handle higher payments and want to build up yourequity in your home faster, you can opt for a 15-yearfixed. With a 15-year, you'll get a lower rate and paymuch less interest over the life of the loan. Thepayments each month, however, will be quite a bithigher since they aren't being stretched over so longa period.
Here's an example: If you get a $125,000 loan with a30-year fixed rate of 7.75%, you'd be on the hook formonthly payments of $895.52. On a 15-year version ofthe same loan, you might get a rate of 7.25%, but yourmonthly payment would be $1,141. If you werecash-short and wary of higher monthly payments, you'dgo with the 30-year loan. But ultimately it would costyou: On the 30-year loan you pay a total of $197,386in interest over the life of the loan, while the15-year mortgage sticks you for only $80,394.
A fixed rate makes the most sense for those who planto stay put in their new home for a long time. You paya little more in interest, but it is stretched over alonger period so the monthly effect can be minimal.And if you're buying when rates are low, locking in agood deal is probably worth it.
Adjustable-Rate loansAdjustable-rate loans get their name because the rateyou pay changes according to a set formula as interestrates fluctuate on the open market. As noted above,the upside is that lenders charge a lower rate forsuch loans because you are taking on some of theinterest-rate risk. This makes your monthly paymentslower -- at least in the beginning. Such loans providea way for many buyers to afford a larger loan amountfor a given monthly payment. An adjustable works outwonderfully if rates drop -- something you shouldnever count on. But watch out if interest rates rise.In a year or two, your payments could far exceed whatyou would have paid for a 30-year fixed.
The trick with adjustables is to tailor the loan toyour needs. Generally, the cheapest rate out there ison a one-year adjustable. (Well, yes, there are evencheaper loans that adjust monthly, but those are tooesoteric for most buyers.) With a one-year, your ratecan change annually, making these loans particularlyrisky. Lenders often try to draw you in with "teaser"rates that are especially cheap for the first year,but which will almost certainly jump up the next year.
There is a limit to how much an adjustable can adjust,however. Lenders limit the amount the rate can rise,often to no more than two points a year, with alifetime cap of six points. Moreover, if you arewilling to endure the hassle and expense ofrefinancing after a year, it's possible you'll comeout ahead. See Should You Refinance? for more.
A slightly more expensive option is what's known as a"delayed adjustable." When you see "3-1 adjustable" or"5-1 adjustable" it means that the loan stays fixedfor three or five years and then resets annually. Thesame pattern holds for a 7-1 or a 10-1. The longer thefixed period, the higher the rate. The idea is tomatch the loan to the amount of time you plan to stayin the house. For instance, if you expect to moveafter three years, a 3-1 is a great option. After 10years, you might as well opt for a fixed rate. Theprice difference will be minimal.
Figuring out which kind of loan makes sense for youdepends entirely on your circumstances andtemperament. But several of the sections found herecan help. What Kind of Loan Should I Get? walks youthrough some typical home buying scenarios andsuggests mortgage solutions. And you can use theworksheets found in How Much House Can I Afford? andFixed or Adjustable? to help you decide what size loanyou can handle and whether to take a chance on anadjustable.BACK TO THE TOP
3. "How Does a Bank Decide Whether I Get a Loan?"
There are many factors that go into the bank'sdecision, from how long you've been at your job to howmany credit cards you carry. The most important thinglenders look at, however, is your ability to meet yourobligation to them, which is a function of your incomeand debt levels.
To gauge your ability to pay, lenders look at a pairof numbers called the "housing ratio" and the"total-obligation ratio."
They're not as daunting as they sound. The first isjust the percentage of your gross monthly income that you'll need to spend on housing expenses after you buy the new home. It includes your mortgage payment,taxes, insurance and maintenance. Lenders will want tosee a ratio of 28% or lower. The total-obligationratio, meanwhile, is the portion of your income thatgoes to covering both your housing expenses and anyother obligations, such as credit cards, car loans andchild support. There, your lender will want to see aratio of 36% or lower. Both of these ratios are oftennegotiable upward.
Our worksheet, How Much House Can You Afford?, willtake you through the same process a lender uses toassess your application. It will tell you your ratiosand give you an idea of what size house they willallow you to buy.BACK TO THE TOP
4. "How Much Cash Do I Need Upfront to Buy a Home?"
These days, not much. Ideally, you would have enoughcash for a 20% down payment, closing costs equal toabout 3% to 5% of the purchase price, and enough leftover to cover two or three months of monthly housingexpenses. That gives you a big chunk of equity in yourhouse upfront and makes the lender happy -- somethingthat usually translates into a better deal. Thetrouble is, coming up with that much cash can be allbut impossible for many first-time buyers. After all,we're talking $40,000 on a $150,000 loan or $70,000 ona $250,000 mortgage.
The good news is that lenders over the last couple ofyears have become increasingly willing to finance asmuch as 95% or even 97% of a home. The reason: Theycan now unload the risk of such loans onto somebodyelse. To limit their exposure, many lenders regularlysell their loans to the Federal National MortgageAssociation (Fannie Mae), which then bundles them intosecurities which are eventually sold to investors. Itused to be that Fannie Mae only would buy loans for80% financing. But it recently standardized thelending criteria for 97% financing and will now buythese loans, making lenders much more willing toprovide them to you. It's now common for first-timebuyers to put down only 5%, or $7,500 on a $150,000 loan.
While this sounds enticing, remember that puny downpayments have their price. First of all, you startwith very little equity in your home. Also, if youdon't have 20% to put down, you'll probably have toante up for mortgage insurance (which protects thebank against default and can top $1,000 a year if youput 5% down on a $200,000 loan).
If you are buying in an urban area or have low tomoderate income, look into programs offered by yourcity or state that provide below-market loans withlittle or no down payment required. If you're reallycash-strapped, you can get 100% financing by"piggy-backing" a second loan equal to 20% of thepurchase price on top of your 80% loan. But that 20%second mortgage will come at a much higher rate.BACK TO THE TOP
5. "Just What Are Points Anyway?"
Lenders and home buyers are constantly referring to"points" when talking about mortgages. This is a fancyterm for the considerable fees you pay when you take out a loan. One point is equal to 1% of your loanamount. So, if you need a $150,000 mortgage and youhave to pay one point in fees, that charge equals$1,500. Lenders refer to points variously asloan-origination fees, discount fees or buy-down fees.
Like the interest you'll pay each month, points areessentially finance charges -- only you pay them upfront. Lenders blend them with interest rates to comeup with the characteristics of the loan. For example,the more points you pay up front, the lower theinterest rate the bank will charge you over the courseof the loan. Also, like interest, points are 100% taxdeductible in the year you pay them.
There is a science to figuring out how many points youshould pay under what circumstances. Sometimes you canopt out of paying points altogether, taking highermonthly payments instead. To figure out what makessense for you, check out our Points or No Points?worksheet.BACK TO THE TOP
6. "How Long After I Apply Will I Get the Money?"
These days it can take anywhere from two weeks to twomonths to get a loan commitment from the bank,depending on how complicated your application is orhow flooded your lender is at the time you apply. Ifyour loan is fairly standard, you should be able toget a commitment within two to four weeks after youapply.
Once the lender says it will give you the money,you'll probably still have some hoops to jump through.Most commitment letters come with certain conditionsthat you'll have to meet, like providing morefinancial information or submitting to a finalinspection of your property.
You won't actually get your hands on the money untilyou close the deal, usually a week or two after youget final approval from the bank. Don't dawdle. Loancommitments expire about 45 days after you receivethem and the rates and terms you agreed to may have tobe renegotiated with the bank. All in all, you shouldcount on it taking six to eight weeks from the timeyou apply until the home is yours.BACK TO THE TOP
7. "How Do I Know the House Isn't Going to FallApart?"
You won't know for sure until you move in, but thebest way to protect yourself is to hire an experiencedhome inspector to check the house's structure andsystems, including the roof, heating, plumbing,electrical and air conditioning systems. Check out ourHome Inspectors section for advice on how to choose agood one.
The cost of a home inspection ranges between $250 to$500. If you can, have the home inspected after youagree on a price, but before you sign the contract andput down a deposit. If you are in a rush to go tocontract to lock in the deal, make sure your contractstates that the terms of the purchase are conditionedon the approval of a professional home inspector.
Just because you need to hire a pro, doesn't mean youcan't do some checking around yourself before you makean offer. Check for soft spots in the flooring andlook for freshly painted patches on the ceiling orwalls that could be hiding water damage. Turn electricswitches and water faucets on and off. If it's summer,turn off the air conditioning and turn on the heat tomake sure it works. Likewise, if it's winter, test outthe air conditioning. Tour the basement looking forwater on the floor and see if the hot water heaterlooks rusted or cracked. A little diligence before youstart negotiations could save you a lot of time,effort and disappointment.BACK TO THE TOP
8. "O.K. I've Reached a Deal With the Seller and I'veGot Approval for the Loan. Now What?"
Now it's time for your attorney to order titlesearches and other final documents required by thebank and to schedule the closing -- the time and placewhere cash and ownership of the property changeshands.
The closing can take an hour or two and requires thepresence of eight to 10 people -- you, your attorney,the seller, his attorney, the bank, its attorney, andthe broker. You'll spend the bulk of the time signingdocuments and endorsing certified checks.
This is where you can expect to shell out the bulk ofthe cash. Along with the rest of the down payment,you'll have to cover an assortment of fees knowncollectively as "closing costs." Lenders are requiredunder federal law to give you a "good faith estimate"of all these charges and you should come ready to paywith a certified check. If your bank requires mortgageinsurance (which is likely if you aren't putting atleast 20% down) you'll also need to pay the firstpremium. Ditto for homeowners insurance.
Be sure to inspect the home right before you actuallyclose the deal. Make sure it is in good condition andany property, such as light fixtures or built-inbookcases that you were told you would get with thehouse are still there. All the appliances should workand it should be broom clean. After the closing isover, have the locks changed and the home is yours.BACK TO THE TOP
9. "Where Do All the Wonderful Tax Benefits Come In?"
You've heard again and again how buying a home is thebest tax break around. Maybe you've even been called achump for renting. After all, paying $1,200 a monthfor your mortgage is really the equivalent of paying$900 a month in rent. But how does that work exactly?
Here's the deal: Mortgage interest (including points)and real estate taxes are tax deductible. That doesn'tsound very sexy, but it adds up. Since most of whatyou pay for your mortgage in the first years isinterest, on a $1,200 mortgage payment you get todeduct about $1,080 a month. That reduces your taxableincome by about $13,000 a year. If you're in the 28%tax bracket, that deduction is worth about $300 amonth.
To see the benefit, you can either wait for a bigpayout after you file your income-tax return, oradjust what is withheld from your paycheck each month.Claim additional allowances on your W-4 form and yourpaycheck will jump immediately. You'll have to do theworksheet on the back of the W-4 form to figure outhow many additional allowances you can claim. Butusing the above example, you could take two or threemore.
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