Make up your mind if you really, really want to own your own house. Maybe it is just something that makes up your American Dream but you have not actually counted the cost. Can you really afford now to buy your own house?
You have to settle what you really want now and in the future. This is the first step towards understanding the huge financial and lifestyle commitment of being a house owner. Whether you are boldly going ahead or cautiously putting it on hold for a few more years, learn about it.
It will always pay to arm yourself with good financial basics before you buy your first home.
What Are The Most Important Things To Know Before Getting a Mortgage?
You’ve probably heard many pieces of advice from friends and the media, and I know it can be very confusing. While part of them are really useful and valuable, part of the advice is controversial and should be taken only in case of a specific financial situation.
Therefore, we’ve summarized the most important things you have to know before getting a decision regarding your mortgage:
1. Shop Around for Your Mortgage and Get Pre-Approved
Some people do their ‘shop around’ in the comfort of their homes by looking at different websites. After comparing published rates, they usually select a single financial institution to work with.
While this may be convenient, it is still better to personally meet with several banks. This way, you can see the different options they offer and they can answer your questions on the spot. More importantly, many of them will be willing to pre-approve you on several mortgage offers.
Pre-approval will save you a lot of time. It will give you a maximum amount you can work with while hunting for a house. This is a lot better than finding a house then going back to the bank to get an approval. This means that the pre-approved amount becomes your budget for the house.
Banks take different times to pre-approve and some take much longer than others. It is better to invest your time working for your pre-approval. You will get a lot of benefits for doing this. You may even find a bank that will slice 0.25% off your mortgage rate when they pre-approve you. In the long run, that seemingly insignificant portion could be a lot valuable in terms of time and money savings.
2. A 20% Down Payment Is Essential
If you do not have money equivalent to the 20% down payment, you better pause for a while. Going ahead with less than that could mean more money out of your pocket. The bank will definitely try to cover their exposure representing the shortfall from the 20% equity.
This is what will happen. When you want to purchase a house but cannot put up the full 20% down payment, the bank assumes more risks. They’ll see you not as a serious house buyer who may later dump the house on them. They might assume that you will not make sufficient payments and leave them with the house. The bank will have to spend to foreclose the property.
Don’t Forget The Insurance
So before they give you a loan, they will require you to sign up for mortgage insurance. It will cost about 1% of the total mortgage balance each year. The bank will add it to your mortgage payment. In effect, you are going to add 1% to your loan rate. So, if your loan rate is 3.5%, you will actually be paying 4.5% per year.
Here’s another bad news. That mortgage insurance will stick to your account like glue until the balance of your principal reaches a benchmark. It has to be less than 80% of the value of the house. There will be no ifs and buts about this as far as the bank is concerned. They won’t remove the insurance until they’re positive it’s less than 80% of the lowest possible value of your home.
Why 20% Down Payment?
Why do the banks do this? It’s a safeguard against borrowers who might not follow through with their obligations. Unfortunately, their parameters put you in this category of borrowers. You are trying to borrow money without bringing much of your own to the deal. You won’t even try to raise the 20% acceptable down payment for your mortgage.
Financially, the real impact of not putting up the entire 20% are you having to pay more. For the early years of your mortgage, you are going to pay an additional 1% more to the bank. This means that if you’re buying a $300,000 house, your mortgage insurance comes up to $3,000 per year. The disheartening thing about this is, your payment will not apply to your principal. The money just goes away every year.
So, the simple way out of this is to save money for the 20% down payment. By being smart with your money, you may just be able to do this fast enough. Practicing good money sense gives you another advantage aside from coming up with the down payment. It gives you the discipline to handle your finances well, which is really the key to successful home ownership.
Having a clean title to your own home is very fulfilling but there’s a cost, a huge one. If you’re used to spending money without much planning and control, saving for the 20% is good training. It might build a good financial foundation that will be beneficial to you when you finally become a homeowner.
3. Looking Beyond Your Starter Home
Where will you be 10 years from now?
Visualize your family and life situation in that period of time and see if your house fits into the picture. If you purchased a starter home, you could easily predict that it will be too small for your family later. Then, you can see yourself shopping for a much bigger house. A good strategy would be to purchase a house big enough for your future family. This way, you won’t have to keep moving to a bigger house each time your family grows.
Of course, this may entail a higher mortgage but you can weigh the benefits. For one, you won’t have to go through the process of house hunting, purchasing, moving in and settling down repeatedly.
4. A 15-Year Mortgage Versus a 30-Year Mortgage
Let’s cut through the illusion. For a 15-year mortgage, your interest will only be a third of the interest for a 30-year mortgage. This means that effectively, more money from your monthly amortization pay for the principal and less for the interest. 15 years is also obviously a lot shorter than 30 years.
A 15-year mortgage comes with a lower interest rate. However, you will see that many borrowers still go for the 30-year mortgage. This is because, on paper, a 30-year mortgage will have a lower monthly payment. People often compare the two terms’ monthly payment and will only see that the 15-year mortgage is a lot higher. Many people just raise their hands sincerely believing they will not be able to afford it.
Think of it this way. If you’re saying you can’t afford a 15-year mortgage, then you also can’t afford a 30-year mortgage. Technically, whether it’s 15-years or 30-years, your situation is the same. You’re buying a house you can’t really afford.
Unless there is a deeper and compelling reason to get a 30-year mortgage, a 15-year mortgage is better. If you really can’t afford the 15-year mortgage for the house you want, you should probably look for a cheaper property.
Assume that you got a 30-year mortgage and tried your best to pay it off early. So you made triple, quadruple and quintuple payments until you paid it off in 5 years. Now you’re debt-free. Now, assume that it was a 15-year mortgage and you did the same strategy. You would have probably paid it off in less than 3 years and be debt free earlier. Plus, you would have paid less interest to the bank.
5. Set 40% Of Your Take-Home Pay As Ceiling For Debt Servicing
While other financial coaches would advise a much lower percentage, 40% works good enough to take financial worries away. The computation is quite simple. Take the total of the monthly payments for all your existing debts. Then add the monthly payment for your 15-year mortgage. Divide the total amount over your monthly net take home pay (See How To Calculate Your Mortgage Payments And What Are Its Main Components).
If the resulting percentage is above 40% then you should reconsider buying that house. It would mean that nearly half of what you would be earning, you would just use to pay off debts. Financially, that is not a very good situation to be in for you and your family.
Follow The Rule
Many people who are not aware of this simple financial rule fall into financial binds. It would be good if your loan officer would caution you about going above the 40% limit. You might find some financial institutions that follow this rule before they grant a loan. The key is to have a budget that caps debt servicing to 40% of your take-home pay.
If you do not follow this rule, you might end up borrowing more than you could afford. Some homebuyers make the mistake of purchasing a much bigger house than they could pay for. Some of them did not realize that they’ve bought houses one and a half the price over their budget. They often realized their big mistake only when they started their monthly payments.
Keep to a budget where only up to 40% of your net take-home pay goes to debt payments. If the house you want won’t exactly allow you to stick to it, keep saving more money for now. Or perhaps look for a much lower priced house.
6. Make Sure Your Wallet Is Full When You Move In
Before moving in, it is normal for you to get all excited. However, don’t use all your money for the down payment, closing cost or other expenses like maybe some new house decorations. Keep a good amount of cash handy when you move in. This is not superstition. This is you being prepared for the unavoidable stack of expenses that you’ll discover when you move in.
You’re going to find out that you lack a lot of things.
These are mostly items that your landlord previously took care of. You’ll need a lawnmower or a lawn-mowing provider. You’ll need your own set of different tools. You need to furnish your new home. Even low-cost or DIY furniture will cost you some money. You might need appliances, decorations, small things like a doorbell or kitchen hooks and food and drinks. If you have friends who will help you move in, it would be nice to have food ready for them.
These expenses will add up to a good amount no matter how much you pinch the pennies. Avoid the temptation of using your credit card for these items. It’s not a good way to start your life in your new house saddled with credit card debts. Remember, the card payments will also eat up to your 40% debt threshold.
So, while you are preparing to say goodbye to your apartment, build up a fund for these moving in expenses. You will be glad you did because later, you can really relax – right in your own brand new living room.