How to Nail Your First Home Purchase
Like most Millennials, owning your own home isn't just about creating a dream of personal space. It's about financial independence, too. Owning a home is one of your most significant financial decisions and can be the foundation of your financial security. It can also be a source of stress and strain if you do not properly plan your house purchase. Being house poor is a real thing.
The process is complex, from setting your goals to getting the keys. I break down the key steps you should consider so your purchase goes smoothly and you live your ideal pursuit.
Buying a home is one of the most significant financial moves you will ever make. You should be aware of many issues, including how the costs of purchasing and owning a home will impact your overall financial planning goals. In addition to this blog, I provide this checklist to help you organize your thoughts surrounding your home purchase. Download the list here.
Buy When You Are Ready
I often get this question: "The housing market is crazy these days. Should I buy?" The answer is, "It depends." Yes, the housing market nationally is a bit crazy, but your real estate market is unique, and you may still find a good opportunity. I tell folks to buy when they are ready. Buy a home once you have thoroughly mapped out the risks. Buy your abode when you are willing to accept those risks. And buy after you clearly understand how being a homeowner will fit into your ideal life.
Home Buying Timeline
The timeline below outlines key milestones when buying a home.
Set Your Goal
Like I said, being house poor is a real thing. And being house poor comes in many flavors. The house you can purchase may not be the house you want to live your ideal life. You will need to use one of the most powerful tools in personal finance to determine the price, down payment, and mortgage for your future home. You need to set up a budget.
In fancy financial jargon, this budget will be a pro forma budget. In other words, this is a forecasted budget. This budget estimates your future income, taxes, retirement savings, savings for different goals, student loan payments, other debt obligations, and living expenses.
Pay special attention to properly setting aside enough money in your budget for your other vital objectives, such as saving for your (future) children's education, travel, retirement, or starting a business. This is where most potential home buyers get messed up. Failure to account for spending and savings for things that are very important to you can result in a situation where you are not living your best life. Instead, you end up living for the home. You end up being house poor.
Next, your living expenses in this forecasted budget should include the new costs of being a homeowner. Those costs will consist of mortgage principal and interest, private mortgage insurance, homeowner's insurance, taxes, maintenance costs, and homeowner's association fees.
When determining how much home you can afford, it's also important to note the trade-offs you may have to make. Evaluate location, school district, taxes, and size. If your ideal location is out of your price range, see if surrounding neighborhoods offer a more affordable option. Prioritizing what's most important will help you evaluate your options.
The Loan
As you set your forecasted budget, you will want to account for different loan regimes. Do some scenario analysis to see what your payment will be with varying rates of interest, down payments, and terms. You have many options when it comes to loans. Reflecting on your goals and budget will help you determine the best loan to aim for.
What's the Right Size Down Payment?
Putting down at least 20% on a new home is highly cost-effective. You save on mortgage costs, and you also save on the cost of mandatory private mortgage insurance (PMI), which lenders require for instances where there is less than a 20% down payment. Another advantage is that in a tight housing market where you may be competing with other buyers for your dream home, having 20% in cash may push a seller in your direction.
However, 20% can be challenging for many Millennials to attain. There are other options. Using your budget, estimate your future cash flow under different down payment scenarios. A smaller down payment increases your mortgage payment but may allow your current budget and goals to pencil out. Alternatively, a larger down payment may mean more time spent saving. Some qualified borrowers may be able to acquire a loan requiring only a 3.5% down payment. Doing your homework now will help you further down the road. And doing this exercise with a pro forma budget that reflects your other goals will help you determine what you actually can afford.
Don't Forget to Save For Closing Costs
In addition to saving for a down payment, you will also need to save for closing costs. Although closing costs are typically less for buyers than sellers, they can still be significant. Accounting and saving for these costs are critical.
Rule of Thumb
Rules of thumb can be helpful when reviewing your pro forma budget. But they are just rules of thumb. Your total cost of mortgage principal, interest, taxes, and insurance should be less than 28% of your gross income. Only a thorough investigation of your pro forma budget will help you make the best-informed decisions.
Proactively Manage New Risks
A pro forma budget will help you anticipate risks before buying the home. I like to say a forecasted budget allows you to live your life before committing to anything. In addition to accounting for homeowner's insurance, review life insurance coverage for you and your co-owner if you plan to buy the house with someone else. Life insurance is needed to ensure that the survivor will have a plan to cover the mortgage and tax payments in the event of an untimely death. Also, use your pro forma budget to estimate the new emergency fund you need to have once in your new home. Your emergency fund will help you cover unforeseen costs. And this fund should be equal to three to six months of your essential living expenses.
Setting Your Goal and Planning Your Down Payment
Review your current budget to determine the maximum percentage you can save from your income for a down payment. It's best to select a monthly saving number and then open an investment or high yield savings account that you automatically add to every month.
An investment or high yield saving account is vital for two reasons: you want to boost your savings by earning interest, dividends, or capital gains as quickly as possible. Whether you deposit your savings to an investment or a high yield savings account depends on your timeframe, risk tolerance, and need. While your retirement accounts may be structured for growth because of the long-term time horizon, preserving capital is crucial when saving for a down payment. There is limited time to recover due to a market drop.
Next, having separate funds earmarked for your home goal makes it more difficult to accidentally use the savings – which helps keep you on track.
Consistently contributing to yielding accounts specifically for funding your down payment, closing, and moving costs is an excellent way to potentially accelerate the achievement of your goal. A financial planner can help you set up your home purchase goal and down payment savings strategy.
Start the Lending Process
As you get closer to your goal's purchase date, check your credit report and start with a pre-qualification interview with a mortgage loan officer. They'll help you understand all the things that lenders consider besides income. Assuming everything looks good, your next step is to get pre-approved for a mortgage loan. Once you feel ready to start looking, go talk to your bank – or a few banks.
Mortgage Pre-Approval
A mortgage pre-approval in today's market is essential. The pre-approval will buy confidence from your realtor and will likely be an advantage when it's time to negotiate with a seller. Getting pre-approved can be time-consuming and arduous. But, having one can prevent costly delays and disappointments.
A mortgage pre-approval requires a complete financial package, including proof of identity and employment, income and debt information, and savings and investments. The pre-approval doesn't guarantee that you'll get a loan, but it tells a seller you can make a legitimate offer and have committed to making the process as quick as possible.
The mortgage pre-approval will outline how much the bank is willing to lend you for a given interest rate. It outlines what the bank thinks you can afford. This letter does not outline how much you think you can afford. Your pro forma budget, based on your other goals and values, will determine how much you can afford. This is key to keep in mind.
Shop & Purchase
This can be the most stressful and emotional phase of attaining your goal. But you've got it! You have put tons of sacrifice into getting to this point. Keep your goals and values in mind as you make a purchase decision; doing so will help you live your ideal life.
The Takeaway
Buying a home is a monumental achievement. By saving for a down payment and being careful to purchase a home that fits within your overall aspirations, you'll be able to progress to your ideal pursuit. Taking prudent planning steps is essential for your success.
Do you need help strategizing your home purchase goal? Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.
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Schedule a free call with Nate Baim, MBA, CFP®
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