Advice for First-Time Home Buyers

Anh Nguyen always dreamed of having a walk-in closet. So the first thing she did after buying her Arlington, Va., duplex a year ago was make that dream a reality: Racks and shelves of clothes and shoes now line the walls of what was once a tiny bedroom. Creating her dream closet led to polishing up a finished basement to create a real third bedroom. Nguyen needed the space for two roommates, her best friends, who would be moving in to help cover the costs of ownership.

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The 25-year-old IT consultant qualified for a $320,000 mortgage on her own, but having roommates keeps her firmly in the comfort zone. At a 5.3% interest rate, her monthly mortgage payment is $2,000, and she covers more than half of that with rent money from her roommates. The three share the cost of utilities, making Nguyen's budget even more manageable. "I really lucked out," she says. "Aside from my roommates' financial support, they make the house feel like a home."

The new deal. Home prices appreciated smartly during the recent housing boom, but that didn't stop younger people from breaking into the market. Four in ten buyers are purchasing for the first time, and the median age of those first-time homeowners is 32. Thanks in part to an explosion of zero-down-payment loan products, the number of first-time buyers younger than 25 jumped from about 11% earlier in the decade to 14% last year, accounting for almost 6% of all home sales. In 2005, 43% of first-time buyers purchased with no money down, according to the National Association of Realtors.

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Buying your first home no longer involves mortgage deals from the Department of Veterans Affairs or the Federal Housing Administration designed to meet the needs of first-timers. "There are so many options out there that these programs aren't as beneficial," says Jim McMillan, a senior loan officer with JP Mortgage/JPMorgan Chase.

The no-money-down VA loan is all but dead. But the FHA loan is a good vehicle if you have less-than-stellar credit. Find a housing counselor at www.hud.gov.

Finding the cash cow. Even if you don't need money for a down payment, you'll still need cash for closing costs—figure on 2% to 3% of the purchase price. You'll also need cash for the earnest-money deposit to show the sellers you're serious about your offer. The deposit, typically 10% of the offering price, is applied to the purchase.

One source of cash may be your Roth IRA, from which you can withdraw the amount of your contributions at any time. In addition, after the account has been open for five years you can withdraw $10,000 in earnings -- tax- and penalty-free -- to use toward the purchase of a first home. You can also take up to $10,000 out of your traditional IRA penalty-free for the purchase of your first house or to cover closing costs. But in that case you'll owe taxes on the money. Another option is to ask the seller to pay your closing costs and roll that amount into the cost of the home.

A generous family member might be willing to make you a gift to help cover costs. Lenders usually ask for a letter stating where the funds came from and confirming that the money is not a loan, says Ilyce Glink, author of 10 Steps to Home Ownership (Three Rivers Press, $15).

Brian Roy of Allentown, Pa., owes his homeownership to a gift, of sorts. He was 30, just out of medical school and saddled with more than $200,000 in student-loan and credit-card debt. Feeling that he "needed to get started in life," he began checking out his options for buying a home. Because he had so much debt and no down-payment money, he was offered a rate of 6.5% on a first mortgage, plus a second mortgage with a variable rate of 6.9% that could go as high as 22%. That's when the Bank of Roy stepped in.

Brian's father, Dennis, offered him a 30-year fixed-rate loan at 6.5%. Brian snapped it up and was able to buy a property with two units—one to live in and one to rent.

The Roys structured their family loan through CircleLending, an Internet loan-administration company that specializes in private loans. For an upfront fee ($200 to $600, depending on the amount and terms of your loan), CircleLending does all the paperwork to set your loan in motion. Large loans and those paid back over more than one year generally carry an annual service charge of about $100.

Brian's credit will benefit as his payments are reported to a credit agency -- and the money stays in the family.

How Much Can You Borrow?

Lenders look at three things when you apply for a mortgage: credit score, debt-to-income ratio and down payment. "If you've got two of the three elements working for you, you're in good shape to buy," says Jim McMillan, a senior loan officer with JP Mortgage/JPMorgan Chase.

All lenders are credit-score-driven these days. FICO scores, the most commonly used, range from 300 to 850, but the number to shoot for is about 750, says McMillan. The higher your score, the more flexible lenders will be. But even with a score of 700, he says, you'll still be considered an A borrower and qualify for the best rates.

Another big consideration is your debt-to-income ratio. Traditionally, lenders have followed the 28/36 rule: No more than 28% of your monthly gross income should be dedicated to your mortgage payment, property taxes and insurance, with total debt payments equaling no more than 36% of your gross income. But if you have no other debt, you can dedicate 36% of your income to home payments. With an FHA-backed loan, you may be permitted to apply as much as 41% of your income to total debt.

Coming up with the down payment is a struggle for many buyers, but it can make a big difference, especially if you don't have stellar credit. The more money you put down, the less risk the lender takes on. A 20% down payment is the threshold at which you're exempt from private mortgage insurance, which can add a few hundred dollars to your monthly mortgage payment. Thanks to a new law, mortgage insurance premiums are now fully tax-deductible if your adjusted gross income is less than $50,000 ($100,000 if married and filing jointly) and you itemize deductions.

How the 28/36 rule applies: If you make $40,000 a year, your payment for your mortgage, property taxes and insurance should be no more than 28% of your gross income, or $933 a month. Payments on total debt should be no more than 36% of your income, or $1,200 a month.