4 Smart Steps to Take Before Buying Your First Home
Becoming a homeowner can be a daunting process for anyone, especially young adults or those without experience making such big purchases. Rushing through this long-term, multi-step financial process -- deciding how much home you can afford, fixing any blemishes on your credit report and saving for a down payment -- can prove tremendously costly. Years before you even think about hiring a real estate agent and starting an in-person home search, you need to take the time to prepare yourself financially.
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If you intend to buy a house in the next five years or so, here are four steps to help lead you down the path to homeownership.
1. Consider where you want to live.
Don’t buy a home where you live now, just for the sake of homeownership. For many twenty- and thirtysomethings still exploring their career paths, buying a home can really limit their freedom. If you’re serious about becoming a homeowner, make sure the city you decide to buy in is a place you won’t mind sticking around for a while. Experts often advise would-be buyers to plan on staying in a new home no fewer than five to seven years. “You’re going to spend thousands of dollars to get into the home. To get out of it is going to be equally expensive and may possibly cost more when you do it in less than five years or in a down market,” says Keith Gumbinger, vice-president of HSH.com, a publisher of mortgage information and rates.
How do you decide which area is best for you to settle down in? You should definitely consider the local job market and cost of living. Other key factors that will likely impact your quality of life: the city’s demographics, access to public transportation and the social scene. If you’re single, for example, you might be interested in places with an abundance of other unmarried people (see Best Cities for Singles). Or people with limited budgets might want to look at cities where they can still have a life outside of the office without having to pay a fortune for it (see Best Cities for Cheapskates).
2. Determine how much home you can afford.
Once you’ve decided where you want to live, use a home search Web site, such as Realtor.com or Trulia.com, to get a detailed look at the market, recommends Eric Tyson, co-author of “Home Buying for Dummies.” It’ll provide perspective on the types of properties for sale and what sellers are asking for. Seeing exactly how much homes cost will help you determine how much you can actually afford and how much you'll need to save for a down payment. If homes in your desired neighborhood are outside your price range, you can delay buying until you save more money, or you can downsize the type of home you’re looking to buy, or search in a different neighborhood.
That’s what happened when I embarked on a new home search with my boyfriend last spring in the Washington, D.C., metro area. In the beginning, he was pretty adamant about being in the city -- me, not so much. We soon realized that our list of must-haves (a modern home with three bedrooms, two bathrooms, central air conditioning and designated parking) meant we could only afford a fixer-upper in northwest Washington. Because neither of us is handy -- and I wasn’t comfortable buying a place that needed a ton of work -- that wasn’t an option. After that reality check, we broadened our search area and settled on a new townhome community located in a Maryland suburb about ten minutes outside D.C. Homes there cost about half as much as comparables we’d seen in the city.
3. Boost your credit.
Your credit score plays an important role in qualifying for a mortgage. A score of 740 or above will help you secure the best interest rates. In the Washington area, for example, that’s about 4% for a $200,000, 30-year fixed-rate mortgage with a 20% down payment, according to Bankrate.com. (Look up mortgage rates in your area.) If your score is lower than 740, however, expect to pay a higher rate. For that same loan in the D.C. metro region, if your credit score ranges from 680 to 699, the lowest rate you’d be able to get is about 4.25%.
Many young would-be home buyers might find themselves with blemishes on their credit report, thanks to missed student loan or credit card payments. Lucky for me, I learned long before pursuing homeownership that such behavior comes back to haunt you in the form of a low credit score. I’ve changed my bad spending habits and boosted my score. If you check your credit report early, you'll have ample time to correct any issues. “What you don’t want is to have to address a bunch of mistakes on your credit report while actively looking for a home and trying to get approved for a mortgage loan,” says Gumbinger.
Visit AnnualCreditReport.com to get a free report from each of the three major credit bureaus. (See Avoid Credit-Repair Scams.) If you notice a problem in one report, be sure to check with the other two bureaus, too. You can dispute an error by contacting the credit bureau directly. Note that your free credit report does not include your actual credit score. You'll usually have to pay to see your FICO score. At myfico.com, you can get your credit report and FICO score from each of the three credit bureaus for about $20 each. (Your score can vary from bureau to bureau.)
4. Start saving for a down payment.
In addition to building stellar credit, you should also save enough for a down payment of at least 20% of the home price to snag the best mortgage terms. That amount saves you from having to pay for private mortgage insurance, or PMI, which protects the lender if you default on the loan (read more about this in What It Takes to Buy a Home). Even with an excellent credit score, if you put just 5% down on a home that costs $201,700 (the national median existing home price as of April 2014), private mortgage insurance will cost you an additional $92.61 each month, according to HSH.com.
That down payment’s not chump change; 20% of $201,700 amounts to $40,340. For many young adults with starting or even mid-level salaries, it can take many years to stash away that much. Start saving now!
You should keep the cash liquid because you're aiming to use it in the next few years. We stored our funds in a regular savings account to give us direct access to it. You might also consider a short-term certificate of deposit. Neither option will earn you much right now, but your money will be safe from market losses and easy to tap as soon as you need it. In the meantime, here are the 10 Best Ways to Earn More Interest on Your Savings.
Once you’ve completed these steps, you should be ready for the second phase, which includes finding a trustworthy real estate agent, getting preapproved for a mortgage loan, viewing potential homes in person and making an offer on a home. We’ll have more on these steps in an upcoming Starting Out column.