In this post, we will review the prudent steps to take when buying your first home. Oftentimes, the first home purchase is the biggest financial decision someone has made and our goal is to outline the process that you can use to make sure you feel prepared when making this decision.
Defining Your Goal
The first step that any homebuyer needs to take before they can begin planning their purchase is to define what the goal of buying a home looks like.
Start by paying attention as you drive around town. What parts of town do you like and could see yourself living? Use an app like Zillow or Redfin to look at how much properties in that area cost and whether the homes that would be in your price range are homes you’d be happy living in.
You will also want to decide on a timeframe that you’d like to make the purchase in. Is this a 1-year goal? 3-years? 6-months? This timeframe will affect how much you need to be prepared to save for a down payment.
Determining Your Down Payment
The general rule of thumb when purchasing a home is to put 20% down on a home. This allows you to avoid having to pay ‘Private Mortgage Insurance’ or PMI as part of your monthly mortgage payment.
Additionally, there are closing costs involved whenever purchasing a home. Average closing costs are 2-5% of the loan amount. This will be needed on top of the down payment and should be planned for.
Example: If you decide that you’d like to plan on a home purchase of $300,000 and would like to target a 20% down payment, you will need $60,000 for your down payment and an additional $12,000 for your estimated closing costs for a total savings target of $72,000.
Calculating Your Projected Mortgage
When determining whether a home is within your price range, you also need to consider the monthly mortgage payment and whether that will fit within your budget. A typical mortgage has four components:
1. Principal
2. Interest
3. Taxes
4. Insurance
You may see this referred to as PITI for short and a financial planning rule of thumb is that you want to keep your mortgage payment to 28% or less of your gross monthly income and PITI plus any additional monthly debt payments you may have to 36% or less of your gross monthly income. These are rules of thumb so you can certainly take unique circumstances of your situation into account, but it is important to make sure that any mortgage payment you take on is sustainable and fits within your budget.
The principal and interest component of the mortgage will be factored by your loan. If we use the example from above, your loan of $240,000 would have an amortized monthly payment of $1,288 if you were to get a 30 year fixed mortgage with a 5% rate.
The taxes component will be based on your appraised property value and the tax rate for the location of the home. Home insurance will be specific to the cost of the homeowner’s policy that you obtain but according to a study done by NerdWallet, Dallas had the most expensive average monthly insurance cost in the country with an average rate of $324 per month on a $300,000 dwelling.
While you may be given the option if you have a 20% or larger down payment, generally the taxes and insurance will be escrowed with the mortgage servicer. This means that you pay them each month as part of your monthly mortgage payment and the servicer handles making the payments to the appropriate parties.
Developing a Savings Plan
Once you have determined a target home price and a down payment that will produce a mortgage payment within your budget, you can develop a savings plan to achieve the necessary down payment within the timeframe you’d like to make your purchase.
We are big fans of opening a separate account for the specific savings goal. Research shows that naming the account after the goal will also decrease the likelihood that you withdraw from the account if the need is unassociated with the goal of the account.
Once opened, you can fund the account with any savings you have already accumulated or gifts a parent or grandparent might be willing to make towards the goal. With your monthly savings target in mind, you can automate the process of saving your desired amount through an automated transfer set up to move funds just after each paycheck to the goal account.
Example: Using our $300,000 home purchase example from before we need to target a $72,000 ‘House Account’ balance to achieve our 20% down payment target. A generous gift from parents of $16,000 is used to initially fund the account and with a target of making the purchase in three years that would leave a monthly savings target of $1,556 per month to accumulate the additional $56,000 needed. If you get paid on the 1st and 15th of each month then setting up automated transfer on the 2nd and 16th for $778 ensures that your savings will happen automatically.
Getting Preapproved and Making an Offer
A mortgage preapproval is a letter produced by a lender saying they are willing to provide a mortgage up to a stated amount. It tells a seller that you are creditworthy and a serious buyer when making an offer on a home.
A preapproval is generally good for 90 days, so you don’t want to get preapproved until you are serious about looking. During the preapproval process, you may need to provide paystubs, proof of your down payment funds, information about any existing debt you are making payments on, and have a credit check run.
Once you find the home you would like to purchase you will submit a formal offer letter to the seller that will include the following details:
• Offer Price
• Earnest Money
• Closing Costs
• Projected Closing Date and Option Period
• Contingencies
When the offer is accepted a formal purchase offer agreement will be generated and signed by both parties.
Closing on the Property
Once your offer is accepted there will generally be a 30 to 60 day window until the actual closing date occurs. During this window a number of items will generally occur:
• There will generally be an option period in states that allow one where the buyer can back out of the deal without losing their earnest money
• Home Inspection
• Any contingencies on the home will be completed
• You will work with your lender to finalize your loan
• The lender will order an appraisal of the property
• You will establish a homeowners policy to go into effect the day of closing
Leading up to closing day, you will be given a closing statement that will outline the amount you must come to closing with including down payment and all other closing costs. The cash to close amount will generally be wired to the title company shortly before closing from your bank account.
WARNING: Wire fraud has been an increasing issue related to wiring closing funds. You should always call the title company to confirm that the wiring instructions you received are legitimate before initiating the wire.
Once you get to closing, you will spend about an hour signing paperwork and then receive the keys once the loan is confirmed funded.
If you are new to saving and investing, watch our ‘Finance 101’ video series here to learn about compound interest, stock market expectations, and good financial habits to build early in life.
If you’d like to discuss any of these strategies and how they might apply to your situation, schedule a meeting with our team here.
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Disclosure: The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Raymond James Financial Services, Inc. and your Raymond James Financial Advisor do not solicit or offer residential mortgage products and are unable to accept any residential mortgage loan applications or to offer or negotiate terms of any such loan. You will be referred to a qualified Bank Consultant for your residential mortgage lending needs.
