Buying a house can be a fun and exciting experience but it’s also one of the most important financial decisions that you are going to make during your lifetime.  This article is designed to help home buyer’s understand:

• The home buying process from start to finish

• The parties involved in the process (real estate agent, attorney, bank, etc.)

• Common pitfalls to avoid

• What to expect when applying for a mortgage

• How to calculate the amount of your down payment

Owning Versus Renting

You first have to determine if owning a house is the right financial decision for you.  Society wires us to think that owning a house is automatically better than renting but that is not necessarily true in all situations.  From a pure dollar and cents standpoint, it may make sense to keep renting given your personal situation.  We typically tell clients if there is a fair chance that they may need to sell their house within the next 5 years, in many cases it may make sense to keep renting as opposed to buying a house given all of the upfront costs associated with purchasing a house.  It takes a while to recoup closing costs and when you go to sell your house you will most like have to pay your real estate agent 5% - 6% of the selling price.

Determine How Much You Can Afford

Before you even start looking at houses you have to determine two things:

• The down payment and closing costs

• The amount of the monthly mortgage payment that fits into your budget

There is no point in looking at $300,000 houses if you cannot afford the down payment or the monthly mortgage payment so the initial step involves determining what you can afford.

Calculating Your Closing Costs

Closing costs are in addition to your required “down payment”.  First time home buyers often make the mistake of just using the 5% down or 10% down as a rule of thumb for their total upfront cost for buying a house. They often forget about closing costs which can add an additional 2% - 5% of the purchase price of the house to the amount due at closing.  Closing costs include:

Discount Points:  An up-front fee that you can choose to pay if you want to reduce the interest rate on your loan.

Origination Charge:  Fee for processing your mortgage application, pulling credit reports, verifying financial information, and creating the loan

Rate-lock Fee:  If you choose to lock in your interest rate beyond a certain period of time

Other Lender Fees:  Document preparation fee, processing fee, application fee, and underwriting fees

Appraisal & Inspection Fees:  Fees for the lender to inspect and appraise the value of the house

Title Services:  Fee charged by the title agent to determine the rightful ownership of the house you are buying and some lenders require title insurance.

Government Recording Charges:  Every home buyer must pay these charges for the state and local agencies to record the loans and title documents

Transfer Taxes:  Depending on where you live, your state, county or city may charge a tax when the ownership of a home is transferred

Escrow Deposit:  At the closing of your home loan, if you decide to escrow or if an escrow is required, there will be an initial deposit in your escrow account to pay for future recurring charges associated with your home, such as property taxes, school taxes, and insurance.  You will typically need to pay for the first year of your homeowner’s insurance in full before your home loan closes.

Daily Interest Rate Charge:  This charge covers the amount of interest that you will owe on your home loan from the time your loan closes to the first day of your regular mortgage billing cycle.

Flood Insurance:  This is a form of hazard insurance that is required by lenders to cover properties in flood zones.

Attorney Fees:  Fees typically vary from $300 - $1,000.  Most individuals will work with a real estate attorney to review and negotiate the purchase agreement on their behalf. These fees are sometimes paid to the attorney prior to the closing.

As you can see there are a number of fees that you have to be prepared to pay in addition to the down payment required by the lender.  Lenders are required by law to give you a “good faith estimate” (GFE) of what the closing costs on your home will be within three days of when you apply for a loan.  However, these are just estimates and many of the fees listing on the GFE can legally change by up to 10%, potentially adding thousands of dollars to your final closing cost bill.   A day before your closing the lender should provide you with a copy of your HUD-1 settlement statement, which outlines all of the closing fees.

Calculating Your Down Payment

The amount of your down payment will vary based on the type of loan that you received to purchase your house.  The three main types of home loans are:

• FHA Loan

• Conventional Mortgage

• VA Loan (Veterans Affairs)

FHA Loan: FHA stands for Federal Housing Administration.  The loans are made by banks but they are guaranteed by the FHA which added additional protection for the lender.  FHA loans come with a minimum down payment of 3.5% which make them very popular.  With these loans borrowers pay PMI (private mortgage insurance) premiums both upfront and each year until the loan is paid down to a specified level.  Loan limits vary by housing type and county.  These loans tend to favor low to middle income borrowers who do not have a means to make the traditional 10% - 20% down payment at closing.

Conventional Mortgage:  Minimum down payment varies from 5% - 20%.  Borrowers that put down less than 20% will have to pay PMI (private mortgage insurance).  Conventional mortgages typically require a higher FICO score than FHA loans.  These loans tend to favor borrowers with higher credit scores and have enough cash on hand to make a sizable down payment.

VA Loan:  VA loans are available only to veterans.  The greatest benefit of these loans is they require no down payment and they allow qualified borrowers to purchase a home without the need for mortgage insurance.   VA loans also tend to have more flexible and forgiving requirements.  The VA charges a mandatory Fund Fee of 2.15% for regular military and 2.40% for Reserve/Guard on purchase loans.Let’s bring it all together in an example.  If you anticipate on buying a house for $200,000 and you plan on taking an FHA loan, the amount that you will need to save for the closing will be in the range of $11,000 - $17,000 (3.5% for the down payment and 2% - 5% for the closing costs).  This calculation will obviously vary based on the type of loan you plan on taking to purchase your house.

Determine what your monthly mortgage payment

After you have determined how much you need to save to meet the upfront cost of purchasing a house, the next step is to determine the monthly mortgage payment that fits into your budget.

Step 1:  Establish your current monthly and annual budget.  There is no way to determine what you can afford if you have no idea where you are now from an income and expense standpoint.  Tip: Be brutally honest with yourself when listing your expenses.  The last thing you want to do is underestimate your expenses, buy a house you cannot afford, and then go through a foreclosure.   You will also have to factor in additional expenses into your budget as if you owned the house today such as lawn care, snow removal, appliances, and maintenance expense.  As a renter you may not have any of these expenses now but as soon as you own a house, now when something breaks you have to pay to fix it.  Homeownership is often times more expensive than most individuals anticipate.

Step 2:  Based on your current monthly income and expenses, how much is left over to satisfy a monthly mortgage payment?  The general rule is your monthly mortgage payment (including property taxes, PMI, and association fees) should not exceed 32% of your monthly gross income.  Tip: Leave some extra room in your budget for life’s unexpected surprises. For example, furnace need to be replaced, dishwasher brakes, spouse loses a job, plumbing issues, etc.

Step 3:  Use an online mortgage calculator to determine the loan amount that meets your estimated monthly mortgage payment.  Do not forget to take into account property taxes, school taxes, association fees, PMI, and homeowners insurance when reaching your estimated monthly payment.

The parties involved in the home buying process 

There are a lot of different professionals that you will interact with during the process of purchasing your house.   It’s important to understand who is involved, what their role is in the process, and how they are compensated.

Buyer & Seller: This is pretty self-explanatory.  Most buyers and sellers work through realtors and attorneys to complete the real estate transaction so there is typically little or no direct interaction between the buyer and the seller.  However, in a “for sale by owner”, the buyer or the buyer’s realtor/attorney will be in direct communication with the seller since there is no real estate agent on the sellers side.

Real Estate Agent (Realtor):  Real estate agents are important partners when you are buying a house.  They can provide you with helpful information on homes and neighborhoods that isn’t easily accessible to the public.  Their knowledge of the home buying process, negotiation skills, and familiarity with the area you want to live in can be very valuable.  In most cases, as the buyer, it does not typically cost you anything to use a realtor because they are compensated from the commission paid by the seller of the house.

Real Estate Attorney:  Remember, buying a home is a legally binding transaction.  A real estate attorney can help you avoid some common pitfalls when purchasing your home.  The home buying process eventually results in a formal purchase agreement between the buyer and seller.  The purchase agreement is the single most important document in the transaction.  Although standard printed forms may be used, a lawyer can explain the forms and make changes and additions to reflect the buyer’s wishes. Examples are:

• What are the legal consequences if the closing does not take place?

• What happens if the inspection reveals termites, radon, or lead based paint?

• Will money be held in escrow from the seller’s proceeds to replace certain items?

How much does a real estate attorney cost?  It varies, but expect to pay somewhere in the range of $350 - $1,000.  Often times you have to pay the attorney a retainer or pay them in advance of the closing.  The amount an attorney charges is usually dependent on the level of services that they are provided to you.  Some attorneys may just be preparing the deed while other attorney’s may provide you with a more complete package which can include deed preparation, title examination, purchase agreement review, and lender work.   Make sure you fully understand how the attorney’s fee structure works and it often helps to ask your professional network or friends for attorney’s that they have worked with and would recommend.

Bank / Credit Union:  Most home buyers need a mortgage to finance the purchase of their house.  It is recommended that you contact a few banks and credit unions in your area to compare interest rates, closing costs, and fees associated with the issuance of your mortgage.  Similar to selecting a real estate attorney we strongly recommend asking your professional network (accountant, investment advisor) for lenders that they recommend working with.  You will have a lot of interaction with the lender throughout the home buying process and working with a lender that makes the underwriting process as smooth as possible will make the overall home buying experience much more enjoyable.

Home Inspector:  After your offer has been accepted by the seller you will need to hire a home inspector to visit the house.  Your real estate agent will most likely recommend a home inspector to use.  The job of the home inspector is to visit the property to make sure there are no issues with the house that may not be apparent to the untrained eye.  They look for termite damage, structural issues, mold, condition of the roof, electric, plumbing, drainage, septic, radon levels, etc.  A few days after their visit they will provide you with a formal report of their inspection.   You typically pay them at the time they conduct the inspection.  The cost of a home inspection typically ranges from $250 - $600.

Insurance Broker:   You will need to obtain a homeowners insurance policy prior to the closing date.  Since you are adding a house to your insurance coverage, often times this is a good opportunity to look at your insurance coverage as a whole because insurance companies will usually offer discounts on “bundling” your insurance coverage.  Meaning that a single provider covers your house, cars, and personal umbrella policy.  The annual cost of your homeowners insurance will vary greatly depending on the value of your house and where the house is located.  For homeowners that have an escrow account associated with their mortgage, the homeowners insurance premium is typically baked into your total monthly mortgage payment , the insurance company issues the invoice directly to the bank, and the bank pays your homeowners insurance directly out of your escrow account.

Timeline: The home buying process from start to finish

Now that we have explained how to determine what you can afford and the parties involved in the home buying process it’s time to put it all together so you know what to expect step by step through the process of purchasing your new home.

Step 1:  Get prequalified for a mortgage.  You may think you can qualify for a $250,000 mortgage but you really do not know until you actually apply.  In the preapproval process you will provide some information to the bank that will be issuing your mortgage such as tax returns, statements showing investment and savings accounts, and they will usually run a credit report.    The more intense financial due diligence happens after an offer has been accepted on your house and they are actually preparing to provide you with the loan.

Step 2:  Begin looking at houses.  Most individuals at this point will hire a real estate agent to help them find and look at houses.

Step 3:  Make an offer.  Once you find the house that you want, you will have your real estate agent present the seller with your offer.  This is where the negotiation process begins.  If the seller is listing the house for $200,000, you can make an offer for whatever amount you choose. Once an offer is presented to the seller, three things can happen:

• The seller can accept it

• The seller can reject it

• The seller will counter offer

Your real estate agent can really help you in this process to determine what may be a reasonable offer.  It is usually dependent upon how long the house has been on the market, where is the property located, is there a situation that requires selling the house quickly, and what have other similar houses sold for in the area.  After making the offer you will typically receive a response within 48 hours.  The seller will sometimes give their real estate agent a range saying that they will accept less than the asking price but only to a specific threshold. In most situations the buyer and the seller meet somewhere in the middle. If the house is listed for $200K, the buyer may put in an offer for $180K and after some back and forth they eventually meet somewhere around $190K.  But that is not always the case.  If there are multiple offers on the house you could end up in a “bidding war”.  Offers are “blind bids” meaning that you and your real estate agent have no way of knowing what other people are offering the seller for the house.  Buyers are essentially making their “best guess” that their offer will win.  You may make an offer for full price only for another buyer to come in two hours later and offer $10,000 over their asking price.  You really have to lean on your real estate agent to give you some guidance based on their knowledge of the market.

Step 4: Offer accepted……now what?  Typically, purchase offers are contingent on a home inspection of the property.  Your real estate agent will usually help you arrange to have a home inspection conducted within a few days of your offer being accepted.  There are usually contingencies in your offer agreement that provides you with the chance to renegotiate your offer or withdraw it without penalty if the inspection reveals significant material damage.  If the inspector discovers issues with the house you will have to make the decision if you want to ask the seller to fix the issue prior to the closing date.  Prior to the close you will have a walk-through of the house, which gives you a chance to confirm that any agreed-upon repairs have been made.

Step 5:  Apply for a mortgage.  Now that your offer has been accepted the mortgage underwriting process will kick into high gear.  The bank will assign you a “loan officer” or “mortgage broker” to serve as the direct contact at the bank throughout the mortgage approval process.  You will provide them with the information on the house that you intend to purchase, they will send you the mortgage application with all of financial documents that they will need to formally approve you for the mortgage. The bank will also arrange for an appraiser to visit the house and provide an independent estimate of the value of the house.  After all if they are giving you a loan for $200,000, they want to make sure that house is worth at least $200,000 in case you were to stop paying the mortgage then essentially the bank would own the house and have to sell it.  You will receive a “commitment letter” from your bank once your mortgage has been formally approved.

You will need to show the bank documentation of the account that is currently holding the cash that will be used for your down payment and closing costs.  If someone gifts you money to buy your house, the person that made the gift will most likely have to sign a letter stating that it was an outright gift and not a loan.

Step 5½ : You will simultaneous engage a real estate attorney to begin working with at this time.  Your attorney will review the purchase agreement, initiate a title search and review the results, begin prepping the deed, and communicate directly with the seller’s attorney if changes or additions need to be made to the purchasing agreement.

Step 6: Set a closing date.  The closing date is the date that you will sign a huge pile of papers and the house officially becomes yours.  There is typically an “estimated closing date” set in the purchase agreement but a firm date needs to be set by the buyer, seller, attorneys, and the bank.  The seller’s real estate agent, the buyer’s real estate agent, your mortgage broker, and the attorneys on both sides will typically communicate with each other to establish the closing date.  A special note……..a lot can happen during a real estate transaction that can delay the closing date.    Issues can arise on the seller’s side or the mortgage process could take longer than expected.  In other words, even though you have a “final closing date” be prepared for the closing date to change.  If you are renting right now and have a lease, if your closing date is May 1st it’s usually recommended that you have your current lease run until May 30th or June 30th in case the closing date gets pushed back.  Real estate transactions have a lot of moving parts and a lot of unexpected things that are out of your control can happen.

Step 7:  Contact your insurance broker to establish a homeowner’s policy.  Your bank will require you to have homeowners insurance on the property.  You must pay for the policy and have it at closing.  You are free to select your own insurance carrier but the lender will typically require the insurance company issuing the policy to be a specific rating or higher.

Your insurance broker may also help you with your title insurance policy.  Many lenders will require you to have a title insurance policy at closing.  As part of the home buying process a title search should be conducted which results in a report that shows who owns the property and if there are any liens against the property.  Title insurance protects you and the lender up to the full value of the property if fraud, a lien, or faulty title is discovered after your closing.

Step 8: The day BEFORE the closing.  It is recommended that you send a reminder email to your real estate agent, attorney, and mortgage broker to confirm that everything is a “go” for the closing the next day.  You and your real estate agent should make a final inspection of the property within 24 hours prior to the closing.  In many cases, the lender will make a similar inspection before closing.  The bank that is issuing you the loan should also be able to provide you with a copy of your HUD-1, which is a long, one page document that details all of the financial activity associated with the purchase of your house.  You should review this document with your mortgage broker and/or attorney prior to the closing to make sure everything is accurate.

You will also need to confirm with your attorney/mortgage broker the amount of the certified check that you will need to bring to the closing.  A certified check is a special type of check issued by a bank that guarantees that the funds to back that check are guaranteed by the bank issuing the check.

Step 9:  The date of your closing.  You made it!!!!!! Today is the day your new house officially becomes yours.    There are two primary things that you need to bring with you to the closing:

• Certified check

• Homeowners policy and proof of payment

The actual closing is conducted by a “closing agent” who may be an employee of the lender or title company, or it may be an attorney representing you or the lender.  The lender and seller, or their representatives, and the real estate agents may or may not be at the actual closing.  It is not unusual for the parties to the transaction to complete their roles without ever meeting face to face.

For the most part, your role at closing is to review and sign the numerous documents associated with a mortgage loan.  The closing agent should explain the nature and purpose of each one and give you and your attorney an opportunity to check them before signing.

At the conclusion of the meeting you receive the keys to the house and you are officially a new homeowner.

Step 10: Begin making your monthly mortgage payments.  One of the top questions that we get is “What is an escrow account?”  You will hear that term a lot when you are going through the mortgage process.  Think of an escrow account as a separate savings account that is attached to your mortgage.  When you make a monthly mortgage payment, it is made up of a few components:

• Principal & Interest Payments: Amount applied against your actual loan

• PMI (if applicable): Mortgage insurance

• Escrow: Cash reserve to pay taxes and homeowners insurance

If my monthly mortgage payment is $2,000, only $1,100 of that amount may actually be applied against the loan. The other $900 may be used to pay my monthly PMI and the remainder is deposited to my escrow account.

When your property taxes and school taxes are due, the county that you live in will typically send those tax bills directly to the bank holding your mortgage and then the bank in turn pays those bills out of your escrow account.  The bank will typically mail the homeowners a receipt that the tax bill has been paid.  It’s basically a forced monthly savings account for your anticipated tax bills.  The same thing is true for your homeowner insurance premium payments. The bank that is holding your mortgage forecasts how much your taxes and homeowner insurance is going to be for the next 12 months and then builds those amounts into your monthly mortgage payments. The bank does not want you to lose your house because you were unable to pay your property or school taxes.  The property and school tax bills show up once a year and depending on where you live those bills can be for thousands of dollars.

If there is additional money left in your escrow account after the taxes and homeowner insurance has been paid, the bank is usually required to send a portion of that additional cash reserve to the homeowner in the form of a check.  Those are fun checks to get in the mail. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.