Let’s dive into the various components of the home buying process. Purchasing a home is a significant financial decision (no pressure). Building a foundation of knowledge will enable you to ask better questions and make informed decisions along the way. Let’s get started!

Research Your Local Real Estate Market

As a first step, research home prices in your local real estate market. You can use real estate search websites such as Zillow and Redfin to look at current listings and recently sold properties in various zip codes. This will help you get a sense of prices in different parts of town.

You Will Need Cash

If you plan on getting a loan to purchase your home, your lender will likely require a down payment. Conventional loans require at least 5% down. For example, if you plan on purchasing a $400,000 home, you will need to provide at least $20,000 (5%). Some experts suggest waiting to purchase a home until you’ve saved a 20% down payment. Although there are some disadvantages to this approach (e.g. delaying a home purchase in an appreciating real estate market).  

You should have cash reserves remaining after you purchase the home. You’ll need to pay for moving expenses, furniture, home improvements, any repairs, etc. Additionally, you should have an emergency fund remaining after the home is purchased. You don’t want to be completely out of cash immediately after moving in. Depending on your circumstances, you may consider putting less money down to maintain some cash reserves after moving in. 

Saving the cash necessary to purchase a home will likely take time. As a starting point, create a savings target (total cash required) and develop a systematic savings approach. 

Components of a Mortgage Payment

A mortgage payment has several components. It’s important to know these components so you can accurately estimate your total mortgage payment. 

Principal & Interest Payment: This is a fixed monthly amount determined by your loan term, amount borrowed, and interest rate. You can use a loan calculator to determine this payment. This payment will not change for as long as you keep the loan.

Property Tax: This tax pays for local public schools, roads, police departments, fire departments and other local programs. Property taxes can be estimated by multiplying the county tax rate by the purchase price of the property. You can also use an online calculator to estimate your tax payment.  Many people choose to have the lender include estimated property taxes in their overall monthly mortgage payment. The lender would make the annual tax payment on behalf of the homeowner when the tax bill arrives. This is known as a lender escrow account. 

Homeowners Insurance: This insurance provides dwelling, liability, personal property and other coverages for your home. The average cost is approximately $120/month (based on national averages), however your premium will vary based on your zip code, home size, and other factors. This annual premium payment can also be escrowed through your lender. 

Flood insurance (if necessary): If you live in a flood plain, the lender will likely require you to carry flood insurance. In most cases, your homeowners policy will not cover any flood damage sustained from natural causes (hurricane, rainfall, etc). The average cost of flood insurance is about $700 per year. 

Homeowners Association (HOA) Dues (if necessary): Some neighborhoods require participation in the local HOA. These dues pay for common area maintenance, lawn care, pool upkeep, roof & foundation repairs (for condos & townhomes), and other shared neighborhood amenities. Keep a close eye on the HOA dues if you plan on purchasing a condo or townhome. They can often be surprisingly high. 

Private Mortgage Insurance (PMI) (if necessary): If your down payment is less than 20% of the purchase price, your lender will require you to carry this additional insurance. In many cases, PMI can be cancelled after your loan-to-value ratio (LTV) falls below 80% (i.e. you have more than 20% equity). As your property appreciates and you pay down the loan balance over time, the amount of equity you have in the home will increase.   

A few cautions: 

Mortgage calculators provided by real estate websites will often underestimate many of these components. The interest rates, property taxes, and insurance premiums, are often too low. Make sure to calculate these numbers yourself.   

The current annual property tax amount paid by a homeowner can be found on the county’s tax appraisal website (publicly available information). However, some property owners currently pay substantially lower property taxes than what you would pay if you purchased the property. Some homeowners may qualify for special tax exemptions or reduced assessed values based on their personal situation. Counties will often revise appraised values upwards following a property sale. If you want to be safe with your estimates, assume that you will pay the full county tax rate based on the purchase price of the property.

What Can You Afford? 

To determine how much you can comfortably afford, you’ll need to do some budgeting. As a first step, create a cash flow statement based on your current income and expenses. See this post to learn more. 

Next, adjust your current expenses to reflect your future monthly housing costs after you purchase your desired home.

• Replace your current housing cost with the new mortgage payment from the previous step. 
• Make adjustments to utilities (water, gas, electricity, garbage) to reflect the size of the home you’re purchasing. 
• Consider adding line items for: lawn care, pest control, housekeeping, and home maintenance (repairs; trips to the hardware store) 

• How does this forward-looking home expense budget compare against your net income? 
• Are you running a cash flow surplus (generating savings)?
  • If no, you may need to reduce your purchase price, reduce your other expenses (or both). 
  • If yes, how much are you able to save toward other financial goals?  

Another way to look at this calculation: as a rule-of-thumb, some experts recommend spending no more than 33% of your monthly gross income (income before taxes) on housing. For example, if your gross income is $100,000 per year, your monthly mortgage payment should not exceed $2750 ($100,000 / 12 x 33%).   

Keep in mind, the more you spend on housing, the less capacity you have to save for other financial goals: retirement, college, travel, etc. There will always be a compromise. 

Qualifying for a Home Loan 

If you need to obtain financing to purchase a home, you’ll need to qualify with a bank or local credit union.  

The bank takes several factors into account to determine your maximum loan amount and your interest rate. These factors include: history and consistency of income, current monthly debt payments, and credit score. 

Debt-to-Income (DTI) Ratio: total monthly debt payments divided by gross monthly income. Monthly debt payments include: student loan payments, auto loan payments, credit card minimum payments, and your new estimated mortgage payment (from step 2). Many lenders will not approve a loan if the back-end DTI is above 43%.

Credit Score: Your credit score indicates your credit-worthiness based on your historical relationship with debt. High credit scores qualify for the lowest interest rates. Learn more about what impacts your credit score here. 

Pre-qualification 

Based on your income information and monthly debt payments, a lender will be able to determine the amount of a loan you could qualify for. This is simply an estimate (not a loan approval) from the bank.

Pre-approval 

Once you’re ready to start making offers, the bank will ask you for a list of financial documents: paystubs, tax returns, bank statements, investment statements, etc. The bank will also run your credit. Once you’re approved, pre-approval typically lasts about 90 days. A pre-approval letter from a bank will make your offer more legitimate to a seller. The seller knows you’ve already gone through the financing process — the likelihood of financing issues coming up before closing is lower. 

Appraisal waiver 

Competitive real estate markets may require a full appraisal waiver when making an offer. This means that if the appraisal report shows that the fair market value is less than the agreed upon sales price, you may need to make up the difference. For example, if your offer is accepted at $500,000, and the appraisal shows a value of $470,000, the bank will only issue a loan based on a $470,000 value. If you’re putting 20% down, the maximum loan amount is $376,000 (80% of $470,000).  In this case, you would need to come up with the $30,000 difference from savings (in addition to your down payment), or you’ll need to restructure your financing with the lender.

Hire a Real Estate Agent

After you have your financial house in order, enlist the services of a qualified real estate agent.  

A qualified agent should: 

• be knowledgeable about the real estate market you’re targeting
• provide advice on various neighborhoods, school districts, traffic routes, crime rates, etc
• be a proficient negotiator
• provide excellent client service and communication 

In most markets, the buyer does not pay a commission upon purchasing a home. The seller typically pays both the buyer’s agent commission and the seller’s agent commission (usually a combined 6% of home value). 

Making Offers

You may have heard the saying: “don’t fall in love with the house.” In competitive real estate markets, it may take several strong offers before one offer is ultimately accepted. Try not to get attached to any single property. Making offers will require patience and emotional fortitude — expect a roller coaster of emotions.   

It’s not easy to determine how much to offer on a property. It will depend on the market, your timeline, the desirability of the home, etc. Rely on your agent to help you make a competitive offer.  

Offer Accepted 

Option Period: This is a specific period of time (typically 1-10 days) written into a real estate contract that gives the buyer the option to terminate the contract for any reason. If the contract is terminated within the option period, any earnest money would be returned to the buyer. 

During your option period, you should have a professional home inspector evaluate the house for all issues. Major problems to look out for: foundation, electrical, plumbing, roof, water intrusion, mold, asbestos.  

If structural issues come up in the initial inspection, consider hiring a structural engineer to provide a specialized evaluation. Recurring foundation repairs are expensive. 

As issues emerge, the buyer can negotiate down the previously agreed upon sale price. However the seller is under no obligation to cooperate. These back-and-forth negotiations during the option period are often stressful. Having a qualified agent with negotiation experience on your side may be helpful.

Keep in mind that these inspections and negotiations need to happen quickly (before the option period expires). Otherwise, if you terminate the contract after the option period, you will give up your earnest money. 

Closing

Assuming you have been pre-approved for financing, closing is usually scheduled about 4 weeks after the contract has been signed. This allows the lender enough time to fully underwrite your loan and get financing in place.  

Closing typically takes place at a title company. The title company plays an important role in the real estate transaction — it acts as an independent third party. The title company collects funds from the buyer (and lender), holds them in a title escrow account, and releases funds to the seller after all documentation has been signed, verified, and filed. 

You will be asked to sign many documents at the closing table. The title company representative (escrow officer) should explain every document to you and answer your questions. 

After both seller and buyer have signed the closing documents and the necessary forms have been filed, you will obtain the keys from the seller. Congratulations — you’re officially a home owner! 

You’ll likely have many questions come up throughout the home-buying process. If you’re new to the process, I strongly recommend surrounding yourself with a team of qualified professionals: real estate agent, mortgage lender, financial planner.