Class #4 Notes: How to Prepare for a Home Purchase
We’ve made it to our fourth week of our five-week back-to-school personal finance program, and this week we tackled a timely topic, one that I’m meeting with members often about these days – how to prepare for a home purchase.
Deciding to buy a home is not a decision to make lightly – it’s a commitment like no other. According to a recent SoFi survey1, we found that 35% of respondents have a goal of purchasing a home over the next five years. Many first-time buyers don’t know exactly what to expect or how to approach the home-buying process. That’s where my expertise can come in handy.
Buying a home requires some groundwork, but it’s not especially complicated. By educating yourself and planning in advance, you can put yourself in a good financial position to become a property owner. Here are the steps to keep in mind throughout the home-buying process:
Determining Your Price Range
Most people don’t realize that owning a home costs more than a monthly mortgage payment. There are various factors you need to consider when making this major financial purchase, but knowing how much you have and how much you make will help you understand what you can afford. More specifically, these numbers will help you determine three things:
Down Payment: Typically, homebuyers are encouraged to put down as much as they feel they can reasonably afford. The more you put down, the less you’ll be borrowing, which means you’ll have a lower monthly mortgage payment. Roughly 3.5 – 5% of the purchase price is a typical minimum downpayment, though private mortgage insurance (PMI) will be required. In order to obtain more favorable rates and avoid PMI, a 20% down payment is ideal.
Cash to Close: Your down payment won’t be the only thing due on closing day. In addition to the down payment, you’ll be expected to cover closing costs. Generally, closing costs cover things like: title insurance, title search fees, appraisal costs, escrow or attorney fees, surveying, and lender fees. Closing costs can vary based on factors such as the purchase price of your property, but you can expect to pay an estimated amount of somewhere between 3% to 5% of your home’s purchase price.
An Affordable Mortgage Payment: You’ll need to make sure you can comfortably afford your ongoing housing expenses, too. This can be accomplished by trying to cap your total mortgage payment (principal, interest, taxes & insurance) at 28% of your gross monthly income. By limiting your mortgage payment to this percentage of your income, you’ll likely be better equipped to manage other financial obligations and avoid becoming “house poor.”
Prepping Your Finances
Now that you have a solid understanding of some of the costs associated with owning a home, you need to determine your time horizon and begin prepping your finances. For starters, you’ll likely want to create a budget and maximize your cash flow; this could include things like reducing high interest debt and paying off any existing credit card balances. If you missed our session on tackling debt, you can go back and reference it here.
Once you have a timeline in place, you should determine if you’ll save or invest in anticipation of purchasing a home. When you plan to purchase will determine how you may want to save. For example, if you plan to purchase in less than three years, parking your money in a savings account can help lower risk exposure. If you have a longer time frame, investing may help grow your money at a higher rate than a savings account, though it also comes with market exposure.
Establishing and monitoring your credit is also crucial to the home buying process. While you may qualify for a mortgage with a credit score in the low 600’s, the higher your score is, the higher the likelihood that you’ll obtain a better rate, which helps with lowering your overall costs. To keep your score in a healthy range, generally, you should try to pay off credit cards in full every month, keep any $0 balance accounts opened, and stay on top of your progress by signing up for free credit score monitoring (like SoFi Relay).
Choosing the Right Mortgage
Securing a home loan is about more than getting approved and signing on the dotted line. It’s a journey that can be jammed with confusing jargon and seemingly endless options when it comes to types and terms. And here’s the really stressful part— decisions around your mortgage term could have consequences for your financial future. It’s important to know what these terms mean:
• Fixed Rates: Fixed-rate mortgages take the anxiety out of possible rate fluctuations, which makes them a popular choice for borrowers who plan to live in their new home for longer than average, which is currently slightly more than 13 years. A fixed rate mortgage allows you to lock in your monthly cost for the life of your loan.
• Adjustable Rate Mortgage (ARM): ARMs typically start out with a lower interest rate and payment than fixed-rate home loans, which makes them attractive to some homebuyers. It’s the unpredictability of future rate fluctuations that can be a downside. Though many ARMs have caps on how high or low the interest rate can go, over time, borrowers could end up with payments that are larger than they want or can afford.
• Interest Only: An interest-only mortgage is a loan with monthly payments only on the interest of the amount borrowed for an initial term at a fixed interest rate. The interest-only period typically lasts for 7 – 10 years and the total loan term is typically 30 years.
Once you’ve decided which mortgage product would be right for you then you have to determine when you want to start the process. While you can start working with an agent and looking at properties at any time, the financial processes may not be quite as straightforward.
• Pre-Qualification: This process includes a soft pull of your credit score, and a lender will use your stated income to calculate your debt/income ratio. Potential homeowners will be informed of their product eligibility, and initial rate/loan amount options. The pre-qualification process is preliminary and helpful for those who are just starting to look at properties and want to get a ballpark estimate of what they can borrow.
• Pre-Approval: This process is a bit more in-depth and will include a hard credit pull, verification of your income where an underwriter will review your tax returns, account statements and pay stubs, and then provide verified calculations of debt/income ratio, and credit approval. Potential homeowners will receive formalized notifications of loan eligibility (rate, product, loan amount) conditional on physical appraisal. A pre-approval is a stronger commitment from a lender to provide you a loan and can make you a more appealing buyer when sellers are reviewing offers.
Now that you have the basics of home buying, I’d recommend checking out SoFi’s Mortgage Calculator, which makes it easy to get an idea of how much you can save on your mortgage with different down payments. If you’re looking for more information on home buying, be sure to check out SoFi’s First-Time Home Buyer’s Guide.
We’ll see you again next week for our final class on Wednesday, October 7 at 12pm PT/3pm ET where my colleague Brian Walsh, CFP® at SoFi, will highlight crucial aspects of college planning. And remember, if you want to learn more on purchasing a home or refinancing your mortgage, SoFi members can schedule a session with any of our SoFi Financial Planners here who will be happy to help you plan this next major financial milestone with you.
Thanks again for joining us this week and we’ll see you again soon!
1Survey conducted via SurveyMonkey of 1,230 people ages 18 to 74 during August 19, 2020 to August 20, 2020.
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