The Brooklyn FI Guide to Buying A Home
Is it better to rent or to buy? That’s the age-old question that seems to be top of mind as we’ve all been at home over the last year. I’m not going to go over the pros and cons of each as we have a lovely webinar on that topic that you can watch here, but I am going to talk about how to know if you're ready to purchase a home, things you should NOT do when purchasing a home, and other items to look out for as you’re going through the process.
I think the big question most people ask after deciding they want to buy a home is “are we actually ready to buy a home?” There are a few tell-tale signs that indicate you are indeed ready to buy a home:
Your emergency fund is FULLY funded with 6 months worth of living expenses (including your hypothetical new mortgage)
You have 20% saved for a down payment in a savings or brokerage account (NOT your 401(k) or any other type of retirement account)
An additional 4-5% of the home's purchase price is saved for closing costs, and 1-2% of the home's purchase price is saved for small renovations and furnishings.
A credit score of 760 or more so you are guaranteed access to the best interest rates
You have a desire to stay put for AT LEAST 5 years. Purchasing a home is a costly transaction, and oftentimes to recoup the cost of the transaction it takes 5 years at a minimum. Expect to pay around 10% of the home’s value in transaction expenses related to its purchase and sale.
If you check all of the boxes above, congrats! Let’s quickly talk about what not to do when making this big purchase:
Don’t take on a mortgage that is going to hinder your ability to save monthly. Our general rule of thumb is that you need to save at least 20% of your annual gross income in addition to paying your mortgage and covering living expenses.
Don’t view this as an investment that is going to “make you rich.” View this as your HOME!
DO NOT use retirement accounts to fund your down payment. Your retirement accounts are there to help you achieve financial independence, which your home will NOT do.
The next big question is often “How much home can I afford?” A lender is going to tell you that your debt to income ratio should be 36%, meaning your mortgage and any other debt should be no more than 36% of your gross income on a monthly basis. As I mentioned earlier, it is incredibly important that you don’t hinder your ability to meet your annual savings goal of at least 20% of gross income, so BKFI takes a bit of a different approach. We shave 20% off of your annual gross income to account for that savings, and then apply the 36% debt to income ratio rule to your net (after-tax) income. We have a nifty spreadsheet to help with this!
So now that we’ve covered how to know if you are ready to purchase a home and how much home you can realistically afford, what’s next? Before you actually start going and looking at homes you’ll need to get a pre-approval from a lender as well as engage a real estate agent. Getting pre-approved by a lender typically only takes a few days, and the approval is usually good for 60-90 days. You’ll need to provide the lender with all of your financial information such as income, account statements, and tax returns. A pre-approval is essentially the lender telling you how much home you are approved to purchase based on the parameters I explained above. If you’re in need of a good lender or real estate agent, reach out to your planner at Brooklyn FI for an introduction. We’ve got knowledgeable folks who have helped multiple BKFI clients and team members successfully purchase homes.
Now for the fun part - you’ve found the perfect home and have an accepted offer! What happens next? This means you are officially in escrow! The first things that usually happen in escrow are the payment of your option money to the seller and ordering an inspection on the home. The 5-10 days after having an offer accepted are typically known as an “option period” where you can walk away from the deal and only lose your option money in the event something unexpected comes up in the inspection (or you decide not to move forward for any other reason). “Option Money” is typically 0.1% of the purchase price that is paid to the seller immediately, and while they get to keep it if you walk away from the deal, if you do go through with the purchase the option money is counted as part of your down payment. Keep in mind, different states and cities have different rules and your particular purchase may play out differently.
After the option period is over and the inspection is complete an appraisal is then ordered by the lender and your loan is officially in underwriting. At this stage in the process, you’ll have the ability to “lock in” your interest rate, and if you feel like the interest rate isn’t as competitive as it should be, you can shop around with a few different lenders. An appraisal is ordered to ensure that the home is actually worth what you are paying, because the lender doesn’t want to loan you an amount of money that is greater than the value of the asset (the house) backing the loan. While your loan is in underwriting the lender is going through all of your financial information at a very detailed level as well as verifying your employment/income and reviewing a myriad of other items to ensure lending you money is reasonable. It is also important to note that you cannot take out any other loans during this process as they might throw off your debt to income ratio thus preventing you from being able to be approved for the loan and purchase the home. The underwriting phase of the process usually takes at least 30 days and can feel pretty intense as you’re asked a lot of questions.
While in escrow your lender and realtor will both be in contact with a title company. The title company’s primary function is to hold and disburse funds from your escrow account and issue an insurance policy covering the ownership of the property after they’ve done research on the title and made sure there aren’t any new discoveries. This is where your closing will take place, and who you will wire your down payment funds to on the day before or day of closing. The title company is basically at the center of the process making sure all of the boxes are checked and everything is on schedule.
A few other things that might come up during the underwriting process and regarding your mortgage are:
Points - these are also called “discount points,” and are paid directly to the lender at closing in exchange for a reduced interest rate on your overall loan. A point is equal to 1% of your mortgage amount. Most of the time points don’t make sense, especially in today’s low interest environment, unless you 100% plan to stay past the point of breaking even. To figure out how long the “break even” period is, divide the cost of the points by how much you will save on your monthly mortgage payment.
Loan Origination Fees - an origination fee is paid directly to the lender and usually covers their administrative costs. This is typically 1% of the loan, but it is common to work with a lender that doesn’t charge an origination fee, or only charges a small processing fee of around $1,000. Lending fees are typically negotiable, so it is always a good idea to ask for a reduction!
Closing Costs - these are various fees and expenses related to your home purchase that are due at closing in addition to your down payment (typically 4% of the property value). They vary state to state, but some of the general items found on the list of closing costs are:
Payment for a year’s worth of homeowner’s insurance
Your share of property taxes due for the year
Title insurance to protect you in the event someone challenges your ownership of the home
Mortgage interest that accrues between the closing date and the date your first mortgage payment is due (your first mortgage payment isn’t due until the beginning of the first FULL month after closing)
Fees to the title company that covers the administrative work they put into transferring the title to you and facilitating the closing
Attorney’s fees if you live in a state that requires having an attorney review everything
After you’ve made it through underwriting and your loan is approved you then move onto closing day, the day where you sign a THICK stack of documents and YOU GET THE KEYS! After closing, the title company disburses funds to all of the proper places and gets all of the signed paperwork filed in the proper place. At this point the process is complete and you are officially a homeowner :) Now it’s time to live in your new home and enjoy it for at least a few months before you start buying new things and remodeling. “This house is perfect and I don’t need to make any changes at all!” - said no new homeowner ever.