One of the biggest financial decisions people will make in their lifetime is the choice to buy a home. Why would anyone want to make such a large financial commitment when renting is cheaper, flexible to where you want to live, and short term in obligation? The reasons are quite straightforward: homeownership allows you to build equity and allows you a deduction for mortgage interest paid, which makes it the single biggest tax break available to most taxpayers, not to mention all the intangible benefits that ownership has to offer. When you are buying a home your monthly payouts will increase and you'll need to set a few dollars aside for those unexpected expenses, but owning your home can be one of your most rewarding decisions if you play your cards correctly from the start.

Step One: Clearing Up Existing Debt
Proper preparation before you buy your home is half the battle. The first item on your list is to obtain a copy of your credit report. What you'll want to do here is clean it up; if you have open credit cards that you never use, close them out. Then you'll want to look for any mistakes or discrepancies with your creditors' reporting and have them corrected as well. Saving as much money as possible for your down payment is important, but not worth overlooking your high-interest rate debt. Any credit-card rates that have an interest rate greater than two times the prime rate are way too high. For example, if the current prime rate is 6%, you should try to pay off all your credit cards with an interest rate of 12% or greater, or look for another lender with a better rate in which to transfer your debt.

Step Two: Shopping for Lenders
Once you've cleaned up your act, you're ready to start shopping around for a lender. Check out or to find multiple lenders in your area. Then the fun begins; let three or four of the lenders compete for your business. Do not give each lender approval to access your credit report! Obtain a preliminary copy of the "good faith estimate" (HUD-1 form) and analyze every charge on it. Then, once you've selected the lender you're going to use, allow them to check your credit.

Lenders have lots of imagination and flexibility when it comes to the fees that are charged to the borrower. Fees such as "loan origination", "processing fees" and "underwriting fees" can be negotiated down usually at least 50% or even waived by the lender if they want your business bad enough. "Points" are a real drag too. When you pay points, you pay interest (1 point = 1%) in a lump sum upfront to get a lower rate on your fixed-rate mortgage, which basically increases the amount of your down payment. Points are unnecessary additional charges by the lender. Refuse to pay these fees or take your business elsewhere.

In some cases it may be worth the fee to hire a real-estate attorney to clean up the bogus costs or get yourself a knowledgeable real-estate agent who can lead you through which costs are customary and those that are flexible or potentially eliminated. For example, "title costs" in the State of Florida are the responsibility of the buyer (unless the seller agrees to pick up the costs), so you need to know that these costs should appear on your good faith estimate. If your lender is an out-of-state lender, then they may have different fees (which usually exceed $1,000) and may show up as a surprise cost on your HUD-1 settlement statement prior to closing.

Why Lenders Love PMI
Lenders are like hungry wolves circling their prey when it comes to first-time homebuyers. Most lenders charge private mortgage insurance (PMI), if you fail to make an initial down payment of 20% or more on your home. This insurance protects the lender, not you, in case of default on your loan. Generally a lender will consider a loan financed at more than 80% of the home's value a greater default risk and require the PMI payment. Just how much is this payment for PMI? If you're applying for a $200,000 loan with 10% down payment, you can expect to pay at least $100 per month for the PMI payment. It's not unusual to see PMI payments in the range of $150 to $200 a month.

For those of you already in a mortgage with a PMI payment, when you reach a certain equity percentage in your home (usually 20%) you can cancel the PMI. Over 30 years, a $150 monthly PMI payment can add up to over $54,000! Since the lenders will not remind you that you can cancel the additional payment, many homeowners never take the time to cancel the PMI payment themselves and the lenders are more than happy enough to keep receiving your money.

Step Three: Coming Up with the Down Payment
What can you do if you can't afford the 20% down payment on your home loan? Let's say you're looking at a $200,000 home and you have $10,000 for the down payment. Clearly, most lenders will require a PMI payment if you do not put at least $40,000 down on the home (lending/loan fees have been excluded from our loan calculation). For most first-time homebuyers a $40,000 down payment is out of the question. So, here's where you'll need to get a little creative and try to "piggy-back" your loans so two lenders take part in the loan. This would work like an 80-15-5 type plan: you'll finance 80% on a primary mortgage, finance 15% on a second mortgage or home-equity loan, and 5% as your down payment. By using the home-equity loan plus your down payment, you can leverage that amount against the purchase price of your home and cover the 20% down requirement and thus avoid PMI. The home-equity or second loan will most likely have a variable rate or a rate higher than your primary mortgage, so you'll need to keep an eye on this loan and try to pay it off first. The interest from the home-equity loan is also deductible interest on U.S. federal taxes (home-equity debt is subject to a $100,000 ceiling for deductibility).

Types of Loans

Fixed-Rate Loans The most common mortgage loan is the 30-year fixed-rate loan because the interest rate does not change over the life of the loan. Most homeowners prefer this type of loan since they know that their monthly mortgage payment will remain steady over the years. A 15-year fixed loan is becoming more popular because it reduces your time horizon on the loan, allowing you to decrease dramatically the amount of interest you\'ll pay over the life of the loan. Generally these loans will carry a higher rate of interest since the lender is giving up their opportunity to make more money in an economy where the interest rate is rising.

Adjustable-Rate Loans
The median length of stay in a home is only 8.2 years (1998 U.S. Census data), so if you plan on staying in the new home for a short period of time, you may want to consider alternative financing to the traditional fixed-rate loan. Adjustable-rate loans offer a lower interest rate for a set period of time. The interest rate on these loans can be adjusted annually or you can see them listed as "3-1", "5-1", "7-1" or many other variations. For example, under a "7-1" adjustable rate loan, the loan will stay fixed for the first seven years and then reset each year thereafter. This means that the loan will stay fixed for the first seven years. Then in the eighth year, the rate is adjusted based on current market conditions, which is usually based on the one-year Treasury index.
Initially, the interest rates on adjustable-rate mortgages can be anywhere from one to three percentage points below the conventional fixed mortgage, and then typically adjusted annually after the fixed term expires. If you only plan to stay in the home for seven years, then this may be the perfect loan for you. You\'ll need to watch out if interest rates start to rise; you may find yourself paying more than the traditional 30-year fixed.

Remember, it's definitely worth the extra effort to review your HUD-1 settlement statement prior to the closing date of your new home; the figures listed there should match those that were provided to you on the good faith estimate. If the figures are inflated or you see new charges, contact the lender and ask them to explain or correct the mistakes. After all, purchasing a home is a valuable long-term commitment, so make sure that you fully understand all the terms of your loan and don't overlook any hidden charges that you'll later regret.

Related Articles
  1. Credit & Loans

    Mortgages: Fixed-Rate Versus Adjustable-Rate

    Both of these have advantages and disadvantages depending on your financial needs and prospects.
  2. Home & Auto

    The Benefits Of Mortgage Repayment

    Buying a home may be the biggest debt you'll ever incur. Learn why you should retire it sooner, rather than later.
  3. Retirement

    Too Much Debt For A Mortgage?

    Just because a lender is willing to offer you a loan doesn't mean you should take it.
  4. Insurance

    What is a Force Majeure?

    A force majeure clause frees both parties in a contract from fulfilling their obligations in the event of some catastrophic or unexpected occurrence.
  5. Credit & Loans

    Explaining Equated Monthly Installments

    An equated monthly installment is a fixed payment a borrower makes to a lender on the same date of each month.
  6. Home & Auto

    Read This Before Buying a Vacation Home with Friends

    Going in with friends to buy a vacation home will save you on the mortgage and expenses. But if there's conflict, it could end up costing your more.
  7. Home & Auto

    The Most Expensive Neighborhoods in London

    Understand what makes London such a desirable place to live and why it is so expensive. Learn about the top five most expensive neighborhoods in London.
  8. Home & Auto

    Why Housing Costs Shouldn't Exceed 30% of Your Budget

    Financial experts will argue that there’s no problem with allocating 50% of your net income to housing, but that barely leaves enough money for living comfortably. Reducing housing expenses to ...
  9. Investing Basics

    Tiny House Movement: Making Market Opportunities

    The tiny house movement throws all assumptions about household budgeting and mortgage management out the window, and creates new market segments too.
  10. Investing

    Where Should I Keep My Down Payment Savings?

    While saving up for a down payment, where should you keep your money. A bank? The stock market? It all depends on your timeline.
  1. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  2. Can I take my 401(k) to buy a house?

    Once you reach 59.5, you can use the funds in your 401(k) retirement savings account to buy a house or any other expense ... Read Full Answer >>
  3. Can I take my 401(k) to buy a house for my children?

    Under the standard regulations for 401(k) retirement savings plans, you may elect to withdraw funds from your 401(k) for ... Read Full Answer >>
  4. How is market value determined in the real estate market?

    Anyone who has ever tried to purchase or sell a home has probably heard a lot about the property's fair market value, or ... Read Full Answer >>
  5. What is the difference between "closed end credit" and a "line of credit?"

    Depending on the need, an individual or business may take out a form of credit that is either open- or closed-ended. While ... Read Full Answer >>
  6. In what instances does a business use closed end credit?

    The most common types of closed-end credit used by both businesses and individuals are mortgages and auto loans. Businesses ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!