Investing for Life: An action plan for home buyers

Whether you're buying your first home or your 31st home, there's no question that real estate is a complicated financial transaction that requires careful planning. When you buy your first home, it's likely the first time you've taken on a substantial loan and responsibility for maintaining property. These new obligations may require adjustments to your lifestyle, especially if you've previously been renting.

These are some of the main financial decisions you'll need to make when buying your first home:

Buy now or wait?

Some buyers wonder if they should put off a purchase, thinking if they do, prices could fall and they could get a better deal. You'll need a crystal ball to get this one right. Rising interest rates could slow demand for homes and ease some price pressure. But higher rates in the future could make getting a mortgage now with a low rate a smart move. In any event, over the long term, buying a home should be a good financial move and a solid investment, if you buy wisely.

Buy versus rent?

Compare the costs of renting to the costs of owning a home (mortgage payment, insurance, property taxes and upkeep). Remember to account for the fact that you can deduct mortgage interest and property tax payments on your income tax return as itemized deductions.

The downside of renting is that your landlord can raise your rent periodically. When you own, your biggest expense, the mortgage payment, will remain constant (assuming you have a fixed-rate mortgage), but property taxes and homeowners insurance premiums will go up over time. 

How expensive a home you can buy depends on two things: the money you have available for a down payment and your income. 

If you have stock or mutual fund investments that you're counting on for that down payment, you'll need to sell the shares and put the proceeds in a savings account well ahead of your purchase. You'll have to keep tax implications in mind when you sell equities, and you should talk to a financial advisor about which shares to sell and when.

Banks, mortgage lenders and realtors will offer to run your numbers and tell you the price of a house you could afford and the mortgage you could carry. They usually base their estimates on two ratios. Here's how they work:

Front-end ratio: The housing expense, or front-end, ratio shows how much of your gross (pretax) monthly income would go toward the mortgage payment. As a general guideline, your monthly mortgage payment  -- including principal, interest, real estate taxes and homeowners insurance -- should not exceed 28 percent of your gross monthly income. To calculate your housing expense ratio, multiply your annual salary by 0.28, and then divide by 12. The answer is your maximum monthly housing expense ratio.

Back-end ratio: The total debt-to-income, or back-end, ratio, shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees. In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your debt-to-income ratio, multiply your annual salary by 0.36, and then divide by 12. The answer is your maximum allowable monthly debt-to-income ratio.

Be careful to include the cost of additional expenses such as maintenance, repairs and service fees (lawn, garbage, cable TV, etc.) as part of your monthly housing payment. Home buyers often underestimate the cost of the trips to Home Depot, Lowes and Wal-Mart, which come often during the first year of home ownership. As a consequence, many people reduce or eliminate their contributions to retirement plans or other savings, thinking that when these expenses go down, they'll begin saving again. But something always comes up -- and saving for the future takes a back seat to unanticipated expenses.

To avoid this trap, factor in costs for maintenance and repairs before you buy. My rule is that the total of all housing expenses should not be more than 25 percent of your gross income. Common sense should tell you that with about 25 percent of your gross income going toward home expenses and effectively 25 percent going to income taxes (federal, state and Social Security), you're left with only 50 percent of your income to live on and save for retirement, plus kids' education and other long-term goals.

How much cash is necessary?

The amount of money you'll need on-hand depends on the price of the home, the type of mortgage and closing costs. Typically, you'll get the best deal on a mortgage when you put down 20 percent or more. 

If you put down less, your mortgage options may be limited to those with higher interest rates and mortgage default insurance (called primary mortgage insurance, or PMI), which protects the lender if you default on the loan. By putting at least 20 percent down, you'll save about one-quarter to one-half of a percentage point on the rate and hundreds of dollars per year on PMI. 

If you get a loan for some of the down payment money, you're obligated to tell the lender. Also figure in that you'll need to come up with several thousand dollars for closing costs, such as application and appraisal fees, inspections, title insurance, insurance and attorneys fees.

Review your credit report

Before you apply for a mortgage, get a copy of your credit report and look it over. Note any errors, inactive accounts or late payments. You'll want to clean up your report before a lender reviews it. Close open credit accounts you don't use, notify the credit bureau of any errors and prepare explanations for any accounts with less-than-perfect payment records.

Get pre-approved

If you're looking to buy a home within the next 90 days, get pre-approved for a mortgage so you'll be ready to make an offer on the spot when you find a home you love. A pre-approval is a lender's commitment on a loan before you find a property. It's the next best thing to having cash when you're shopping for a home. Be careful not to disclose the amount you're approved to borrow, which could tip your hand to the seller.

When you get serious about buying, have a professional inspector give the house a careful look before you close the deal. An inspection provides an unbiased analysis of the home structure, creating a documented list of repairs or deficiencies that need to be taken care of. These inspections can include structural and chemical testing (radon, lead paint, etc.) and can be used to bargain a lower price (enough to cover the costs of repairs) or to get out of the deal altogether if it turns out you're eying a money pit.

Individuals who cannot risk that their mortgage payments could increase are best served with a fixed-rate mortgage because payments won't change over the life of the loan. First-time home buyers will get hit with many surprises and additional expenses. One of these shouldn't be an unexpected hike in your monthly mortgage payment. Adjustable-rate mortgages offer lower initial rates and payments, which typically increase in subsequent years. In any case, never use an adjustable-rate mortgage because its low initial payment is all you can afford. Your rate and payment will increase, overextending you financially.

Bank or mortgage broker?

A mortgage broker can represent many lenders and will say they "shop the market" for the lowest rate for you. Banks, on the other hand, have only their own mortgage programs to offer, but they'll also offer special "relationship" packages, such as linking your accounts on one statement, or a lower mortgage rate for keeping checking accounts with them.

You should shop both banks and mortgage brokers before you decide on a mortgage. That's because rates in the mortgage market will vary day-to-day, depending on the supply of money various lenders have to offer. Sometimes the large banks and local lenders offer rates that brokers can't match. Also, significant differences often exist in rates among various brokers due to the volume of loans they write for the month.

The following is a more succinct action plan for the financial side of home-buying. If you follow this advice and do your homework, home sweet home won't turn into heartache.

Before you begin house hunting:

·  Get a copy of your credit report and review it for errors and negative statements

·  Determine how much you can afford to borrow and pay for a home

·  Get pre-approved for a mortgage

·  Decide what type of home you want, the size, features and location

When you are house hunting:

·  Shop around and look at more homes than you think you need to see

·  Apply for a mortgage when you have a signed purchase contract

·  Keep good records of all paperwork -- it will come in handy at tax time

Ray Martin

View all articles by Ray Martin on CBS MoneyWatch»
Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.