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The 5 steps to buying a house

Like any area of personal finance, there’s no big secret to buying a house — but it does involve thinking differently than most people.

I’m talking about the folks who make the biggest purchase of their lives without fully understanding the true costs. That’s why I decided to update my article on buying a house to help you understand those costs … and show you exactly how to go about doing it.

Note: I’ve distilled these lessons from my friend Owen Johnson’s 7-part primer on real estate investment. If you want even more detailed lessons on purchasing real estate, be sure to check out his posts.

The steps are:

  1. Obtain your credit report and score
  2. Find out how much house you can afford
  3. Meet with a Realtor
  4. Find a direct lender
  5. Make the offer

Step 1: Obtain your credit score and report

If you plan to buy a house in full with cash, you can just skip this part (and also, you must be a student of mine!).

However, if you’re within the majority of people who don’t have the funds to do that, you’re going to need to get a mortgage. And to get a mortgage, you’re going to need to get your credit score and report.

Credit score vs credit report

Though your credit score and credit report have a lot in common, you need to know that they are NOT the same thing.

Many people conflate the two, and though they are very similar in a lot of respects, they’ll tell you different information.

Here’s a description of both as well as how exactly you can obtain them:

Credit report
This is an all-inclusive report detailing your credit history. It’ll include information such as your:

  • Loan history
  • Accounts opened and closed
  • Payment history
  • Credit balance

You’re entitled to a free credit report each year, per the Fair Credit Reporting Act.

Credit score
Your credit score is an actual number — the same number that renters and lenders will utilize in order to assess how safe it is to have you as a customer.

A strong credit score will save you a lot of money and give you a position of strength to negotiate from. A weak credit score may be a reason to rent for a few more years.

When you’re attempting to get a good rate from a lender, you’re going to want a good credit score. In fact, a good credit score can be worth tens of thousands of dollars to you. (This is the kind of Big Win we should focus on, rather than cutting back lattes.)

For example, imagine there are two home buyers:

  • Kyra, who has great credit (760)
  • Dakota, who has poor credit (620)

In their 30s, they decide to buy houses of similar prices. How much do you think they each pay?

Spoiler alert: Not the same amount.

Check out the graph below:

Screen Shot 2017 06 21 at 11.40.03 AM 2
Source: MyFico.com. Data calculated in June 2017.

Because Dakota has poor credit, he’ll end up paying over $68,000 more in interest than Kyra — whose credit is awesome.

If your credit isn’t the best though, you might still be able to get an okay down payment request on the loan.

However, if you want a standard FHA loan (the best loan for first-time buyers), you shouldn’t go below 580. If you do, you’re probably going to end up with a loan that requires a 10% down payment and a terrible interest rate.

If your credit score is bad (below 620), you’ll want to improve it. Here are a few resources from IWT that’ll help you do just that.

Action Item: Get your credit score and report

To get a free credit report, there are three major companies that will provide them for you:

  1. Equifax
  2. Experian
  3. TransUnion

It doesn’t matter which one you use, they’ll all be able to provide you the same information. The report is the data used to calculate your credit score.

Checking your credit score is also incredibly simple. There is a seemingly endless amount of sites and services out there that’ll provide you your credit score, but here are a few notable ones that will provide you your score for free:

  1. NerdWallet
  2. Credit Karma
  3. Mint

Step 2: Find out how much house you can afford

Unfortunately, finding out how much you can afford is a bit complicated — involving intense algorithms, big mathematical equations drawn on chalkboards, and an abacus.

Just kidding! You can easily find out how much you can afford using the 28/36 rule.

This is a rule of thumb used by creditors to determine roughly how much they’re willing to lend to you. Here’s how it works.

  1. Household expenses should not exceed 28% of your gross monthly income.
  2. Household debt should not exceed 36% of your gross monthly income. This is also known as your debt-to-income ratio.

Let’s take a look at those areas more deeply to understand why it matters to you and the creditors.

Household expenses

These expenses are also known as the PITI — and they are:

  • Principal. This is the part of the payment that goes towards paying down the amount you borrowed to purchase the house.
  • Interest. This is the rate creditors charge for lending you the principal.
  • Taxes. This is your property tax.
  • Insurance. This is your homeowner’s insurance.

When you calculate your PITI compared to your income, you arrive at your “front-end ratio” aka the number creditors use to determine how much house you can afford.

Here’s how to calculate it:

Dollar amount of your PITI ÷ Dollar amount of your gross monthly income = Front-end ratio

And then:

Front-end ratio x 100 = Front-end ratio percentage

You’ll want your PITI number to be less than 28% of your gross monthly income.

For example, if your gross monthly income amounts to $4,000 / month, the best mortgage you’re likely to attain would amount to no more than $1,120 / month, since that’s 28% of your income.

Household debt

This number compares your income to your debt — and it determines how risky it is to lend to you.

The riskier you are, the smaller chance you have of attaining a home loan, or at least a home loan with a good interest rate.

Here’s the calculation for it:

Dollar amount of monthly debt you owe ÷ Dollar amount of your gross monthly income = Debt-to-income ratio

And then:

Debt-to-income ratio x 100 = Debt-to-income ratio percentage

Say you owe about $1,000 in debt month to month and make $75,000 a year ($6,250/month). We’d then take 1,000 divided by 6,250 to get your debt-to-income ratio, like so:

1,000 ÷ 6,250 = .16

Multiply .16 by 100 and you have 16% for your debt-to-income ratio.

The lower the number is, the better. While the 28/36 rule of thumb says that you should ideally have no more than 36% for your debt-to-income ratio, most lenders will provide you a mortgage up to 49%.

So if your debt-to-income ratio amounted to 16% like in the example above, you’d be in good shape for a loan.

Once you know roughly how much you can afford, it’s time to find someone who’ll help you find a perfect house: Your Realtor.

Step 3: Meet with a Realtor

Much like a good lender, a good Realtor will be an agent who is going to represent you and your interests. Unfortunately, there are a lot of real estate agents out there who just want to make a buck and keep their companies afloat. This means it’s going to be a little bit of work on your part to find a trustworthy real estate agent — but it’s absolutely worth it.

In general, there are two types of real estate agencies out there:

  1. Seller’s agency. These agencies represent the person selling the actual house. They are there to protect the interests of only the seller. You’re not looking for a seller’s agent.
  2. Buyer’s agency. Like the seller’s agent but … well, for buyers. These agencies represent you and want to protect your interests. You want to find a buyer’s agent.

Go check your state board of Realtors in order to find a reputable buyer’s agent. They’ll be able to connect you with someone who’ll be able to find you a good house at a solid price point. You can find your state board’s information through Google or this website here.

For the most part, you won’t have to pay for the buyer’s agent service — but this changes from place to place. Just make sure you do your research.

NOTE: Never sign a buyer’s agency contract! According to Owen, “a good buyer’s agent is forming a long-term relationship with you and you shouldn’t need a contract to keep you with them.”

Once you find a good real estate agent, you’ll be able to start looking for houses. Luckily, it’s a buyer’s market out there. As a result, there are a huge variety of places you can start looking for homes, such as:

  • Newspaper ads. Yeah, yeah. I know. “Get with the times!” Fact is, the way your parents found and bought a house is still in use and you can find plenty of good information on open houses in newspapers.
  • The internet. Websites like Realtor.com or Zillow.com will be able to provide you with solid home listings in your town.
  • Ask your Realtor. Once you find your Realtor, they will be able to set you up with some private open houses. They have access to something called the Multiple Listing Service. This is a comprehensive online resource that has listings to the vast majority of properties in the country — and it’s a resource many American households turn to when searching for new homes.
  • Neighbors. If you like your neighborhood or know which one you like, go ask people if any houses are for sale. It’s also worthwhile to meet people before you’re stuck living near them for years.

Action item: Find a Realtor

Contact your state board of Realtors and ask them to put you in contact with a good buyer’s agent in your area. Be sure to treat all agents with respect. Even when you’re looking at houses with another agent showing you the listing, make it clear with them that you are working through your very own buyer’s agent. This just makes the whole process much more transparent and thus easier for everyone involved.

When you find the house you want, it’s time to…

Step 4: Find a direct lender

Lenders are the actual institutions that will be providing a mortgage for buying your home. They include companies like banks and mortgage banks.

When it comes to finding a lender, direct and correspondent lenders will typically be able to provide you with solid rates and low closing costs. Here’s a more detailed description of the two:

  1. Correspondent lender. This is a lender who provides the money for your mortgage but sells it to you through a direct lender such as a bank.
  2. Direct lender. These lenders will provide you with a mortgage directly with no additional fees.

I suggest going with a direct lender and cutting out the middleman.

From here, you’re going to want to do a bit of research into lenders that’ll provide you the best rates. A few options on that end:

  • Ask a friend. If you have friends or relatives who already own property, call them up and ask them if they know of a good, reputable lender.
  • Call up the bank. Since most all banks provide mortgage lending, you should call up any and all major banks in your town and ask to talk to someone about getting a mortgage.
  • Check online. The internet is a vast resource at your disposal. Be sure to leverage it then by visiting sites like BankRate.com to see if you can get a good deal.

REMEMBER: Your lender is an integral part of you buying a house. To that end, you’re going to want to make sure you have someone who you like and is honest with you. As my friend Owen Johnson says, “A good lender representative pays attention to their clients through closing, and makes sure the deal happens. Be open and honest with your lender … and triple check everything your lender sends you.”

Action item: Call three lenders and ask about their rates

Call up three lenders, whether they be through your bank, your friend, or online. Ask them about their rates and compare your results. Once you’re ready, choose one of them and say you’re interested in getting a mortgage. They’re going to give you a pre-approval letter, which you’ll need to have in order to actually purchase the house — more on that later.

Step 5: Make an offer

When you find a house that you like and want to make an offer, your next step to buying the house is to find out what the property is actually worth. Though it might be tempting (read: incredibly stupid) to just throw out a ballpark number, do the smart thing and research the ever loving crap out of this house.

To do that, I suggest a number of tactics:

  • Hire an outside property inspector. These inspectors are third-party professionals who will go through your home and examine it for structural flaws, damages, and repair suggestions. When they’re finished, they’ll provide you a full report of the house and you can use this as leverage in your negotiations.

    They’re allowed to go through the house as long as you ask the real estate agent for permission, so be sure to ask permission. Here’s an incredibly handy tool from CertifiedHomeInspector.org to help you find one in your area.

  • Ask your lender for a home appraisal. When your loan is approved, you’ll be able to attain an appraisal from your lender on the house. That means that your lender will take into account a number of factors regarding the house including price of houses surrounding it, number of rooms, how large it is, whether or not it has a swimming pool, etc.

    Depending on where you are, the appraisal might take a little while — though no more than one to four weeks. The appraisal will not only give you a good idea of what a fair asking price for the house is, but it will also protect your lender from overpaying for a house.

  • Look at things other than money. Remember: There’s much more to life than money — and that sentiment is very true when it comes to buying a house. When you’re negotiating, remember that you can always ask for other perks such as a washer and dryer, a sprinkler system, or even things like new windows or paint. You don’t have to just focus on money.

During this time, you’ll be able to negotiate on things like property repairs if the inspector found something, as well as plan your move.

Once you get the appraisal, your loan is approved, and everything is inspected, you’ll be ready to close the offer. On the day of closing, the seller will typically allow you to walk through and inspect your property. As Owen says,

“If anything seems different at this point than what you expect, bring it up, because you aren’t going to have much recourse after the closing. Things to watch out for range from tenants still living in the house when you agreed to have the building delivered vacant to a window being broken that wasn’t broken at inspection.”

You’re also going to want to have your lawyer send you a copy of the settlement statement so you can review it before closing the deal. This statement provides a breakdown of all the costs on your end and the seller’s end.

Unfortunately, the settlement statement is often an incredibly bizarre and Kafkaesque document with myriad fees, charges, and funds. Make sure that you ask your lawyer any questions you have regarding the statement so you’re clear on everything. Seriously. A small error in your settlement can mean a huge amount of money lost on your end, so be attentive.

Action item: Call your parents (or anyone you know who owns a house)

Ask them if they could walk you through their settlement statement with them in order to help you research and prep for the closing process. These statements are financially sensitive materials so make sure you ask someone who will be fine with you reading their settlement.

(Bonus) Step 6: Move in!

Now it’s just time to move into your new home. Call up three to five of your best buds, and lure them in with lofty promises of pizza and beer so you don’t have to lug all your stuff in yourself.

There you have it. The steps you need to take in order to buy a house. After you move in and get settled, start basking in the fact that you’ve finally reached the American Dream® … but is it really all that it’s cracked up to be?

If you’re reading this before you’ve bought a house, I’m glad I caught you.

Over the years, I’ve talked about how much I absolutely hate with every fiber of my being generally dislike investing in real estate.

After all, it’s easily the biggest purchase many of us will ever make in our entire lives. Yet the large majority of people are willing to rush into it without any research or consideration to alternatives (i.e., not purchasing a house at all and putting lots of money into an index fund).

And … why? Why do we choose to dive right into the biggest commitment of our lives? The fact is, buying a house is an ever-pervasive invisible script that we blindly follow without a second thought.

You know what they are. Invisible scripts are those guiding beliefs so deeply embedded in our day-to-day lives that we don’t even realize that they’re present.

For example, all our lives we’re told things like:

  1. First, you need to get good grades to go to a good university.
  2. Then, you need to get a college degree.
  3. After you graduate, you need to get married.
  4. Eventually, you need to have kids.
  5. You should buy a house in the suburbs.

And the compulsion to eventually buy a house is one of those scripts that fits right in there, despite the fact that it’s one of the biggest, life-altering decisions you can make.

Don’t get me wrong: You can and should buy a house eventually — but only if it’s right for YOU. If it’s not, you might find yourself strapped to a money sink you didn’t even know was there.

I’ve talked before about the myths surrounding real estate. They include things like:

  • “I’m throwing away my money if I keep renting!” WRONG. People who say things like this don’t take into account the “phantom costs” of owning a home. Those are things like home maintenance and repairs, property taxes, insurance, HOA fees, and utilities that fall on YOUR shoulders to address when you own. Home values may also not rise enough to give you the equity you expect.
  • “I can take advantage of the tax savings!” This doesn’t even make any sense. Even if you deduct a good amount of your mortgage interest from your taxes, you’d be deducting money you’d ordinarily never spend.
  • “If I cut back on avocado toast, I’ll be able to afford a—” Stop it. Just. Stop.

Of course, I don’t think that buying a house is always a bad decision. The majority of the time though, people just jump into it for the wrong reasons.

If a house is a part of your idea of a Rich Life, then I want to help you pay for it the smart way. That’s why I’m offering you a gift: A chapter from my NYT’s bestseller I Will Teach You to Be Rich, for FREE.

This chapter goes into the nuts and bolts of creating your own Conscious Spending Plan. It’s an automated way to help you spend, save, and invest without the pain of managing your money each week.

Just click on the link here and you can download the chapter for free. Enjoy!