Your Investing Life: Buying your first home
January 20, 2015
You've pictured walking up to your front door, opening it, and stepping across the threshold into a place you own. Now you're finally ready to make the leap and buy your first home. It's exciting—and probably a little nerve-wracking too.
Here are a few things to keep in mind to help you stress less as you get ready to become a homeowner.
Start a house savings fund
You'll want to have a decent-sized down payment already set aside before you start house hunting. Aim to have at least 20% of your home's purchase price saved, so you can avoid the added expense of private mortgage insurance (PMI).
Most lenders require you to pay PMI until you build up the equity—the amount of the home you own as opposed to your mortgage lender—to that percentage.
"You might be tempted to invest your down-payment dollars in something more aggressive than a money market fund or savings account, especially when interest rates are low," said Mary Ryan, a financial planner with Vanguard Asset Management Services.
"A word of caution, however. Investments such as mutual funds, stocks, and bonds can go down as well as up. And because you'll need to use the money you've saved for your down payment, the possible gain might not be worth the investment risk," Ms. Ryan said.
Fix your price range
A good rule of thumb is to buy a home that's less than 2½ times your annual income. When you look at the amount you can afford to pay, include all the expenses that come with owning a home: taxes, utilities, maintenance, plus any home improvements you may want to make.
"One thing you want to watch out for is becoming 'house poor.' There's more to life than your home purchase," Ms. Ryan said. Try to find a balance between stretching a little—an extra $20 a month over the course of 15 or 30 years might make sense—and stretching too much. It's your first home, so you may have to compromise on your dreams a bit to keep your budget from bursting.
Polish your credit history
Request copies of your credit report before starting your home search. Make sure your credit history on the reports is accurate and work to fix any problems that you find. A clean credit history puts you in a stronger position to get a mortgage and helps make you more attractive to sellers.
Prepare with preapproval
Work with a mortgage lender or bank to get prequalified for a mortgage loan. You—and the owners of the home you'll potentially buy—will know that you've been approved. You'll also have an idea of what your monthly payments will be, minus any taxes or fees. Be prepared to provide some detailed financial information about yourself—along with a co-purchaser, such as a spouse or partner, if you'll have one. If you own your own business, you may have to provide several years' tax returns to verify your income.
Use retirement funds with care
Your employer may allow you to take a loan against your retirement plan balance for home purchases. The advantage of this type of loan is that, instead of paying the interest to a third party, you pay it back to yourself. Getting approved to take the loan also won't be as difficult as it might be when securing a mortgage from a lender, especially if your credit rating isn't the best. The interest rate you'll pay back could also be less than what a mortgage lender might demand.
However, this action could have some consequence on your finances if you change jobs before you pay off your loan balance. Most employers require you to pay the outstanding balance in full when you leave. You may also give up some investment returns, depending on the rate you pay back to your plan account versus the rate of return you may have received if the loan amount remained invested.
Also, if you withdraw money from your IRA for a down payment on your first home, the normal 10% penalty that those younger than 59½ pay for withdrawals from traditional IRAs doesn't apply. And at any age, you can withdraw up to $10,000 penalty-free from an IRA to buy or build a first home for yourself, your spouse, kids, grandchildren, or parents.
While it can be an option, tapping your retirement savings, whether it's in an employer plan or an IRA, is something to consider carefully before moving ahead. You'll want to balance buying your first home now with your desire to meet your financial needs once you retire.
Find a great rate with a reputable lender
As the song says, "You better shop around." There are a number of sites on the internet that let you compare rates from multiple lenders and explore some of the additional costs and fees they charge. You can also check lenders' reputations to feel confident in the lender you choose. And, as with every contract, read the fine print, which will reveal any costly closing fees that can add to the purchase price.
You may have "points" on your mortgage. Each point, which is a fee paid to your lender, equals 1% of your loan amount. There are two types of points: Discount points allow you to prepay some interest on your loan to lower your rate and can be tax deductible, while origination points cover the lender's cost to create—or originate—your loan and aren't able to be deducted on your tax return.
To help you decide whether it makes sense to use points for your mortgage, consider the size of your down payment and the length of time you expect to be in your new home. If you have enough money saved for your down payment to pay the cost of discount points upfront or plan to be in your house for a long enough time to cover their cost, using points can make sense. There are zero-point loans available if you need to keep closing costs, including your down payment, as low as possible.
Consider the tax implications
You may qualify for some tax deductions, especially if you take out a mortgage to buy your home. You can find details about what you can deduct—and what you can't—at irs.gov.
The mortgage interest deduction allows you to deduct interest on up to $1 million of debt used to buy or improve a home. If you've previously just taken the standard deduction when filing your income tax form, "itemizing your tax deductions can be an attractive option once you buy your first home," said Sarah Hammer, an investment analyst in Vanguard's Investment Strategy Group.
If you chose to include discount points in your mortgage, you can deduct them provided the cash you paid at closing via a down payment equals the points you purchased.
You can also deduct local property taxes from your taxes each year, provided you aren't subject to the alternative minimum tax (AMT). It's common to reimburse the seller of your home for any local taxes already paid on the property. You may be able to deduct this amount in the year you buy your home, so check the settlement sheet you'll receive when you close on your home purchase to confirm this amount.
There are some tax credits (up to $500) available for energy-efficient home improvements. "A tax credit is more valuable than a deduction because it directly reduces the tax bill, dollar for dollar," Ms. Hammer said.
Also, keep your receipts from all the home improvements you make. You can add them to the price you paid for your home to determine its final purchase price, or its "cost basis," for tax purposes. If you invest a substantial amount of money into upgrading, you could end up reducing the amount of profit—the spread between the purchase and sale price—on your home, which may help you limit the tax you'd owe when (or if) you eventually sell.
Get a home inspection
Before you sign on the dotted line, it's a good idea to hire a licensed home inspector to give your potential new home a thorough once-over. The cost of the inspection will more than pay for itself if it allows you to avoid costly and unexpected repairs or gives you the opportunity to walk away from the purchase.
Consider hiring a buyer's agent
Engaging a buyer agent who's contractually bound to put your interests first can save you some money and headaches. Without that agreement, it's possible that both the seller's agent and the agent who showed you the home you're buying could be representing the seller's interests, rather than yours. A buyer's agent can help advise you during the bidding process.
Enjoy your new home
Buying a home is a big decision. But by taking a few sensible steps, you can feel confident taking that step and ready to "make this place your home."
- All investing is subject to risk, including the possible loss of the money you invest.
- An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
- We recommend that you consult a tax or financial advisor about your individual situation.