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It’s The Biggest Purchase You’ll Ever Make… Don’t Mess It Up

Like any area of personal finance, there are no “secrets” to buying a house.

But it does involve thinking different than most other people, who make the biggest purchase of their lives without understanding the true costs. Although I may be aggressive with my asset allocation, I’m conservative when it comes to real estate. That means I urge you to stick by tried-and-true rules, like 20 percent down, 30-year-fixed-rate mortgage, and a total monthly payment representing no more than 30 percent of your gross pay.

If you can’t do that, wait until you’ve saved more. It’s okay to stretch a little, but DON’T stretch beyond what you can actually pay. If you make a poor financial decision up front, you’ll end up struggling — and it can compound and become a bigger problem through the life of the loan.

Don’t let this happen, because it will undo all the hard work you put into other areas of your financial life. If you make a good financial decision when buying, you’ll be in an excellent position. You’ll know exactly how much you’re spending each month on your house, you’ll be in control of your expenses, and you’ll have money to pay your mortgage, invest, take vacations, buy a TV, or whatever else you want to do.

Here are some of the things you need to do to make a sound decision:

1. Check your credit score.

The higher your score, the better the interest rate on your mortgage will be. If your credit score is low, it might be a better decision to delay buying until you can improve your score. Good credit translates into not only a lower total cost, but lower monthly payments.

The table below (reproduced from MyFico.com) shows how interest rates affect your mortgage payment on a thirty-year fixed $216,000 loan:

FICO score APR * Monthly payment
760-850 4.22% $1,058
700-759 4.44% $1,086
680-699 4.61% $1,109
660-679 4.83% $1,137
640-659 5.26% $1,194
620-639 5.8% $1,268

* APR figures calculated in June 2011

2. Save as much as possible for the down payment.

Traditionally, you had to put 20 percent down. In recent years, people were allowed to put as little as zero down — but it’s becoming all too clear that this was a very bad idea. If you can’t save enough to put 20% down, you have to get something called Private Mortgage Insurance (PMI) which serves as insurance against your defaulting on your mortgage payments.

PMI costs between 1 and 1.25 percent of the mortgage, plus an annual charge. The more you put down, the less PMI you’ll have to pay. If you haven’t been able to save at least 10 percent to put down, stop thinking about buying a house. If you can’t even save 10 percent, how will you afford an expensive mortgage payment, plus maintenance and taxes and insurance and furniture and renovations and…you get the idea. Set a savings goal for a down payment and don’t start looking to buy until you reach it.

3. Calculate the total amount of buying a new house.

Have you ever gone to buy a car or cell phone, only to learn that it’s way more expensive than advertised? I know I have, and most of the time I just bought it anyway because I was already psychologically set on it. But because the numbers are so big when purchasing a house, even small surprises will end up costing you a ton of money. For example, if you stumble across an unexpected cost for $100 per month, would you really cancel the paperwork for a new home? Of course not. But that minor charge would add up to $36,000 over the life of a thirty-year loan — plus the opportunity cost of investing it.

Remember that the closing costs – including all administrative fees and expenses – are usually between 2 and 5 percent of the house price. So on a $200,000 house, that’s $10,000. Keep in mind that ideally the total price shouldn’t be much more than three times your annual gross income. (It’s okay to stretch a little here if you don’t have any debt.) And don’t forget to factor in insurance, taxes, maintenance, and renovations. If all this sounds a little overwhelming, it’s telling you that you need to research this stuff before buying a house. In this particular case, you should ask your parents and other home owners for their surprise costs.

4. Get the most boring, conservative loan possible.

I Like a thirty-year, fixed-rate loan. Yes, you’ll pay more in interest compared with a fifteen-year loan. But thirty-year loans are more flexible because you can ALWAYS pay extra toward your loan and pay it off faster if you want to. But you probably shouldn’t. Consumer Reports simulated what to do with an extra $100 per month, comparing the benefits of prepaying your mortgage versus investing in an index fund that returned 8%. Over a twenty-year period, the fund won 100% of the time. As they said, “…the longer you own your home, the less likely it is that mortgage prepayment will be the better choice.”

5. Don’t forget to check for perks.

The government wants to make it easy for first-time home buyers to purchase a home. Many state and local governments offer benefits to first-time home buyers. Check out HUD’s directory of local homebuying programs in your state. Also, check with your employer, who may also offer special first-time home-buying rates. Ask — it’s worth it. Finally, don’t forget to check with any associations you belong to, including local credit unions and teacher’s associations. You may get access to special lower rates. Hell, even check your Costco membership (they offer special rates for members, too.)

6. Use online services to comparison shop.

You may have heard about Zillow, which is a rich source of data about home prices all over in the United States. Also check out Redfin.com which is disrupting the real estate market by letting home buyers get access to more information — like local tax records — online. You can do your research online and Redfin will send an agent to negotiate for you. They claim an average savings of $14,000. For your homeowner’s insurance, check Insure.com to comparison shop. And don’t forget to call your auto insurance company and ask them for a discounted rate if you give them your homeowner’s insurance business.

Ramit Sethi is the author of the New York Times best-selling book I Will Teach You To Be Rich and runs a blog of the same name with 300,000 monthly readers. Click for a free chapter from his book.