What to Think About Before Buying Your First Home

Kevin K. Chung, CFP®, CIMA®, Senior Financial Planner, First Republic Investment Management and Chris Pederson, Relationship Manager, First Republic Bank
October 3, 2016

Home ownership has traditionally been an important part of the American Dream so it's not surprising that there can be a lot of pressure to buy — especially with interest rates near historical lows. Buying a home can be a smart move from both a financial and personal perspective. However, that doesn't mean owning a home is always the right choice for everyone. If you think you might be ready to begin the process of purchasing a home, here are some factors to consider.

Is buying a home right for you?

Like any other decision, there are pros and cons to buying a home. One of the biggest upsides to buying is the opportunity to build equity. As a renter, you pay money to your landlord every month and say goodbye to that money, forever. Additionally, renters can be subject to periodic rent increases and may have less control over living arrangements like having extended visitors, pets or other factors.

Homeowners, however, build an ownership interest in an asset that may grow in value if the property value increases and as they pay down their mortgage principal. In addition, homeowners also have an option to access their equity via a home equity line of credit (HELOC). Homeowners may also be able to recoup some or all of their investment costs if they eventually sell, especially if housing prices continue to rise.

Homeownership may provide valuable income tax benefits as wellFor income tax purposes, homeowners can deduct the mortgage interest and possibly the property taxes, depending on which tax bracket you are in. A typical mortgage is structured so that, during the initial years of the repayment period, a greater portion of your monthly mortgage payment is allocated to interest payments than to principal payments. Therefore, these tax breaks may significantly reduce your after-tax costs of homeownership. 

On the flipside, homeownership carries additional expenses and financial responsibilities that you would not face as a renter, including property taxes, maintenance and repair costs and potentially higher utility bills and insurance premiums. Homeownership is a long-term commitment and can make it more difficult to relocate on short notice if an opportunity in another city suddenly arises. In addition, homeowners bear the risk that the value of their property may decline, causing the equity in their home to either decline or even disappear. If a homeowner does not have enough equity and property values decline, it is possible for the homeowner to owe more on the mortgage than the home is worth.

Figuring out whether it makes more financial sense to buy or rent depends on several factors. You should ask yourself the following questions when deciding between buying and renting:

  • Why do I want to buy a home?
  • Can I afford the down payment and additional costs of homeownership?
  • How long do I want to live in this home?
  • How would I feel if I had to live in this home longer than expected?
  • What hidden costs could be lurking if I bought this home?
  • What financial opportunities would I be foregoing if I bought this home?
  • Could I afford to stay in the home if I lost my job or if housing values declined?
  • What will my life look like in five to 10 years?

Getting a mortgage

Obtaining a mortgage is often the trickiest part of the home buying process. Although requirements differ from lender to lender, you should generally plan to have the following in place in order to qualify for a mortgage:

  • Down Payment – The amount of down payment varies from lender to lender, but in general, you will need to have enough cash to fund a down payment equal to at least 20 percent of the purchase price of the home. If you do not have enough cash to fund a 20 percent down payment, you may be required to pay an extra monthly premium for Private Mortgage Insurance (PMI). PMI protects a lender from losing money in the event that a borrower defaults on the mortgage. For larger purchase prices (such as those that exceed $2.5 million), your lender may also require more than the traditional 20 percent down payment.
  • Proof of Funds – Before you apply for a mortgage, you should compile your latest bank and brokerage account statements and other financial records to prove that you have the necessary assets to cover the down payment and qualify for the liquidity needed for reserves. Lenders will require these documents for the loan approval process.
  • Evidence of Income Source – Income is one of the major determinants of how much a bank will lend. You will need to provide the lender with your latest income statements, tax returns, and proof of current employment.
  • Strong Credit Score – Check your credit report and scores from all three major credit reporting bureaus in advance so that you have adequate time to clear up any reported late payments, errors or surprises before you apply for a mortgage. Borrowers with a good credit score (at least 720) may qualify for lower interest rates. Having excellent credit scores is very important, but ultimately, it’s not your credit score that decides the amount of the loan you qualify for, but rather it is your income that will determine the amount of the mortgage you can qualify for which is  approximately four to five times your annual gross income, depending on mortgage rates, other debt, etc.
  • Non-Retirement Assets – Many lenders will not include retirement accounts in your net worth when determining your qualification for a mortgage.  You will want to accumulate adequate savings outside of your IRAs and 401(k) accounts in order to improve your eligibility for a mortgage.
  • Closing Costs – When purchasing a home, you will incur non-recurring closing costs which vary depending on the lender. These can include home inspection costs, appraisal fees, survey fees, underwriting and origination fees and discount points. In some counties, some of the third party closing costs such as the escrow service fee, title insurance and transfer taxes are either split 50/50 or paid for by the seller. Consult with your local realtor to find out if this applies to you.
  • Reserve Savings – In addition to the down payment and closing costs, you will be required to have enough additional cash reserves which vary depending on the size of the loan and the type of the loan. In the event of a disruption of your employment or some other financial crisis, lenders will want to ensure that you still have enough cash on hand to continue paying the mortgage, property taxes, homeowners insurance, association fees and maintenance costs.

Knowing the local market

Because housing markets vary significantly, it’s important to really understand the local market. Although there are national trends in housing prices, plenty of variations exist among cities, neighborhoods, even streets – so develop a deep understanding of the area in which you plan to buy. Buying a home in New York, San Francisco, Los Angeles or Boston, for example, comes with unique sets of challenges that buyers should consider. Be sure to choose a local realtor who specializes in the respective areas that you’re looking to purchase a home in.

Not all homebuyers who satisfy the items above will necessarily qualify for a mortgage loan. Homebuyers should work closely with their lender of choice to fully understand their specific guidelines and requirements.

The strategies mentioned in this article will often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice.  This information is provided to you “AS IS”, does not constitute legal advice, is governed by our Terms and Conditions of Use, and we are not acting as your attorney. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here.  Clients’ tax and legal affairs are their own responsibility – Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this article.

©First Republic Bank 2016