How To Buy A House When You're Pretty Sure You Can't Afford One

Here are six hurdles for first-time homebuyers that can be overcome.
You can probably buy a house, even when you think you can't.
JamesBrey via Getty Images
You can probably buy a house, even when you think you can't.

The obstacles to buying a first house may appear insurmountable: Home prices have risen, mortgage interest rates are poised to rise, and by most people’s definition we’re in a market that favors sellers.

But for many who think they can’t afford the American dream of owning your own home, there’s some good news: You probably can ― and in a place you’d actually want to live.

Here are six problems that, despite what you’ve heard, don’t have to stand in the way of home ownership.

Problem 1: You don’t have the 20 percent down payment.

Maybe you’re still paying off student loans or living paycheck to paycheck. Your savings account is simply not that full.

The gold standard in buying a house is 20 percent down ― that is, you pay 20 percent of the purchase price upfront. But that doesn’t mean you can’t get a mortgage with a smaller down payment. You can very often pony up much less ― even as little as 3 percent.

And you won’t be alone. According to the National Association of Realtors, 81 percent of Americans purchase their first home with less than 20 percent down.

Paying less upfront has its disadvantages: You’ll need to take out a larger mortgage, obviously. When you put up less than 20 percent, the mortgage lender can also require you to take out private mortgage insurance. But the difference between 20 percent and 3 percent on a house selling for $300,000 is the difference between $60,000 and $9,000. Sounds more doable already, doesn’t it?

What if you’re still coming up short? The solution for many young adults is to tap the Bank of Mom and Dad for a gift.

Your generous donors have to pay gift tax on any sum above the federal exemption limit for that year. The limit for 2017 is $14,000 from one person to another. That means Mom can gift you and your partner $14,000 each and Dad can do the same, which amounts to $56,000. Grandma and Grandpa could also chip in.

If you’re putting down 20 percent or more on a mortgage that’s backed by Fannie Mae or Freddie Mac, the whole down payment can come from a gift. But if your down payment is less than 20 percent, some of that money has to be your own.

Another option that is gaining in popularity, according to a recent study by ATTOM Data Solutions, is to ask Mom and Dad or another relative to co-sign the mortgage with you. Assuming their credit score is good and they have income and assets that boost your mortgageability, you could obtain a loan with less money upfront. The risk here is that if you miss a mortgage payment, their credit will be affected as well as yours ― and if you stop paying entirely, the bank will come after them.

The report found that 22.8 percent of all purchase loan originations on single family homes in the second quarter of 2017 involved co-borrowers listed on the mortgage or deed of trust, an increase from 20.5 percent during the same period in 2016. Among 42 cities with at least 1,500 such loan originations, those with the highest share of co-borrowers were San Jose, California (50.9 percent), Miami (45.2 percent), Seattle (39.1 percent), Los Angeles (31.1 percent), San Diego (29.4 percent) and Portland, Oregon (28.8 percent).

But since not everyone has parents who can or want to fork over financial help, here are some other places to look for down payment money:

Pull from your 401(k) or IRA assets. You may be able to borrow up to the lesser of $50,000 or 50 percent of your 401(k) plan balance, and first-time homebuyers may qualify to take up to $10,000 from an IRA without paying early withdrawal penalties. Be advised, though, that not all plans permit borrowing, and tapping into these resources so soon is likely to slow down your accumulation of retirement savings. Also, you will have to repay your 401(k) ― and some IRAs. Beware that some 401(k) plans require immediate repayment if you leave your current employer.

Skip the big wedding. Although most Americans spend less than $10,000 on their wedding, some people are dropping $20,000, $30,000 and much, much more. The money you don’t spend on one day of celebration could make a substantial dent in your home down payment. A spinoff idea is to create a “wedding registry” that suggests money to buy a house instead of dishware that you already have. For instance, HoneyFund, which calls for honeymoon donations, can also be used to collect money for a down payment.

Play the first-time home-buyer card. There are federal, state and local programs that help would-be homebuyers qualify for loans or offer them grants toward their down payments. Fannie Mae and Freddie Mac have options that can ease the way for borrowers with a wide range of incomes. Even the U.S. Department of Agriculture offers a helping hand to some first-time homebuyers, just in case the rural life appeals.

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Problem 2: You have bad credit.

Bad credit may be the biggest obstacle of all to buying a house. A tarnished credit report will limit your choices to loans with higher interest rates or no loan at all.

The best thing to do is come clean about your bad choices and be prepared to demonstrate the new frugal and fiscally responsible you. Pay your bills and pay them on time. Talk to a mortgage broker and ask for suggestions on how to improve your credit score.

In the meantime, here’s some advice for every house-hunter:

Don’t incur any new debt while you are house-hunting. Defer buying a car until after you buy your house. The mortgage lender will be assessing your income-to-debt ratio.

Don’t even apply for any new credit cards. Each time you apply for a financial instrument ― a credit card, a car loan, a new refrigerator on layaway ― it is considered a “hard pull” on your credit. As a result, your credit score will drop a few points, and that will stay on your record for two years. Yes ― just for applying!

Know what your credit score is. Shockingly, many people start house-hunting without first finding out this all-important number. According to the National Foundation for Credit Counseling, 42 percent of Americans haven’t checked their credit score in at least the past 12 months. What you specifically want to know is your FICO credit score since it’s what lenders look at most often to assess creditworthiness.

As of April 2016, the average FICO score nationwide was 699 on a scale of 300 to 850. Generally, a score below 550 is considered poor. The two magical numbers are 620 for Federal Housing Administration-insured loans and 720 for conventional loans with primary mortgage insurance. If your FICO score falls below the relevant number, you may not qualify for those mortgages. For conventional loans without mortgage insurance, your FICO can dip as low as 620, but the interest rates and affiliated costs on those loans will be prohibitive.

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Problem 3: You fell in love with a house far outside your price range.

Well, first of all, congratulations on actually knowing your price range. Now break up with that dreamy mansion and move on. Shopping for champagne on a beer budget never ends happily.

A house will likely be the largest single purchase of your life. Think of it as an investment that you sleep in or a retirement savings account with a kitchen. You aren’t just house-shopping for current you, but for future you. And someday you’ll want to sell this investment.

So stop thinking in terms of whether your couch will work in the space and think more about the big picture. Make a list of the features you simply must have, the features that would be great to have and the features that you really don’t care about.

Suggestion: Add “good schools” to the must-have list because even if you don’t have children and don’t plan on ever having them, houses in good school districts appreciate faster. A National Bureau of Economic Research study found that for every $1 increase in per pupil spending, local home values increased by $20.

To determine that home price range (if you haven’t), figure out how much you can really afford to spend on housing each month. A standard rule for lenders is that your monthly housing expenses (PITI for principal, interest, taxes and insurance) should not be more than 28 percent of your income before taxes. Some banks will stretch this “housing ratio,” or “front-end ratio,” to 33 percent. So if you earn $5,000 a month, the maximum PITI payment the lender thinks you can handle is about $1,650.

Banks are also looking at a “back-end ratio.” Add up your PITI payment with all other monthly revolving debt payments ― on credit cards, car loans, any other loans you carry. That sum should be no higher than 41 percent to 50 percent of your gross monthly income, depending on the type of loan and lender.

While your dream house may cost too much for now, you don’t necessarily want to be below these ratios. The assumption is that your mortgage payment will stay the same through the years while your income will likely increase with promotions and raises. It may be a squeeze to make your mortgage payments for the first year or so, but the effort should get easier.

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Problem 4: You fear you’ll mess up your life with a bad loan.

For decades, the 30-year mortgage with a fixed interest rate was a kind of one-size-fits-all. At the end of 30 years, you would own the house outright, hold a mortgage-burning party and then live “mortgage-free” in retirement.

But many people no longer reside at the same address for three decades. In 2016, the average length of time to own one particular house was 10 years, according to the National Association of Realtors’ “Profile of Homebuyers and Sellers.” Ten years before that, homeowners tended to move every six to seven years. So there are many types of mortgages on the market designed for how we live now.

Some loans begin with low interest rates that are then adjusted upward by a certain percentage every year or so. The popularity of these adjustable rate mortgages are blamed for helping trigger the foreclosure crisis in the mid-2000s. Banks were accused of not adequately vetting potential mortgagees who found themselves with escalating payments that they couldn’t afford.

That said, adjustable rate loans make sense for some people. The low initial rate is more affordable at the beginning of the loan, when your income may also be lower. If all goes according to plan, you’ll refinance or sell the property before the loan resets beyond your ability to afford it.

Talk through the various options with a mortgage broker, preferably one who works with more than one lender. Make sure any loan you accept doesn’t impose a penalty if you pay it off early. If interest rates drop, you want the ability to refinance ― essentially, to get a new mortgage at a lower rate.

But don’t despair at the complexity. People like you are owning homes and paying down their mortgages every day. The overall mortgage delinquency rate dropped in the second quarter of 2017 to its lowest level since the second quarter of 2000, according to a national survey released by the Mortgage Bankers Association.

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Problem 5: You don’t really know where to begin.

Some first-time buyers think going to every open house that offers free cookies is a smart way to start. Even if the cookies are great, you’re wasting time.

Begin by educating yourself. Since the home-buying process varies from state to state, learn how it works in the state where you want to buy. Fannie Mae and Freddie Mac both offer classes that can help guide you through the process.

Here are some basic things that every buyer should understand:

Real estate agents work on commission. As a buyer, you don’t need to pay an upfront fee for an agent to drive you around and look at houses. The commission rates for both the listing and selling agents are written into the listing contract that the seller signed and are factored into the asking price. The typical commission is 6 percent, split equally. For especially expensive properties, sometimes agents agree to take less.

All this means that real estate agents don’t get paid unless the deal closes. They work to close deals. No deal, no pay day. Period. Agents may be very charming people, but they don’t work for you. They work for themselves.

It’s not usually a good idea to try to get around this unpleasant reality by hiring an inexperienced friend or relative who just obtained a real estate license. Work with an agent who specializes in the neighborhood you want to buy in. Drive around and see whose signs are on the most lawns.

Homes can be bought without bank or third-party mortgages. Some sellers are willing to hold the mortgage. Instead of getting a loan from a bank, the buyer signs a contract to make payments directly to the seller. This is perfect for buyers who cannot obtain a conventional loan because of credit or income issues. It also saves the buyer a big chunk on closing costs. There are no points on the mortgage (essentially, fees paid to the lender). There’s less paperwork. Should the buyer default on the loan, the seller keeps the down payment and can foreclose the same as a bank would.

A house that’s been on the market a long time doesn’t necessarily have serious flaws. Generally speaking, homes that don’t sell within the first few weeks are priced too high. The seller may have unrealistic expectations about the value of his home. There is no harm in making a low offer, and the real estate agent must, by law, present it to the seller. The seller might not like your offer, but if he has a smart agent, he will use your bid as an opening volley in negotiations.

Every house has some flaws. You have to decide whether they’re fatal. Certain problems can’t be fixed but may be managed. If the house sits on a busy corner, there will be traffic noise. If the house faces north, it’s likely darker inside. Are these flaws you can live with? Would a row of dense shrubbery cut down the street sounds? Could skylights and some tree-trimming help with the sunlight situation?

Other problems may be worth embracing. It’s good financial advice to buy the dumpiest house on the best street. A house that is move-in ready will inevitably cost more. Turnkey homes, as they are called, lure you in by making it easy for you to envision living there. But if you want a bargain, bring a contractor with you to the dumpier house and let her help you “see” the potential behind the peeling paint and weed-filled yard.

A final word on open houses: They’re basically training and recruiting platforms for new agents. Free cookies aside, listings rarely sell because of an open house. Most of the people who walk through are curiosity seekers often looking at properties above their price range.

Only 9 percent of buyers found the home they purchased at an open house in 2014, according to the National Association of Realtors. Yet 44 percent of buyers that year included open houses in their search.

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Problem 6: You made an offer and now are seriously terrified.

Home-buying is a negotiation, with price being the big item on the table. But it’s not the only item. Every offer you make should have at least these two contingencies:

1. You will have the chance to get the property professionally inspected. If the inspector turns up problems that would cost too much for you to fix, you can renegotiate the purchase price ― or walk away.

2. Your offer is based on your ability to find favorable lending terms. If you can’t get the money, you’re not legally obligated to buy the house.

Depending on where the property is and what you’re planning for it, other contingencies might include termite inspection and a contractor’s assessment of certain remodeling costs.

When you and the seller have a contract that you both accept, you go into a process known as escrow. A third-party escrow officer will make sure that all the t’s are crossed and the i’s dotted on the paperwork and will handle the money payouts when it comes time to close the deal.

Things can still go wrong in escrow. An inspection can turn up a roof that needs to be replaced or a garage with a mold problem. The buyer may not be able to secure financing by the deadline. Or the bank’s appraiser may deem the house not worth what the buyer is willing to pay for it.

Not every escrow ends with the sale of a property. Nationally, 3.9 percent of home sales failed in 2016, up from 2.1 percent in 2015. First-time homebuyers are more likely to have a deal fall apart, according to the National Association of Realtors, because they’re unfamiliar with the process ― and yes, they may get cold feet and look for a way out.

Breathe deeply. We’re still waiting to meet the person who slept well the night before escrow closed.

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