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In my previous post I talked about a few ways the U.S. government is looking to regulate the subprime mortgage market. While these regulations may cut down on foreclosures related to dishonest lending practices, it won’t help those that simply get in over their head. Before signing on the dotted line and buying a home, there are a few things that you absolutely must do:

Make a Budget

Budgets are at the core of most good financial decisions. It is easier than ever to keep track of your budget using any budget spreadsheet that fits your situation. Make sure you are honest about the numbers you use, and, if anything, be conservative.

Determine What You Can Afford

Using your newly created budget (or previously created for those of you ahead of the game), determine the amount you would be comfortable paying as a whole for your entire mortgage payment. This total mortgage payment will include the loan payment, home owner’s insurance, private mortgage insurance (PMI), and property taxes. You may not have PMI, but you will more than likely have the other three.

Next, subtract your estimated monthly property tax, home owner’s insurance, and PMI payments from your total mortgage payment. Plug the remainder along with your estimated down payment and interest rate into this calculator. The result will be the amount of the loan you can afford given your budget. This loan amount plus your down payment is the amount of house you can afford.

Shop Around

A lot of borrowers tend to skip this fundamental step in obtaining an optimal mortgage. They often rely on the recommendation of their realtor, a friend, or a family member. By shopping around you are looking to compare several factors:

• Rate: This is the obvious factor, but not necessarily the most important. All else being equal, you want this to be as low as possible. But since the rate can be lowered by various other factors that make you worse off, you can judge a deal by rate alone.
• Points/Up Front Fees: One of the ways lenders can reduce your rate is by asking you to pay points up front. One point is one percentage of the loan amount. Points are typically useful if you will be in the house for a long time (my rule of thumb is around four or five years.) Otherwise, get rid of the points and pay the slightly higher rate. Other up front fees can be compared across lenders and can often be negotiated to some extent.
• Prepayment Penalty: Lenders can also reduce your rate by including a prepayment penalty clause in your mortgage. The penalty can apply to selling your home, refinancing, or both. They are usually quoted as either a percentage of the outstanding principal balance or a specified number of months of interest. As with points, a prepayment penalty can be worth it if you will be staying in the house a long time. Many prepayment penalties expire in less than five years.
• Private Mortgage Insurance (PMI): PMI is paid when you have greater than an 80% loan to value. Many knowledgeable brokers can get you PMI for less if you meet certain criteria. Some can find lenders that will waive PMI altogether if your credit score and financial situation is good enough (this is rare, though.)
• Hire a Home Inspector: After my recent home-buying experience, I had to add this to the list. I was set to purchase a property that on the surface looked great. Internally, however, the home needed over $20,000 in urgent repairs. This would have been financially devastating and would cause many buyers to head toward foreclosure.

Following these basic tips will allow you to find a mortgage that fits you and your situation. In an upcoming post, I’ll compare the various loan types (fixed, ARM, interest only, etc) and describe situations where one may be better suited than the others.

Do you have any tips to add? If so, leave a comment.

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