What Every Prospective Homeowner Should Know

Want to buy a home? With both interest rates and housing prices still low, you're not alone. In fact, we've been getting quite a few questions from people looking either to make their first home purchase or to buy a new home after losing their last one to a foreclosure or short sale. If you're in a similar situation, here are some steps you can take to make sure you're financially well-positioned to go get (or get back) your little slice of the American Dream.

1. Decide if you're really ready to be a homeowner.

Contrary to much popular wisdom, owning a home doesn't always make sense for everyone. I'm not just talking about owning a home you can't afford (which is always a bad idea). Even if you can, there are some reasons you may be better off renting at least for now. In some areas of the country, it's still a lot cheaper to rent than to own, especially after factoring in property taxes, utilities (some of which are often included in the rent), and the cost of maintenance and repairs. [More from Forbes: Cities where buying beats renting a home]

In that case, you could be better off paying the lower rent and investing the difference. This could be even more true if you're fortunate enough to live in a rent-controlled area. Not sure if it's cheaper for you to buy or rent? Check out this nifty calculator.

But the main reason to rent is the flexibility it provides. You don't want to have to turn down a lucrative job offer just because you can't sell your home and move, especially when you're just starting in your career. (In my case, I lived in the Washington DC metro area, NYC, Philadelphia, and San Diego since graduating from college.) If you do sell, closing costs usually eat up any advantages you gain from owning within the first 3-5 years.

On the other hand, there are very real advantages in being a homeowner. You have more control over your home. You can deduct the interest and property taxes from your income taxes. You're locking in most of your housing costs from growing with inflation. Perhaps most significantly, you're building equity in an asset that generally appreciates over time and will eventually not have a mortgage payment at all. For a lot of people, this can be the most effective way for them to build wealth because it's a form of forced savings into an investment that they aren't tempted to sell every time the price takes a dip (just the opposite, in fact). [More from Forbes: America's fastest growing small towns]

2. Check your credit.

Once you've decided to buy, you'll want to do what you can to improve your credit. That's because it's one of the biggest factors in determining your future mortgage interest rate that you have some control over. If you haven't done so in the last 12 months, you can start by ordering a free copy of your credit report from each of the three major credit bureaus at www.annualcreditreport.com and check to see if there are any errors on it that could be hurting your score. About 70% of credit reports have them, so there's a good chance one of yours does too. If you find anything, ask the creditor to remove it or dispute it with the bureau directly.

Try to get caught up on any payments you're behind on before they become delinquent and pay down any consumer debt you have as much as possible. You might be tempted to close a credit card once you pay it off, but that can be a huge mistake for a couple of reasons. If it's a card you've had for a while, closing it can shorten your credit history, which hurts your credit score. Second, creditors look at how much debt you have relative to your total credit available. Paying off the credit card helps by reducing your debt, but closing the card can hurt by reducing your total credit available. If your card is costing you a big annual fee, you can always wait until after you close on your home to close the card too. [More from Forbes: Cities where real estate is ripe for a rebound]

That all being said, if you have a lot of available credit, you might actually benefit from closing some of those lines of credit so creditors don't worry about your potential to run up a lot of debt in the future. One way to find out is to use a site like creditkarma.com and quizzle.com. In addition to providing a free copy of your credit score (which you don't get with your free credit report), you can use these sites to see how actions like closing a card could impact your score. Best of all, these features are free to use.

Paying down debt is generally a good thing, but be careful of making payments on old debts or even contacting the lenders (or more likely, the collection agencies). That's because you don't want your actions to turn an old debt into a "new" debt since the latter hurts your credit score a lot more. That doesn't mean you should necessarily forget them. If you can get them paid off in full and reported as such on your credit report, it will generally help your score after about 2-6 months. Just don't do so immediately before applying for a mortgage.

3. Save as much as you can.

You've probably heard that 20% of the home value is ideal as a down payment. There are also closing costs and you'll want to have some emergency funds leftover so you don't run into trouble making your new mortgage payments. No matter how you look at it, the more savings you have, the better off you'll be. [More from Forbes: The most outrageous home sales of 2011]

Not everyone can realistically save enough for the full down payment though. If you're considering dipping into your IRA or taking a loan from your retirement plan to help fund the down payment, make sure you understand all the pros and cons. IRA money can't be put back after 60 days so you're permanently reducing your retirement nest egg. Retirement plans have the opposite problem. They need to be paid back so check to see that you can afford that extra loan payment. In addition, you face the risk of having to pay a tax and possibly a 10% penalty on any remaining balance of the loan that you can't pay back after leaving your job.

4. Figure out how much you can afford to pay in housing costs each month.

When examining your budget, don't just estimate your expenses. Go through at least the last 3 months of your bank and credit card statements to see where your money is actually going. For most people, this can be a real eye-opener.

Also, notice that I said "housing costs" rather than "mortgage payment." Don't forget to include utility bills, property taxes, homeowner's insurance, and an estimate of maintenance costs.  Those costs can really add up.

Remember, the point of this is to avoid biting off more of a mortgage than you can chew. While the mortgage companies have tightened their lending standards, that won't necessarily stop them from offering you a bigger mortgage than your budget can handle. They may know your income, but only you know where that income is going. [More from Forbes: The essential do's and dont's of selling]

5. Get pre-approved for a mortgage before you shop.

Before the fun of house hunting begins, it would be a good idea to visit a mortgage broker or lender and get pre-approved for a mortgage with a monthly payment that fits in your budget (see the previous step). This will let you know what price range to shop in before you get carried away by some amazing but not quite affordable piece of property. When this happens, all reason can get thrown out the window and you can get stuck with a big house and an even bigger mortgage payment to make each month.

The other reason to get pre-approved is that it can give you an edge when competing for a home with other prospective buyers. If the housing market starts turning around, this could become quite a common phenomenon. The key here is to be "pre-approved," which is much stronger than being merely "pre-qualified."

Voila! If you've made it this far, you should now be ready to start looking for your next home. Have fun!

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