Owning a home has always been central to the American Dream. Buying that home – whether it’s your first one, next one, or a weekend retreat – may be the most meaningful and lasting investment you make for yourself and your family.

It is also a time when financial responsibilities "hit home." Many decisions and actions need to be taken, often very quickly. Understanding your mortgage options and the many financial and tax ramifications can make this hectic time a smoother, easier, more rewarding experience.

How Much House Can You Afford?

Two and a half times your annual salary is one common rule of thumb, but it is certainly not the answer for everyone. Since most people finance their homes, it may come down to what monthly mortgage payment you feel you can afford – and, just as importantly, how much your lender will calculate you can afford.

To help you estimate your buying power, with some insight into how lenders may evaluate your mortgage, try our calculator – How Much House Can You Afford. It will guide you through some important factors that should be taken into account

Shopping For A Mortgage

Once you have an estimate of the optimal size of your mortgage, it is time to shop around for the best terms and rates. It’s a good idea to do this before you find and fall in love with a house. You will want your lender to pre-qualify and get a pre-approved mortgage. This tells sellers and realtors you are a serious buyer and can move quickly if your offer is accepted.

Pre-qualification:

• Gives you the lender’s estimate of how much you can borrow. It does not guarantee you will be granted a loan, but it gives you an idea of where you stand with the lender
• Is usually free
• Can be done over the phone

Pre-approval:

• The lender, after verifying your income and performing a credit check, approves how much you can borrow (subject to an appraisal of your property)
• Involves completing an application and the disclosure of financial information
• A usually modest credit report fee applies

Note that first-time homebuyers may be able to take advantage of programs that offer special assistance, such as no down payment. Be sure to ask you lender about these.

Applying For A Mortgage

Next, gather the necessary mortgage application materials. The lender will want a good deal of information about you, so it’s best to have the following details ready:

• Your credit report. Make sure it’s accurate; if it’s not, correct it as soon as possible.
• The name and address of your bank, your account numbers, and statements for the past three months.
• Investment statements for the past three months
• Pay stubs, W-2 withholding forms, or other proof of employment and income
• Information on consumer debt (account numbers and amounts due)
• A purchase contract and a receipt for any good-faith deposit if you have already made an offer on a home.
• Divorce settlement papers, if applicable
• If you are self-employed, balance sheets and tax return

Choosing A Mortgage Type

There are many options for your mortgage, both in how the interest rate is set and the term over which you will make payments. Some of the factors that will influence what kind of a mortgage you and your lender settle on include:

• How long you plan to stay in your new home
• Your desire for predictable payments
• A potential need for lower early payments

You will need to talk this over thoroughly with your lender to be sure you fully understand the particular programs they offer, as it will vary from one lender to another. Most commonly, there are two types of mortgages:

• Fixed Rates: You pay a set interest rate over a set period of time, often 15 to 30 years. Generally speaking, the longer the term, the lower your regular payments will be and the more you will ultimately pay in interest charges. Shorter terms generally result in higher regular payments but lower total interest charges paid over the life of the mortgage.
• Adjustable Rate (ARM): The rate you pay will be adjusted, often on an annual basis, with the rate change generally tied to a published industry benchmark, often a set amount in addition to the prime interest rate. This can result in lower initial payments, but you run the risk of higher payments in the event of a period of strong inflation. ARMs can be used, for instance, if you do not plan to stay in this house for a long period of time, but they do carry a level of uncertainty and should be well understood and carefully considered before proceeding.

Extra care in this phase of home buying can save you money and complications in years to come. Certain kinds of mortgages can prove to be very problematic for some borrowers if they involve such features as:

• Large "balloon payments" (lower payments in the early years in exchange for a substantially large payment later).
• Adjustable rate mortgages that allow for substantial increases
• Home loans that require no down payment
• Risky loan types that can potentially lead to the loss of your home and your investment

In 2007, due in part to risky types of loans, the number of mortgage defaults began to rise substantially, resulting in some people losing their homes and the investment they had made in them. Proceed with caution.

Closing Costs

At the closing meeting – also called the title closing or settlement – you will receive the title to the property and will become the legal owner of your new home. However, in addition to the price of the property itself, you will incur a variety of costs associated with the actual transaction. These are known as closing costs and include the following:

• Attorney’s fees: to pay for preparing and reviewing all the documents needed to close the loan
• Points: each point is equal to 1% of the loan amount borrowed
• Recording fee: the fee your town or county charges for reporting a real estate purchase or sale into the public record
• Title search fee: to make sure the buyer is purchasing the house from the legal owner and there are no liens, overdue special assessments or other outstanding claims on the property
• Appraisal fee: since the house is collateral for the mortgage, the lender needs to determine if the selling price is justified by recent sales of comparable properties
• Lender’s Fees – for loan or document preparation and processing by the lender

Tax Matters

Your new home can bring you happiness and security – and potential tax benefits as well. You can deduct your mortgage interest if you itemize on Schedule A of your federal income tax return. You can also deduct your real estate taxes in the year they are paid to the taxing authority.

Find out if you can also deduct closing fees from your income tax, or whether they are added to the cost basis of your home. You may also be able to deduct points in the year that you buy your home if you itemize your deductions, providing you meet certain requirements.

In the future, if and when you sell your home, you will not be able to deduct a loss on your tax return. However, if you sell it at a gain, you may be able to exclude from taxation all or part of the capital gain. Capital gain (or loss) equals the sale price minus your adjusted basis in the property (i.e. what you paid for it initially, plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes).

Under current, 2008 tax legislation, if you meet the requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you're married and file a joint return) of any capital gain that results from the sale of the residence, regardless of your age – provided you owned and used the home as your principal residence for a total of two out of the five years before the sale. 

Insurance To Safeguard Home And Family

Most mortgage lenders require homeowners insurance, but even if you buy the house outright, you still need to protect against its loss due to fire, acts of nature, burglary, lawsuits and other unforeseen events and therefore need to obtain homeowners insurance.

However, there are other types of insurance equally important to your family’s future in the home. What if you were to become disabled and could not work? Or if one, or both, spouses were to pass away? Would your family be able to continue living in the house? Having life insurance and disability income insurance can be essential to help ensure you and your family enjoy the peace and security of your new home for years to come.

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