Tips for First-Time Home Buyers

YOUR FIRST HOME. Purchasing one is a rite of passage that most non-homeowners dream of. Besides the intangible benefits, homeownership lets you build equity, and is the single biggest tax break available to most consumers. Here's our look at some smart strategies for getting in the door.

First: Pay Off Your Debt
It's a common mistake for home-buyers-to-be: They focus on saving as much money as possible for a down payment instead of paying off other debts. A better approach is to use extra cash to eliminate credit-card and other high-interest consumer debt — even if that means you can put down less on your future home.

Why? First, credit-card debt is expensive and limits your ability to save. The average interest rate on credit cards now stands at 14%, or more than double the 6.1% national average for a 30-year fixed-rate mortgage, according to Bankrate.com. Second, credit-card debt will limit how much you can borrow. That's because lenders often won't allow your total monthly debt service — which includes payments for credit cards, student loans and car loans, as well as homeowner's insurance, property taxes and a mortgage — to exceed roughly 40% of your gross income.

How Much Can You Afford?
The answer to that is a function of two things: How much you can borrow and how much of a down payment you can muster. As a rule of thumb, your annual mortgage payment, taxes and homeowner's insurance shouldn't exceed 28% of your gross income. Then determine how much cash you have for a down payment, leaving yourself enough left over to pay those pesky closing costs, which can add up to 3% to 5% of your total home's value (plus a little something extra for emergency repairs once you move into your new home).

Still having trouble figuring it all out? Click here for SmartMoney.com's home-buying worksheet.

Types of Loans
Now you're ready to start shopping around for the right loan. A first-time home buyer with a steady job and good credit can buy a home with no downpayment these days. These loans are more available, and more reasonably priced, now that they're acceptable to Fannie Mae and Freddie Mac. (The two so-called government-sponsored agencies purchase mortgages worth up to $417,000 on the secondary market — $625,500 in Alaska and Hawaii — absorbing the original lenders' financial risk. Or in places like New York and California where homes are most expensive, jumbo loans are now as high as $729,750.)

But the more money you can muster for a down payment, the more options you will have. For example, Fannie Mae allows borrowers who can put down 5% to qualify for a loan on a smaller salary than with a 3% down payment. You will need to find a Fannie Mae-approved lender to take advantage of this program. Click on Fannie Mae's Web site for a list of all of its products and approved lenders.

Private lenders are also coming up with their own programs to tap into the first-time home buyers' market. Washington Mutual, for example, offers a program for buyers with a 10% down payment: Instead of charging for mortgage insurance, the savings-and-loan builds the cost into the interest rate, making it tax-deductible (which mortgage-insurance premiums aren't).

And if you really want to get creative and avoid paying mortgage insurance altogether, you can take out two piggybacked loans. These are also referred to as 80-10-10s. First, you need to put down 10% of the home's value. Then, you take out a primary loan, usually a 30-year fixed-rate mortgage, for 80% of the home's value. This interest rate should be competitive. For the remaining 10%, you'll need to take out a 15-year fixed-rate mortgage at a far less competitive rate — as much as two points higher than the market. Combine the two monthly costs to come up with your total mortgage payment. Due to the complexity, a piggybacked loan is a bit more expensive than a traditional mortgage and carries higher closing costs. Still, they tend to be cheaper than paying private mortgage insurance.

Questionable Credit
Worried you don't have perfect credit? With Fannie Mae's "expanded approval" program, consumers with slightly blemished credit can also qualify for mortgages at competitive rates that are as much as two percentage points lower than alternative financing. "These are people who might not qualify for fair-market value rates from traditional lenders," says Liz Bayless, director of single family product development at Fannie Mae.

If your credit's still not good enough for one of Fannie Mae's loans, you may yet qualify for a loan insured by the Federal Housing Administration, or FHA. These government-insured loans are issued with even more lenient credit criteria. You can also put down as little as 3% for an FHA loan. A portion of closing costs may be used to meet the 3% cash requirement. The seller may pay the closing costs for the borrower and the lender may also charge a premium interest rate, also known as rebate pricing, to fund the closing costs. Depending on the lender, interest rates are typically a quarter to half a point higher than those in the conventional market. To get a government-insured loan, make sure you find a HUD-approved lender or a mortgage broker who works with one.

There's no income limit to qualify for an FHA-insured loan. However, since these loans are geared toward helping first-time home buyers and low- to moderate-income families, there's a limit to how much you can borrow. The amount varies from region to region, but it's capped at $362,790 in high-cost areas ($426,550 in Hawaii), says Lemar Wooley, a HUD spokesman. To check your area's ceiling, click on the FHA mortgage limits page.

Down-Payment Assistance Programs
Still having trouble coming up with that down payment? Each year HUD gives states and municipalities money to distribute to low- and moderate-income families for housing. Much of it is put toward down-payment assistance programs. Many young prospective home buyers may qualify for a grant (or in some cases a loan that's forgiven if a home buyer stays in the home for at least three years) worth 3% to 5% or even more of the sale price to put toward their down payment or closing costs.

To qualify for a down-payment assistance program, a consumer can earn no more than 80% of a region's median income. Call your state housing finance authority, county housing and community development office or mayor's office for an application.

One final note of caution: Don't confuse any of these programs with no-equity loans being offered to people who already own their homes. These high-cost, high-risk home-equity loans are a bad idea. See our story to find out why.