How Buying a House Works

The first critical step to buying a home is figuring out how much you can afford to spend. Almost no one buys a home with cash. Instead, homebuyers get a loan called a mortgage from a bank. They pay off the loan in fixed monthly payments based on the total amount of the loan and the interest rate. Before you even begin looking for a house, you need to talk with a bank -- or several banks -- to get pre-approval for a mortgage.

The bank will ask you a series of financial questions to determine how much you can afford to pay each month. That number will determine the price range of affordable houses. The main numbers the bank wants to know are how much you earn in income and how much you owe in debt (credit cards, student loans, car loans, etc.). While these numbers give a solid big picture of your finances, you also need to check your budget.

A good budget includes all of your monthly income minus all of your monthly expenses: food, gas, debt payments, entertainment, etc. A complete and accurate budget is the best way to figure out exactly how much money is available every month for a mortgage payment. If that number is lower than the bank's, play it safe and go with your calculations.

Notice that there's a difference between getting pre-qualified and getting pre-approved. Pre-qualified means that you've told a lender your income level and your debt and credit information, and the lender estimated what you can afford. Pre-approval, however, means that the lender has done the legwork of pulling your credit report, checking your debt-to-income ratio, and running a more in-depth analysis of your financial situation. The result is an official pre-approval letter than can be help seal the deal when negotiation with a seller. Sellers know that a pre-approved offer is more likely to result in a completed sale, which might convince them to accept a lower price.

Throughout the pre-approval process, there are some key facts to remember. The monthly mortgage payment is only part of the expense of buying a house. In most cases, you're expected to make a down payment of at least 20 percent of the home price to secure the loan. (First-timers can take advantage of programs that allow them to put down significantly less money.)To do that, you'll need a significant sum of cash on hand. There are also a number of additional costs that are not included in the standard calculation of monthly payments. Ask your lender about property taxes in your area, the cost of mortgage insurance and the average closing costs for homes in your price range.

Read How Mortgages Work for an in-depth review of the whole home financing process.

Before you even begin searching online, sit down and think about what you "need" versus what you "want" in a home. Start with the things you absolutely need: three bedrooms, central air, a backyard, a good school district, etc. Then list your wants: hardwood floors, a large kitchen or a swimming pool. By keeping these distinctions in mind, you can focus your search on the homes that meet all of your needs and include at least a few of your wants. Always be prepared to make some compromises to stay within your price range.

Consider different types of homes such as condos, town homes and apartments. Depending on the stage of your life, a low-maintenance condo or apartment may be a better choice than a single-family home. Also think about the style of home you like: traditional or modern, brick or aluminum siding? While these seem like superficial considerations, you might find that you or your spouse has strong opinions.

Of all of the decisions to make before you begin your home search, arguably the most important is location. The location of your home mirrors your list of needs and wants. If you need a good school district, stick to locations with good schools. If you need to be able to walk or bike to work, search within a tight radius of your office. If you're looking for peace and quiet, avoid homes along major roads. By combining these requirements, you will waste less time looking in the wrong places.

Keep in mind that your location preferences may change over time. For example, having kids raises the importance of a good school district. And what if you lose or leave that walkable job? Would you still want to live in that neighborhood? Make sure to balance your near-term needs with your long-term goals. With a tight housing market, it's not always possible to sell and buy a new house every few years.

Location criteria to consider:

Do you need a real estate agent to buy a home? Absolutely not. Anybody with an Internet connection can search and view homes on the market. You can customize your search by price range, number of bedrooms, style, and location, and even contact the sellers to arrange a showing. But with so many tools at our fingertips, why do most people still use a real estate agent?

To answer that question, we first need to define our terms. Real estate agent (or realtor) is the general name for someone licensed by the state to help people buy and sell homes. Real estate agents provide a huge advantage because they know the process and the paperwork; they have relationships with lenders and understand the local market.

However, as a homebuyer, it's important to understand that most real estate agents are working for the seller, not you. The reason is simple; the seller is the one who pays the commission when the home is sold, not the buyer. Since the real estate agent's commission (usually 5 to 7 percent) is higher when the price is higher, it is in the agent's interest to secure the highest sales price.

Keep this in mind if you contact a real estate agent directly regarding a specific home that you find online. While the agent may be a perfectly decent and ethical individual, the simple fact is that he or she is not working for you. Your agent is working to sell the house. In fact, he or she is bound by contract to try to get the best deal for the seller.

Another thing to understand is that most real estate agents work for a specific agency. If you call up George from Howard Hanna and ask him to show you some properties, he'll likely show you homes that he's listing first, then homes that other Howard Hanna agents are listing. For him, it simply makes the most financial and business sense. But for you, it limits your choices.

The best type of real estate agent for a homebuyer is a buyer's agent. This individual signs a contract with the buyer to help find the best house for the best price, regardless of which person or agency is listing the house. We'll talk more on buyer's agents on the next page.

A buyer's agent is a real estate agent who is working exclusively for you, the homebuyer. A regular real estate agent becomes a buyer's agent by signing a contract with the buyer. The contract stipulates that the agent will work to negotiate the best price, ensure the property is inspected, and represent your interests throughout the entire process. What you tell a buyer's agent, like the maximum you can afford to pay, remains confidential. Using a buyer's agent also means that you will be shown homes that are For Sale By Owner (FSBO).

How do you find a buyer's agent? Shop around. Meet with different real estate agents and have them show you a few houses. Look for someone who really understands you and your particular needs. A good place to start is by asking friends and neighbors for recommendations.

Will you pay more for a buyer's agent? Not usually. In most cases, the buyer's agent splits the sales commission with the seller's agent and you don't pay anything. You could argue that this arrangement still favors the seller, since even the buyer's agent will want the highest commission possible. Buyer's agents counter that the difference in commission is usually so small that it doesn't affect their loyalty to the buyer. For example, if the total commission on a $150,000 is six percent, then the buyer's agent takes home half, or $4,500. If the agent negotiates the price down to $140,000, his take is only $300 less.

Pay close attention to the contract you sign with a buyer's agent. A limited agency agreement may stipulate, specifically, for what the agent will be paid. For example, the agreement might state that if you find a home on your own, then no commission will be paid.

Here are some other types of contracts you should understand when working with an agent:

Once you settle on a real estate agent, it's time to start house hunting!

Whether or not you sign with a buyer's agent, your real estate agent will ask you a series of questions to find out exactly what type of home you're looking for and where. She will take those criteria and search the Multiple Listing Service (MLS) for matching properties.

Since most of the same listings are available online, do some searching of your own. Trulia.com and Realtor.com are two excellent sites for unbiased search results. Sites like ForSaleByOwner.com or Craigslist.org include private listings that aren't in the MLS database. Some listings offer virtual online tours and most include lots of interior and exterior photos. Online listings include useful information like how long the home has been on the market and stats about the local school district. You can even use convenient online calculators to estimate your monthly mortgage payment including property taxes.

Together, you and your realtor will assemble a list of the top homes to visit in person. This is the exciting part. Your agent will make appointments with the sellers' agents for showings. Most showings are done when the current owners are out of the house. In some cases the seller's agent is there to tell you more about the house. If not, the agent usually supplies a printed overview of the home's amenities called the listing sheet. Use the back of the listing sheet to take your own notes on the home's good and bad qualities. Bring a digital camera and snap lots of photos. It's amazing how quickly you forget a beautiful staircase or a clogged shower drain when it's your tenth house of the day.

If you find a few houses you like, return for a second or third walk-through during a different time of day. The neighbor's dog could bark all night or a freight train might pass a block away every day at 6 am. You might feel like you're bothering the owners, but it's worth the extra effort when making such an important long-term investment.

After weeks, months, even years of searching, you've found the house you want. It meets all of your needs and a surprising amount of your wants for an affordable price. Now you are ready to begin the negotiation stage of home buying. It's time to make an offer.

But how much do you offer? Everyone wants to get a good deal, but how much lower than the asking price can you go? And when is it smart to offer more than the asking price? The starting point is your mortgage pre-approval letter. Remind yourself that there is a maximum amount you can afford to pay. The goal is to pay even less than this, giving you more breathing room in your budget.

The listing price is certainly a key indicator of value, but it's not the only one. A good place to start is by checking the sales price of homes that recently sold in the same neighborhood. Your real estate agent can provide you with a Comparative Market Analysis (CMA) or you can look it up on sites like Trulia.com by searching the "sold" listings. If the sales prices of similar homes are roughly the same as the listing price, then you know you're in the right ballpark. If they're radically higher, it could mean that the seller is hiding a flaw. Radically lower? The seller is inflating his price.

Talk to your real estate agent about short-term and long-term price trends. Is the area getting hotter or did the bubble recently burst? How long has the home been on the market and how does that compare to others in the area? You should also see how much you can find out about previous offers. Have there been any? Why were they rejected? A savvy buyer's agent might also be able to gather clues about the seller's motivation. Are they desperate to unload or are they holding out for the asking price?

In rare situations, such as an incredibly hot real estate market in a city like San Francisco or New York, it's necessary to offer more than the asking price. This is something you should discuss in detail with your real estate agent, who can best serve your interests in a potentially expensive bidding war.

Once you arrive on a price, it's time to draw up the details of the offer. More about that on the next page.

An offer letter reads like a legal contract. In some states, once the offer is accepted, the document automatically becomes the purchase contract. Your real estate agent will be experienced with drawing up the offer letter, but make sure you understand the details of the offer agreement before you sign on the line. You may be asked to offer earnest money, also known as hand money, along with the offer. (It's just enough of your down payment to let the lender know you're serious.) This is normal. However, if the seller accepts your offer and you decide to back out of the deal, you will forfeit that hand money.

Since the offer letter often doubles as a contract, it will include a long list of clauses and contingencies required of both the buyer and seller. Here are some examples of items that will be included your offer:

In most states, the seller is under no obligation to accept an offer, even if it matches the listing price. The seller doesn't even have to explain why an offer was rejected. In most cases, though, you should expect to receive an answer within a day or two. If the offer was too low, the seller will tell you. Then it's time for the age-old dance called negotiating.

Unless you live in an extremely depressed housing market, a seller rarely accepts an initial offer at face value. You can almost always expect some sort of counter to your offer and at least one round of negotiations. The obstacle may be strictly related to price or it may be the fact that you want the porch swing and washer and dryer included in the deal. Either way, prepare for some haggling.

It's extremely important that you stay true to your mortgage pre-approval letter throughout the negotiations. It is very easy to fall in love with a house, especially if you've been looking for a long time or feel pressured to leave your current place. Don't let your heart or your emotions prod you into making a potentially disastrous financial decision. Failure to make house payments can resort in foreclosure, bankruptcy or worse. If the seller doesn't accept your best possible offer, you have to walk away and wait for the next opportunity to come along.

With persistence and some luck, you and the seller will arrive at a fair price for the home. Depending on the real estate laws in your state, the offer letter itself might become the contract or you will need to draft and sign a separate document. If you haven't already deposited earnest money, you will do so now. Even if you sign the contract, you can still back out of the purchase, but you will lose that deposit.

Once the purchase contract is signed, both you and the seller will need to follow through on the contingencies of the contract, starting with the home inspection. More about that on the next page.

A professional and thorough home inspection is absolutely critical when buying a home. As the buyer, you pay for the inspection, which will cost between $200 and $500. But don't let the cost deter you. Without an inspection, you could be making the biggest investment of your life in a lemon. Even with a brand new house, there may be hidden problems that only a professional inspector can find.

Your real estate agent can recommend an experienced inspector. If not, look for someone who is certified by the American Society of Home Inspectors. If you are getting an FHA or VA loan, you will also have to have an additional inspection. (Don't let that one be the only inspection you get, however, because it may not be as thorough as a full-blown inspection.)

Your purchase offer should be contingent on the results of the professional inspection. This means that if the inspection turns up something like a really bad termite infestation or cracks in the foundation, you can back out of the contract, or you can have the seller repair the problem to your satisfaction.

Here are the major areas the inspector will cover:

The inspector will provide you with a printed report showing everything that passed and the (hopefully) few things that didn't. This report will be your ammunition if you need to renegotiate the purchase contract to include repairs. If the inspection report is clean, it's time to get ready for the big day: the closing.

With the inspection behind you, the next step is to lock in the terms of your mortgage. Most banks are willing to lock in an interest rate for 60 days. Another important step is for your real estate agent or real estate attorney to conduct a title search to ensure that no one else claims ownership of the title or holds any liens against it. Examples of liens are a second mortgage on the home or a tax lien from unpaid property taxes.

If everything is clear, then you are ready for the closing, one of the most significant days of your financial life. At the closing, you and the sellers -- along with your real estate agents -- will meet in a conference room to sign the largest stack of papers you've ever seen. When you leave, you will have a mortgage, a title, and the keys to your new home.

For a smooth closing, come prepared. First, you will need to gather the following documents:

The closing itself will be run by a closing agent, a neutral third party in the purchase. His or her job is to ensure that you understand each form you are signing, and there are many of them. Here are some of the most important for the buyer:

Expect to spend at least an hour or more at your closing. Make sure you have your lawyer present to double-check all your documents. If you have small children, get a babysitter. All of your attention needs to be focused on listening to the closing agent and double-checking the documents. Incredibly, after the last document and check is signed, the closing agent will hand you a set of keys to your new home. Congratulations! Now you can start worrying about the move.

For lots more information about mortgages, real estate agents and home buying tips, explore the links on the next page.