Real Estate 101 – Purchase and Finance

It’s time to cover the nuts and bolts of real estate, the purchase and finance.  I could write a whole book on this subject.  But, I suspect most readers would get bored after a couple of thousand words.  So, here is the summary version of the important things everyone should know before they purchase a house.

This is the third in a series of four posts on real estate.

Real Estate 101 – Renting vs. Owning
Real Estate 101 – Market Dynamics
Real Estate 101 – Purchase and Finance
Real Estate 101 – Investment Property

Disclaimer: I’m not a licensed broker or a real estate professional and laws change and vary by state.  Before making any decision about buying a house, you should be aware of the laws or consult with a licensed professional.

Real Estate Agents

Real Estate Agent
Image by Mark Knobil

The first decision is whether you should engage an agent or go it alone.  For most first time home buyers, the safe and practical route is to find a buyer’s agent.  This will ensure the paperwork is completed correctly and you don’t get taken advantage of by the seller or the seller’s agent.  And, a good agent will be very helpful in locating and showing suitable properties.  If the seller has a listing agent, a commission will have to be paid either way.  So, there are no potential savings from doing it yourself.

I purchased my house without using an agent in what is called a FSBO (fiz·bow), meaning For Sale By Owner.  There were two important benefits to buying the house directly from the owner.  First, I had a lot more control of the process and was able to negotiate directly with the owner.  Second, I definitely got a better deal on the house, because the seller didn’t have to pay the agent’s commissions.  An agent will tell you the seller pays the agent’s commissions.  But, the reality is that these costs are usually figured into the selling price of the house, which is paid for by the buyer.

The paperwork in California to sell a house is pretty straight-forward and the forms can be found everywhere.  But, it’s definitely not something you would want to mess up.  There is a lot of money at stake and you could wind up in a nasty lawsuit.  I took the California Real Estate course in college, which gave me the confidence to do it on my own.  And, the owner of the property was very honest and straight-forward.  So, the sale went well and we were both happy with the deal.

Getting a Mortgage

In my experience, getting the home loan is the riskiest part of the deal for the home buyer.  There’s no easy way to sugar coat this so I’m just going to come right out and say it, the mortgage business is pretty slimy.  I’ve known a lot of people in the business, going all the way back to the ’80s, including one who went to jail for fraud.  Mortgage brokers often receive incentives from banks to fund borrowers with the worst loans, in order to make the highest possible commissions.  This is called Yield Spread Premium and I believe it is finally illegal.  The YSP is the reason so many people were stuck with subprime loans, even though they should have qualified for Alt-A or A loans.

Here is how the game works.  First, the mortgage broker shows you some incredibly low interest rates and says you are pre-qualified for one of these loans.  Because the interest rate is so low, you will qualify for a surprisingly high loan amount.  This makes the seller happy, because you can afford to pay a lot for the house.  It makes the real estate agents and mortgage broker happy, because their commissions go up.  But, when you study the details of the loan, you discover the interest rate will shoot up over the next couple of years and so will your payments.  If you point this out to the mortgage broker he or she will say, “don’t worry about it, we have some great first-time home buyer programs you qualify for.”  Then, it will take forever to get funded.  As your closing date approaches, the delay will be blamed on the processor, the underwriter or some other circumstance.  Finally, at the last minute, you will be told that you don’t qualify for the first-time home buyer’s loan and you will be presented with a subprime, 40 year or balloon loan.

I had this experience with a mortgage broker, which caused me to walk away from my first house and lose my escrow deposit.  So, when I found our current house,  I marched right into Home Savings and got my own loan, directly from the bank.  The bank’s broker was very honest with what I could or couldn’t do.  And, she was very clear and helpful in explaining my debt ratios and how much I was qualified to borrow.  Although I didn’t qualify for the fixed loan I really wanted, I did get a great indexed ARM that I still have today.

The Purchase Offer

First, I don’t recommend shopping for houses until you are prequalified for a loan.  The only thing worse than falling in love with a house you can’t afford is making an offer on a house and finding out you can’t get funded.  I recommend finding a house you can easily afford and offer less than you are qualified for.  That way, you have some wiggle room if the seller counter offers or something changes in your credit profile.

When you make an offer in California, you will fill out a Residential Purchase Agreement and attach a check as a good faith deposit.  If the seller accepts your offer, your deposit is placed in an escrow account.  If the seller rejects your offer or accepts another buyer’s offer, they will return your deposit and you can start looking for another house.  Often, the seller will reply with a counter-offer, asking for a higher amount.  The important thing to understand about a counter-offer is that it constitutes a rejection of the original offer.  So, you can accept the counter-offer, counter back or ask for your deposit back.

If a seller takes a long time to respond to your offer or they come back with multiple counters, they are likely trying to draw you into a bidding war with other buyers.  The important thing to understand about this is you need to put an expiration date on your offer, preferably for two days or less.  This lets the seller know you won’t be held hostage in the negotiation.  And, it frees up your deposit, in case you find another house that you like better.  Your agent will often encourage you to increase your offer up to the full amount you are qualified for.  This may save the sale and increase their commission.  The danger in doing this is that you may offer more than the house will appraise for.  If that happens, you may have to come up with a larger down-payment.  I would avoid high counter-offers and bidding wars, because they work in everyone’s favor but yours.

Escrow Account

One of the most confusing aspects of buying a home is the escrow and closing process.  This is where you officially lose control of your money and everyone starts telling you what to do.  If you understand the process, it’s not so bad.  If you don’t understand, it can become pretty frustrating.  When I took the real estate course in college, many of the students had already purchased a home and they were taking the class to figure out what happened.  Here is a simple breakdown of what happens and why.

The escrow account is created to hold and disperse all of the money in a real estate transaction.  Incoming sources of money are the buyer’s good faith deposit, down payment and funding from the bank loan.  Outgoing money goes to the seller, agents, brokers, appraiser, pest inspector, taxes, escrow fees, closing costs and to pay off any existing mortgages.  The escrow officer’s duty is to make sure that the proper amount of money is collected and disbursed and the property title is legally transferred, before the deal can close.  This ensures everyone gets paid and no one gets cheated.

Title Search & Insurance

The title of a property assigns and records ownership.  The title search is the process of looking through the county records to make sure the title is clear.  This means that it doesn’t have any outstanding loans, taxes, liens, easements or legal actions that weren’t identified by the seller.  It also ensures the seller has the rights to the title and can legally sell the property.  This way, no one can try to sell you the Brooklyn Bridge.

The Title Insurance is a policy that covers anything that may have been overlooked in the title search.  If you buy the house and find out there is a mechanic’s lien on the property for some construction that wasn’t paid for, the title insurance company has to pay off the lien.  The lender will require title insurance to cover their investment.  So, there are usually two title policies, one to cover the buyer and one to cover the lender.

Closing Costs

The buyer’s closing costs are usually around 3-5% of the price of the house.  The seller’s costs can be much higher, because they also include the real estate broker’s commission.  You will receive a good faith estimate that will list the closing costs, so you will know about how much you have to pay.

At the closing, you will need to bring a certified check for the down payment and closing costs, minus your deposit.  The important thing to remember is that closing costs are negotiable and a motivated seller may be willing to pay some of your costs.  But, they may expect a higher price for the house.  If you are short on money for closing costs, this may help.

Buyer’s Closing Costs

  • Loan Origination Fees (points)
  • Loan Application Fee
  • Home Appraisal
  • Credit Report
  • PMI – Private Mortgage Insurance (if less than 20% down)
  • Escrow Fees (1/2 each)
  • Title Insurance (buyer, seller or 1/2 each)
  • Prepaid Interest & Insurance
  • Home Inspection  (Optional, but recommended)

Seller’s Closing Costs

  • Real Estate Broker’s Fees
  • Title Insurance (buyer, seller or 1/2 each)
  • Recording Fee
  • Transfer Taxes
  • Escrow Fees (1/2 each)
  • Prorated Property Taxes
  • Pest Control Inspection & Remediation
  • Home Owner’s Association Transfer Fees
  • Home Warranty Plan  (Optional, but recommended)

Note: Closing costs and who is responsible for paying them vary.  Not only are these costs different in every state, they often vary by county.

Creative Transactions

There are many kinds of creative property transactions, including short-sales, wrap-around, seller financing and property auctions.  I generally don’t recommend these types of creative transactions to novice buyers, unless you are assisted by a professional.  Many of the properties selling right now are foreclosures and short-sales.  And, a buyer can definitely get a good deal.  But, they can also get tied up into a mess, since many of the recent foreclosures may have been processed illegally.  My advice is buyer beware.

The Bottom Line

The bottom line is that buying a home is a complex and perilous journey.  The difference between getting a good deal and getting taken to the cleaners is in knowing how the process works, before you start looking.

“Don’t stretch yourself too much with a mortgage. Buy within your means.. it’s not worth the sleepless nights.”

Sarah Beeny – Host of the TV Show Property Ladder

Recommended Reading

DINKS Finance – It’s Time to Buy a House
Don’t Quit your Day Job – The Housing Double Dip
The Greater Fool – It’s Different

This post was featured on the Carnival of Personal Finance over at My Personal Finance Journey.  This is the Greatest Blog Carnival on the Net.  Check it out.

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13 comments to Real Estate 101 – Purchase and Finance

  • Hi Bret, this is a very informative article on the pitfalls of buying a house. I had a bad experience where the seller’s agent was in cahoots with the sellers, and knew they had no intent on moving out at closing. It turns out they had an IRS lien on the house so they couldn’t get a mortgage for a new place. They needed our money to clear the lien. We eventually forced them out by threatening to have the sheriff evict them for squatting.
    Jennifer Barry recently posted..From Gunslinger to MonkMy Profile

    • Agents can be a major problem and that’s why I was happy to buy my house FSBO. I refrained from any negative comments about agents, because I believe the majority are honest, hard-working professionals. But, there are also some agents who engage in questionable practices. In the end, I believe the very nature of agency is to be driven by financial incentive. And, this isn’t always what’s best for the buyer or seller.

  • Nicely written, I’ll be watching out for the follow-ups. That is one sad phrase: “Because the interest rate is so low, you will qualify for a surprisingly high loan amount. This makes the seller happy, because you can afford to pay a lot for the house” That a buyer should be happy at the circumstances of sinking ever deeper in debt…
    101 Centavos recently posted..Be a Sprout HeadMy Profile

    • Thanks Centavos.

      It’s funny how debt is now presented as an advantage, by the people who benefit from it. What is sad to me is that consumers are falling for it.

      When I bought my house, my number one goal was to get the selling price as low as possible. I knew the points, interest, escrow and title are all based on the price. More important, the property taxes are based on the selling price and that lasts forever.

  • When we were buying our first home, I remember the real estate agent was saying it was seller market. When we were selling it, she kept saying it was buyers market. I never trust them with their logic.
    Doable Finance recently posted..Market Moves Affect Your Personal FinancesMy Profile

    • I guess it depends on who they are getting paid by. 🙂

      Seriously, like I hinted at in my post comments, agents represent themselves first and clients second. And, I’m not just talking about real estate agents. That’s the nature of agency. I know a lot of RE agents who crawl over broken glass for their clients. Then again, I have met some real commission mongers. It’s important for everyone to know what’s going on, so they can protect their own interests.

  • If you don’t want to buy a house unrepresented but you also don’t want to pay full commission to a realtor, consider going to a “discount” realtor, who will refund half the commission back to you. Do an internet search for “discount realtor” + the name of your city.
    Paula @ recently posted..Reject the “Everyone has Debt” MentalityMy Profile

    • That’s great advice Paula. There are a number of outfits that assist buyers and sellers at a discount. Help-U-Sell is one that comes to mind.

      I suspect there will be a two-tier real estate market at some point in the future. There will be the traditional full service agents and brokers. Then, there will be the discount or online version. We have already seen this happen with travel agencies and stock brokers. Also, there are services like Legal Zoom that could be adapted to this market.

  • Jess Hall

    Thank you so much for sharing this informational article. You are right, home buying is definitely a journey, but once you get there it’s worth all the steps. I recently bought my first place and was lucky enough to find a trustworthy real estate agent that helped me get my dream home. She also recommended to do a mortgage rate comparison and explained all the terms and conditions of my fixed rate mortgage. I wish I could’ve read this article a few months ago 😉 – Thanks again, highly recommend this read to first time home buyers – Jess

    • You are welcome Jess. Home ownership is a feeling that can’t be explained. It’s unfortunate that it can be so difficult to get there.

  • Working in real estate I find these pieces of advice very interesting and I can provide a few tips of my own for those who decide to sell their property.

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