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Buying your own home? Read this first

It seems nothing can stop Americans from wanting to buy their own homes. It's almost as if the credit crisis didn't happen, even though not too long ago we were bombarded daily with stories about crashing prices, underwater mortgages and home foreclosures. It was an American nightmare, not the American Dream.

Image source: Dagmar Heymans | E+ | Getty Images

But if you think about the emotional and economic reasons people want to buy instead of rent, it's not so hard to understand. As a financial advisor, I meet many potential first-time homebuyers who cite these reasons for wanting to buy:

—"Why should I pay a landlord when I can put the money toward building equity in something myself?"
—"Paying rent is like throwing money away."
—"I don't trust the stock market. I'd rather put money in real estate."
—"Renting feels like a temporary situation. I want to put down roots and nest."
—"I want to be able to remodel my home in any way I want, with no restrictions from landlords."

What I usually do at this point in the conversation is a back-of-the-envelope analysis of what it would look like for my client to buy a home. The key components of the analysis involve money saved and money earned.

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Comprehend your costs
How much is saved for the down payment, closing costs and cash reserves? The best scenario involves putting 20 percent down. With 20 percent down, the borrower can receive gifts of up to 100 percent of the down payment with no private mortgage insurance (PMI). PMI can add several hundred dollars to the monthly payment.

However, many first-time homebuyers are cash-constrained. Some may qualify for a Federal Housing Administration (FHA) loan, which requires only 3.5 percent down. Many end up putting 10 percent down, which requires PMI and only 5 percent of the down payment can be a gift.

Closing costs are approximately 2 percent of the purchase price and include title insurance, escrow fees and appraisal fees. There may be a local transfer tax due on the purchase—and that can be substantial.

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Lenders require two to 12 months' worth of cash reserves, which will cover mortgage, property tax, insurance and other debt payments. The cash reserves can be in retirement accounts, but lenders only count 65 percent of retirement accounts, unless you're over age 59½.

For example, Mary wants to buy a home in the $400,000 range. She makes $90,000 a year. She will put 10 percent down. Her lender requires a five-month cash reserve. Closing costs will be 2 percent of the price. There will be a $15-per-thousand city transfer tax due that Mary will split with the seller. She has $500 a month in other debt payments. (The chart below breaks down all these expenses.)

Mary's new home—counting the costs

Home price: $400,000
Down payment: $40,000
Loan: $360,000
Closing costs (2% of mortgage): $7,200
Transfer tax ($15 per $1,000 divided by 2): $3,000
PITI (Principal, Interest, Taxes, Insurance):
Payment @ 5% interest: $1,932.56/month
Private mortgage insurance: $150/month
Property tax (1.25% of purchase price):* $416.67/month
Homeowners insurance (0.35% on loan amount): $105/month
Other debt payments (credit card, auto): $500/month
Required cash reserves (5 months' PITI and debt): $15,521.15
*Lender qualifying rate
Source: Cathy Curtis, Curtis Financial Planning

Mary would need $65,721 saved to buy this home. Plus, she might need to pay various moving costs. I usually add $5,000 to the analysis so that these costs are accounted for.

Get prequalified
Does the client earn enough money to qualify to buy the home? Rule of thumb: Lenders require that housing costs (PITI) plus all other monthly debt payments be no more than 43 percent of gross income. In Mary's case, she would need to earn $86,630 a year to qualify for the $360,000 loan at 5 percent.

If this analysis looks positive, I will recommend that my client visit a lender and get prequalified for a loan. This will involve running a credit report. With a credit score of 700 or above, there should be no issues. Below that, a good mortgage professional will advise clients on how to improve their scores.

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Lastly, a good real estate agent and a good dose of patience will make the experience a lot easier. That dream home may be right around the corner, after all.

—By Cathy Curtis, Special to CNBC.com. Cathy Curtis is an independent certified financial planner and founder and owner of fee-only investment advisory firm Curtis Financial Planning, based in Oakland, Calif.

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