Even after the last few crazy years in the real estate market, home ownership continues to be part of the American Dream for millions of people. If you're ready to buy, make sure you understand the ins-and-outs of what is involved.

Pros & Cons of Home Ownership
For most Americans, a home is their largest purchase in life. House payments (mortgage, taxes and insurance) typically represent the biggest chunk of the monthly bill. But, those payments are also an investment that is, for many Americans, their largest asset or accumulation of wealth.

In addition to regular monthly payments, a home requires constant maintenance and upkeep. When things break, there's no superintendent to call. You fix it. The lawn needs to be cut and the leaves raked. The roof, the driveway, windows, faucets and a myriad of seemingly endless other things need to be replaced and repaired periodically. Bills for water, heat and electricity come every month.

That said, a house (or condo) offers something that no other investment can offer -- a home. After all, you can't live in stocks or bonds. Kids don't grow up in a bank account.

Before You Start
First of all, it's important to make sure you're honest with yourself about what you can afford. A few years ago it was easy for borrowers to get in over their heads. Today, any bank offering you a loan will be going over your household finances with a fine-toothed comb to make sure you can really afford to own a home. To prudently prepare, you need to get your ducks in a row. Here are some things to do.

1) Check your credit reports and know your credit score. (You're entitled to receive a free one annually from each of the nation's main credit reporting agencies.)

2) Familiarize yourself with all of the variables generally associated with financing a home, such as interest rate policies, terms, points, fees, etc.

3) Gather the necessary documentation including recent pay stubs, your last two federal income tax returns, and bank and brokerage statements (showing your assets).

Put Your Own Financial House in Order
Before you even start looking for a home, you need to know what you can afford. The easiest way to gauge your credit capacity is to visit your bank and ask a loan officer to prequalify you. Prequalification will tell you what the bank is willing to lend you and, therefore, how much house you can afford. Prequalification also makes you a more attractive buyer because sellers know any offer you make is serious.

note that prequalification is not the same as applying for a loan. Once you find the home you want to make an offer on, you'll need to complete a loan application for your lender. Today, the loan application process is no easy test. It will take time to gather all the documents (paystubs, tax returns, account statements) the bank will want to examine. Gone are the days of no-doc loans. Prepare accordingly.

Before you apply, it's also a good idea to review your credit report and your spouse/partner's credit report. Make sure all the information on the credit report is correct, and if not, contact the credit agencies immediately. If you have some dark spots, be ready to answer the questions your bank is sure to have. It can help if you can show you've taken steps to rectify any credit blemish.

Understand the Different Types of Mortgages
The amount of house you can afford depends heavily on your mortgage's term and interest rate.

Term -- Mortgage terms are usually 15 or 30 years. The longer the term, the lower your monthly payment will be, but you'll pay higher overall interest costs. Thirty-year loans often permit additional principal payments that can significantly lower the duration of the mortgage. For example, just one additional monthly payment per year will reduce a 30-year loan to 22 years.

Interest rate -- Interest rates are available in two varieties: fixed and variable. Variable rates or adjustable rate mortgages (ARMs) change over the course of the loan, generally offering lower rates in the first several years. As such, they can be best for buyers who plan to sell within a few years. Fixed rates remain the same over the life of the loan and offer stability and predictability, as payments are the same every month. As well, it can be advantageous to lock a fixed rate during times when interest rates are lower than historical norms.

The two types of fixed rate mortgages, 30- and 15-year, have certain differences.

  • 30-year mortgages provide for lower monthly payments because the loan is paid down over a longer period. Drawbacks include small principal pay downs in the early years as well as the risk that market rates will decline over the term. However, a mortgage can be refinanced at a lower rate in the future and there is usually no prepayment penalty.

  • 15-year mortgages carry lower interest rates, reduced total interest payments, and higher principal payments. However, the monthly payments are larger.

Variable rate mortgages are a different animal.

As the name implies, variable rate mortgages have rates that change or adjust. Adjustable-rate mortgages typically offer initial rates that are lower than fixed mortgages [not really that much lower these days...] but the rates go up and down with the interest rate market as the rates are tied to an index that can fluctuate. Thus, they are subject to potential rate increases.

Most ARMs have a cap on rate increases in any given year, as well as over the life of the loan. For example, current terms include rates that can adjust up to 2% in any one given year but no more than 6% over the life of the loan, or rates that can adjust up to 5% initially but no more than 2% in subsequent years.

It is imperative that you are confident that your future income will be sufficient if and when interest rates, and consequently your monthly payments, increase.

How Much Mortgage Can You Afford?
Most banks don't hold onto mortgages until maturity, as most mortgages get sold to Fannie Mae (the Federal National Mortgage Association) and repackaged into mortgage-backed-securities to be sold to investors around the world. This is relevant to you because Fannie Mae has standard requirements that need to be met in order for it to buy a mortgage.

The first requirement is that monthly mortgage principal and interest payments (P&I), plus insurance and property taxes, cannot exceed 28% of the buyer's gross monthly income. The second requirement limits total monthly debt payments (housing, credit cards, car payments, etc.) to 36% of gross monthly income. In addition to these requirements, you also should plan on making a down payment of 10% to 20% of the total purchase price.

[If you're ready to buy a home, use our Mortgage Calculator to see what your monthly principal and interest payment will be.]

Interest Rate Points
Interest rate points or discount points are fees paid to a lender at closing in order to lower your mortgage interest rate. The cost of each point is equal to one percent of the loan amount. For instance, for a $100,000 loan one discount point equals $1,000.

The economic sense of buying points depends on how long you intend keep the loan. In order to determine if points makes sense for you, you need to calculate the cost of the points versus how much they save off each monthly payment.

Break Even Example
$100,000 Loan - 30 Year Term

  • 7.5% Interest, no points = $699.21 monthly payment

  • Buying 1 point for $1,000 = monthly payment $690.68

  • Monthly Savings = $8.53

  • $1,000/$8.53, = 117 months

Your break-even point is 117 months in this case. That means it will take nearly ten years to recover the cost of one discount point. While buying points is sometimes a good decision, the purchase can also cost more than it saves.

Private Mortgage Insurance
Private mortgage insurance (PMI) is an insurance policy that insures the lender against loss in the event you can't pay your mortgage. It is usually required for when the down payment is less than 20% of the loan. Typical rates are about $55 per month for every $100,000 of mortgage amount.

Alternatives to Conventional Mortgages
If you cannot afford a conventional mortgage, there are a variety of alternatives.

Owner financing
This rare type of financing can occur when the seller agrees to be the lender instead of a bank or mortgage company. A buyer simply makes payments to the seller under terms agreed upon. This type of financing usually occurs when a seller is anxious to sell but the current mortgage conditions are too stringent to attract a buyer.

Federal Housing Administration (FHA)
FHA does not make loans but rather insures loans made by private lenders. The insurance encourages lenders to make loans to low income borrowers that typically wouldn't qualify for conventional mortgages. Key advantages of these loans are more relaxed qualifying guidelines and a smaller required down payment, as low as 3.5%. Almost anyone can get an FHA loan, but they only insure relatively small loans.

The Veterans Administration (VA)
These loans offer more generous terms and guidelines (including as little as 0% down payment) and are guaranteed by the U.S. Department of Veteran Affairs. These loans are available to American military veterans and their spouses.

Finally, there are local affordable housing advocates that offer low-cost, low down-payment loan alternatives. For further information, contact the FHA, VA, Fannie Mae, or your local mortgage lender or real estate broker.