Opportunities Knock for First-Time Home Buyers

EDITOR'S NOTE: This article is from Kiplinger's Success With Your Money special issue. Order your copy today.

Richard Khoe used to wonder how he could ever afford to buy a home of his own. Coming up with a down payment in the ever-escalating Washington, D.C., market seemed like a pipe dream.

But last February, after years of living in a studio apartment, the 36-year-old public-policy researcher finally saved enough to buy a three-bedroom rowhouse in D.C.'s gentrifying Columbia Heights neighborhood. He had 5% of the purchase price, and his parents kicked in an equal amount so he could make a 10% down payment.

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Timing was key for Khoe. The seller had reduced the price from $560,000 to $460,000 as the market dipped. And because the owner hadn't updated the appliances -- or the flowered wallpaper in the bathroom -- she accepted an offer of $426,000, with a $5,000 credit for repairs. "Everything was old, but it was in good condition," says Khoe. "So I didn't have to spend more money right away to make the place livable."

The new deal

The housing boom made it easier for all buyers to qualify for a mortgage. In fact, over the past five years, four in ten buyers were first-timers, with a median age of 32. But now there are fewer sources of credit, so lenders are tightening up.

For example, borrowers applying for an adjustable-rate mortgage will have to qualify for the fully indexed interest rate, not the initial teaser rate. And 100% financing deals are drying up. "The whole market is in a panic right now," says Jim McMillan, a senior loan officer with JP Mortgage/JPMorgan Chase. Until the subprime mess gets sorted out, he says, larger institutions are staying away from any loan except 30-year fixed-rate mortgages with 20% down.

First-timers with credit dings are among the hardest hit. One alternative for them is a program that fell into disuse in the easy-credit days: the Federal Housing Administration loan. You apply for the loan at a private lender, but the FHA insures the loan against default. You generally pay a 3% down payment—money that can come from a gift—plus mortgage insurance premiums. Veterans who want to put zero down can turn to VA loans. (For more information about getting a mortgage, see How to Shop for a Mortgage Today, or find a housing counselor at www.hud.gov.)

Buy versus rent

Before you consider how to find money to let you put the key in the lock, think about whether buying is the right move. Are you ready for the responsibility and the extra expenses -- homeowners insurance, property taxes and maintenance, to name a few? (See the True Cost of Owning a Home for more information.)

And there are two other questions to which you should be able to answer yes. First: Can you stay put for the next five years? You'll need about that long to recoup your initial costs, says Ilona Bray, co-author of Nolo's Essential Guide to Buying Your First Home (Nolo Press, $25). Use our tool to crunch the numbers to see if it makes sense financially to buy. Second: Do you know where you want to live? Liking the look of a neighborhood or a condo development is different from experiencing it day in and day out. If you're unsure, give it a trial run by renting.

Find the cash cow

Even if you don't need money for a down payment, you'll still have to ante up for closing costs -- figure on 2% to 4% of the purchase price. You'll also need cash for the earnest-money deposit to show the sellers you're serious about your offer. The deposit, typically 10% of the offering price, is applied to the purchase.

One source of cash could be your Roth IRA, from which you can withdraw the amount of your contributions -- tax- and penalty-free -- at any time. In addition, after the account has been open for five years, you can withdraw $10,000 in earnings to use toward the purchase of a first home. You can also take as much as $10,000 out of a traditional IRA penalty-free for the purchase of your first house. But in that case you'll have to pay taxes on the money. Another option is to ask the seller to pay your closing costs and roll that amount into the cost of the home.

If you can tap generous family members or friends, you might be able to score a gift to help cover closing costs or some of the down payment. Each of your parents can give you up to $12,000 before gift taxes come into play -- and if you're buying with a spouse, they can double the gift. Lenders usually ask for a letter stating where the funds came from and confirming that the money is not a loan, says Ilyce Glink, author of 10 Steps to Home Ownership (Three Rivers Press, $15).

Another way to structure help from your family is to get a loan through CircleLending, an Internet loan-administration company that specializes in private loans. For an upfront fee of $200 to $600, depending on the amount and terms of your loan, CircleLending does all the paperwork to set the loan in motion. Large loans and those paid back over more than one year generally carry an annual service charge of about $100. Your payments are reported to a credit agency and are automatically debited from your account and deposited into the lender's account.

Order your copy of Kiplinger's special issue Success With Your Money. It will tell you how to make the most of your money -- and make a seamless transition to the next phase of your life.