Tips for first time home buyers

A personal goal of mine is passive income that supports a digital, nomadic lifestyle. This is one reason why I decided to own and rent properties. This post is for people looking to either earn income from their first home, or turn it into a free place to live. I own one duplex that is cash flow positive and my personal home has an Airbnb rental in the basement, which pays off the majority of my personal mortgage. This allows me travel for 6 months out of the year, without worrying that I am paying a mortgage on a home I am not currently living in. 

Before we jump in, let’s align on some definitions:

  • Conventional loan: 20% down payment, average closing costs, lower monthly payments, lower interest rates than an FHA loan
  • FHA loan: Federal Housing Administration loan, which allows for a 3.5% down paymnet and reduced closing costs. More detail here.
  • Debt-to-income ratio: In order to be approved for a loan, you need to show that your income can pay your debt, which is your new mortgage. To be exact, no more than 28% of your income should be going toward your mortgage and your debt-to-income ration needs to be lower than 36% in order to secure a loan. (I was unemployed when I bought my last home, and it was very tricky.)
  • Closing costs: A cost of 3-5% (of your total home cost) paid to the lender which includes appraisal fees, taxes, your first mortgage payment, insurance, taxes, etc. Please be sure to compare closing costs to ensure there are no hidden fees.
  • Contingency: A clause in a purchase agreement specifying a requirement
  • Escalation clause: When there are competing offers, this is a tool you can use to increase your purchase price by x, up to x. (For example, my last home was listed at $500,000. I put in an offer for $500,000 with an escalation clause up to $600,000 in increments of $5,000. I won the home for $535,000.)
  • Appraisal: Lenders want to protect their investments, so a home value appraisal is ordered during the closing process
  • Limited Liability Company (LLC): A business structure that allows members to protect their personal assets (from the plaintiff or creditors) if the business were to be sued. LLC’s can be taxed as a sole proprietorship or S-Corp. If taxed as a sole proprietorship, the profits are ‘passed through’ from the business to the members, reported as profit on their personal tax return. LLC’s are regulated on the state level.
  • Sole proprietorship: An unincorporated business, owned by one person, paying personal income tax from business profit.
  • S-Corporation: A tax election, also known as an ‘s chapter,’ alerting the IRS that your business should be taxed as a partnership, avoiding corporate double taxation. S-Corps are regulated on the federal level. More details here.
  • DADU: A Detached Additional Dwelling Unit — usually less than 1,000 square feet
  • ADU: An attached dwelling, like a mother-in-law suite or apartment

What to prepare

In order to buy a home, it’s most important to ensure that you have: 1) enough savings for a 20% down payment, 2) a credit score of 750 or higher, and 3) a debt-to-income ratio lower than 36%. 

Down Payment
There are a variety of loans available from conventional to FHA. Conventional loans require a 20% down payment and closing costs which usually equate to 3-6% of the total home cost. An FHA loan requires 3.5% down and smaller closing costs, however, there are more criteria to meet and you will likely have a higher interest rate and mortgage. I have not applied for an FHA loan, but I do think it’s worth investigating if you do not have a 20% down payment. Do not forget to factor in homeowner’s insurance, taxes, and utilities into your monthly costs. 

Credit score 
If your credit score is below 750, then this means a variety of things: ranging from an unpaid  Verizon bill to an unpaid credit card bill. Find out why your credit is low, and fix it before putting an offer on a home; the higher your credit score, the lower the interest rate, and the less you will need to pay for your loan over time. 

When I first pulled my credit in 2020, I was below 600: Verizon had sent a bill to collections which was never sent to me. For over three weeks, I messaged and called Verizon. The agents understood that I didn’t know the bill existed, but they insisted that I needed to pay the collector, which wouldn’t remedy the false charge. After making no progress, I submitted a claim to the Better Business Bureau: within 1 day, they had sent a letter to Verizon asking someone to investigate. Lo and behold, Verizon owed me $12 dollars. Verizon pulled the charge from collections, my credit was recalibrated, and I hit 750 overnight. 

I am a firm believer that the credit system is not an accurate benchmark to determine someone’s loan risk, however don’t give up if you’ve been wrongly billed, or treated. Resilience is key. 

Debt-to-income ratio
Once you have your  down payment and credit score handled, you can determine your debt-to-income ratio from working with a loan agent. Based on this ratio, they will determine your max loan amount and purchase price for your new home. Each loan agent will give you differing answers based on what they are able to do for you, which is why having 3 quotes is important.

Steps for purchasing your first home

Decide what you want your home to achieve for you
First and foremost, I purchase homes that were built between 1925-1955, because they generally have wood floors and quality materials used throughout. However, they also have old electric and plumbing, which can be expensive to repair or replace.

  • Ensure copper wires are used throughout the house and outlets are grounded. If they aren’t, it’s possible to update the wires and ground the outlets. This can cost between $2,000 and $20,000.
  • Per plumbing, many pipes are cast iron, which corrode easily, which is expensive to replace (and can ruin your lawn.) Also ensure there aren’t any ruptures or tree roots. Be sure to get a sewer scope during your inspection to see if any of the pipes need to be replaced. If they do, that’s OK, just factor this into your decision making process.
  • I look for property that allows me to add a (legally permitted) second structure down the line, called a DADU. In order to do this, the lot size needs to meet criteria set by the city. If you want to increase your cash flow, be sure to have a contact at your local city permitting office who you can reach out to with questions during your home search. 

Find a lender
I like to have 3 lenders approve me for a loan ahead of time, so when I close I can secure the best possible rate. I use one big bank approval, 1 local lender that I have found myself, and 1 local lender that my realtor suggests. If the market is competitive, sometimes you will need to offer the buyer an accelerated closing time frame, which in general, only local lenders can provide. Some people prefer not to use big banks due to lower speeds, however, I have closed with a big bank and it worked just fine, on a normal timeframe (about 3 weeks.)

Find a realtor
A good realtor is key for negotiating good price and terms, but it’s also important to work with someone who knows the market, understands your goals, and is an expert in dissecting a home’s quality. Each future homeowner has different goals going into the purchase: yours should be cash flow, or a free to place to live.

This process is not easy, and the first time is the most difficult because we have so many things to learn as a first time home buyer, especially in a volatile market. With that said, I am happy with my home purchases, the cash flow they provide, and the peace of mind knowing that my homes are accruing value each year while paying for themselves. 

Taxes

Once you have purchased a home, you can write off costs related to renovations and updates including new appiances, closing costs, or even a work truck. I created an LLC for my duplex, which not only protects me from bankruptcy if I am sued, but also allows my accountant to split my income into active versus passive – saving me significant money year-over-year.

Active income tax is paid toward social security and medicare – the more we pay now into the system, the more we get when we retire. (I have chosen to pay less into the system, and more into my own personal retirement accounts, because I prefer to rely on stock market gains. If this is something you see in yourself, then I recommend maxing out your ROTH IRA each year.)

What is the difference between as LLC and S-Corporation?
An LLC can be an S-Corp, depending on how you choose to be taxed as a business owner. An LLC is state law, where an S-Corp is federal law.

Sole proprietorship
If you are earning $100,000 per year as a sole proprietor (all earnings being active income) you will pay $15,300 in social security and medicare taxes. ($100,000 x 15.3% = $15,300.)

LLC & S-Corp
If you are filing as an S-Corporation, you are able to split income into active versus passive. If you are earning $100,000 per year, you can receive $50,000 as active and $50,000 as passive, which means you are only paying social security and medicare on the $50,000 in active income ($100,000 x 15.3% = $7,650.) This saves you $7,600 per year. Filing for an S-Corp can save you significant money, but you must be more mindful of saving for retirement.

Tips:

  • Work with an accountant on your taxes to help ensure you are getting your maximum tax benefit. They can advise if you should open an LLC and file taxes as an S-Corp
  • Have an entirely separate credit card specific to home purchases – when it’s time to gather all inputs for your taxes, it’s easy to show exactly how much you have spent on updating your home. (Still keep the itemized receipts to show specific details if audited.)
  • As you gather documentation for closing, create a separate folder on your computer with details related to taxes, such as closing costs, mortgage statements, tax statements, etc. Then, filing annual taxes will be a breeze.

Disclaimer: I am not a financial advisor. The advice I share in this article is specific to my success, and not for everyone.