Buying a home is one of the most important financial decisions most of us will ever make. Even beyond the upfront investment, ongoing expenses like mortgage payments and repairs can affect your lifestyle for years to come. There’s a lot to consider and the stakes are high, so it makes sense to be fully prepared. Here are three steps you can take to help ensure you’re financially ready for homeownership.
Step 1 – Make Sure Your Credit Score Is Healthy
Your credit score will have a major effect on your mortgage options. It can also affect how much you pay for things like auto loans, insurance and even cell phone plans. So what is a credit score? The short answer is that it’s a three-digit number based on your debt, payment history and lines of credit. You’ll need a score of at least 580 to qualify for a home loan, but you can unlock more options and a better interest rate if you’re above 620.
How to Get Your Credit Report
Everyone is entitled to a free credit report from each of the three major credit bureaus – Equifax, Experian and TransUnion – once per year. There are several sites where you can access your report. If you want to find out what a mortgage lender takes into consideration, get your free credit report here. You’ll also learn about what impacts your credit and how to remove any inaccuracies from your report.
How to Improve Your Credit Score
Making timely payments on your monthly bills is the best way to build your score. It’s also important to maintain a low credit utilization ratio, which is the measure of how much you owe on your cards compared to their spending limits. A good rule of thumb is to keep your ratio below 30 percent for each of your cards, since many credit scoring models will penalize you for going over. Check out our 5 Tips to Get Your Credit Mortgage-Ready for more on how you can bump up your credit score.
Step 2 – Take Control of Your Debt
In addition to checking your credit score, lenders will also look at your overall debt and income. It’ll be tougher to get a low interest rate if you’re scraping by to pay your monthly bills, since lenders prefer to see some financial breathing room when they give out a home loan. Here’s how you can get a clear view of your current financial situation, plus a few tips to quickly pay down your debt if you need to.
How to Calculate Your Debt-to-Income Ratio (DTI)
Your debt-to-income ratio is the percentage of your monthly income that you use to pay bills. Many lenders prefer a DTI of less than 43 percent when giving out loans, because it shows you're able to comfortably make your mortgage payments. You can figure out your DTI with two simple steps.
- Add up all your monthly bills, like credit cards, car payments and student loan payments. (Don’t include things like groceries, utilities or taxes.)
- Divide the total by your gross monthly income to see your DTI percentage.
Getting below 43 percent means you can qualify for a home loan and that you’re in good shape to handle unexpected expenses.
How Pay Down Debt Quickly
If your DTI is over 43 percent, it’s a good idea to pay down some debt (or bump up your income). Not only will you get a better interest rate on your mortgage, you’ll also be better suited to handle any necessary home repairs or emergencies that spring up. Here are a few tips to lower your debt fast.
- Lay off the credit cards. If you’re carrying a substantial balance on any of your credit cards, avoid adding to it. Look at all your spending habits and scale back as much as you can.
- Get lower interest rates. Getting lower rates on your cards may not be as difficult as you think. Start with your oldest card and call the customer service number on the back. Bring up your loyalty and what competitors are offering, then simply ask if they’re willing to work with you.
- Consider a balance transfer. If all else fails, shift some of your debt to a card with a lower rate (or at least a low introductory rate). Do some research to find the best transfer deals. After you make the switch, do your best to pay your balance in full and on time. Late payments can cause your lower rate to skyrocket.
Step 3 – Figure Out How Much House You Can Afford
Once your credit is healthy and your debt is under control, you’re in good shape to become a homeowner. But preparing to buy a home also means knowing exactly what you can comfortably afford. Before you start house hunting, you should know which homes are truly in your price range.
How to plan for upfront costs
A big part of knowing what you can afford involves knowing what costs you’ll have to pay upfront. Most home loans will require you to make a down payment that ranges from 3 to 20 percent of the home’s purchase price. In addition, you’ll typically be expected to cover most (or all) of the closing costs. These costs usually add up to 2 to 5 percent of the purchase price. The good news is that as a home buyer, you most likely will not have to pay a real estate agent commission. Those costs are usually handled by the seller.
With the costs you’ll need to cover in mind, evaluate how much you have saved up. It’s wise to have an emergency fund that will cover your expenses for at least three months, so subtract that amount from your total savings. Will you need to furnish your new home? Subtract those costs as well. The amount you have left will give you an idea of what you can reasonably spend on a down payment and closing costs.
How to calculate the home price you can afford
Once you know the funds you need for upfront costs, you can figure out the maximum home price you can afford. There are many additional factors at play – your annual income, your monthly debt, your credit score and the housing market you’re interested in. Fortunately, you don’t have to work through the math on your own. All you need to do is enter the information into a home affordability calculator to get an estimate on home prices that are within reach.
Begin Your Home Buying Journey with Confidence
Few experiences are more rewarding than buying a house you and your family will be happy in. But to enjoy your new home now and in the future, it’s important to spend responsibly and plan carefully before you commit to a purchase. When you’re figuring out how to buy a house, take steps to make sure you’re financially secure now and you’ll enjoy the benefits for years to come.