Buying a home is a massive commitment—after all, it will take you at least a few years to clear off your mortgage. There are many things you’d want to consider before starting the house-hunting process.
Some experts recommend putting your finances in order beforehand. Others advocate having an appropriate amount of down payment. Yet, it’s not always about the money. You’d want to purchase a home that suits your current lifestyle, among other things.
We took the liberty to draft some essential requirements to help you assess your readiness to buy a home.
You have a good credit score
If you have a good track record of managing your debts—that is, a good credit score—you’ll most likely qualify for a mortgage. A good credit score increases your appeal to lenders, as you seem less risky. And this qualifies you for reasonable interest rates. But what is a good score? According to FICO, a fairly good score is around 700. However, a higher score of 740 or higher is usually considered perfect. Note: taking out a mortgage may be impossible if you lack a credit history — occasionally referred to as a thin file. So, consider acquiring a low-limit credit card or a secured loan to start building your credit history.
Perhaps your score falls below the latter threshold. Here’s what you should do to increase it:
Pay down your credit card debt
If it’s possible, pay more than the monthly minimum. Reducing your revolving debt can help you improve your credit score. You can make additional payments throughout the month to keep yours as low as possible. Remember this: paying down a portion of your debt helps, but paying off the entire sum has the most impact on your credit score. So, if you can, clear all your debts at once, then take other ones to continue building your history.
Expand your credit limit
You can either seek a credit limit increase on your present card or open a second one. Nevertheless, do your homework before applying for a new one. Your credit score takes into account how often you open new accounts. Each application requires the card issuer or lender to obtain your credit record, resulting in a hard inquiry and a few points deducted. Alternatively, you can increase your limit and use your present card frequently to improve your score.
Check for mistakes on your credit report
Examining your credit history for inaccuracies might help you improve your credit score rapidly. It is important to note that about 25% of Americans have a mistake on their credit reports, so it’s worth checking. Fraudulent or duplicate accounts, along with misreported payments, are some of the most common problems.
Have paid-off bad entries erased from your credit record
Your credit record may indicate a string of late payments or an old collection file that you subsequently paid off. If so, request to have them removed (If you have an outstanding collection account, take this seriously. Late payments can harm your score). And so, be sure to contact the debt collector, debt buyer, or original creditor to erase a paid-off account from your credit report.
You have Zero debt
Apart from your credit score, most lenders will consider your debt-to-income ratio. Most of them want to see whether you can manage your current debts apart from the mortgage payment, making your debt-to-income ratio very critical. Historically, the rule has been that your total monthly debt obligations, including your mortgage payment, should not exceed 36% of your monthly gross income. However, this has changed. According to the Consumer Financial Protection Bureau, a qualified mortgage requires a DTI ratio of no more than 43%. And so, before applying for a mortgage, get your current debt under control.
You can start by cross-checking the following:
Credit card debts. Reduce your credit card debts to less than 30% of available credit. Maxed-out cards may indicate that you are not managing your available credit responsibly, lowering your credit score.
Installment loans. If you want to reduce your monthly obligations, it’s best to consider repaying or substantially reimbursing any installment loans (for example, car loans).
Student loans. Consider how your monthly student loan payments will affect your capacity to pay a mortgage—that is, if you’re still in debt. Paying off these debts may provide you with additional budget flexibility to pay off your mortgage loan.
You have enough cash for a down payment
You may well have heard that a down payment of 20% of the buying price is required to acquire a property. But don’t worry, some experts claim that this requirement on a property is a “modern-day illusion.” According to Rocket Mortgage, some lenders will take down payments as little as 3%. Nevertheless, most of them prefer 6%. However, while 3% or 6% sound small, it can be intimidating for prospective homeowners—especially when it translates to thousands of dollars.
It is worth noting that borrowers who make a down payment of less than 20% are usually obliged to pay private mortgage insurance (PMI). A PMI helps safeguard the lender from financial loss if you default paying. It is often included in your monthly payment and ranges from 0.5 percent to 2% of the loan amount (Once you have paid down enough of the loan to achieve 20% equity, your lenders should cancel the PMI.) It can add up to $70 to your monthly payments for every $100,000.
Indeed, paying as much money down as possible upfront can save you on interest during the loan’s term. For instance, suppose you wish to acquire a $200,000 home. You have an excellent credit score and qualify for a 3% interest rate on a 30-year fixed-rate mortgage. If you make a 20% down payment on the home, you will pay approximately $82,844 in interest over the loan’s term. If you paid only 6% down, your cumulative interest charges would be $97,342 — a difference of nearly $14,000. A larger down payment may also imply a lower initial interest rate.
You have an emergency fund and some savings
An emergency fund can help you weather a period of unemployment or pay the cost of unanticipated bills. Most experts recommend having sufficient cash in a savings account to last three to six months. An important thing to remember is that you might be forced to maintain or repair your new property in most instances, especially if you’ve purchased an older home that requires more innovations and modifications. If you lack the restoration or remodeling funds, you may further exacerbate your financial situation. According to HomeAdvisor, homeowners spent a total of $3,192 on upkeep and another $1,640 on repair work last year. This means that you have to have at least $5,000 reserved in your emergency fund.
While freshly constructed homes may not require immediate repairs, setting aside money for future maintenance is a prudent move. According to home experts, a decent general rule to follow when planning for home repairs is to set aside between 1% and 3% of the home’s value, with a larger ratio set aside for older homes.
Another critical factor to consider is your ability to save. Even with a fully-funded emergency fund, you should be able to save every month. So, if you cannot spare more than the monthly mortgage, consider deferring homeownership until your financial flow becomes more reliable.
You’ve done a thorough research
Understanding how much mortgage you can afford entails knowing the size of your monthly payments and the number of closing costs, general liability, and taxes. So, always compare your current housing prices to a new home mortgage, whether you’re a homeowner looking to upgrade or a renter looking to purchase your first home. A mortgage calculator is an excellent tool for determining how much property you can afford. By entering information such as down payments and interest rates, you can determine how your monthly premiums change. As a result, you’ll have a better understanding of how much you’re willing to pay. When determining affordability, most financial experts recommend using the 28/36 rule. This implies that you should spend no more than 28% of your monthly gross income on house payments and 36% on total debt.
Along with being confident with your financial capacity to pay a mortgage, you should consider how a home aligns with your lifestyle. For instance, do you enjoy dining out on weekends? Do you take annual vacations? Will the financial burden enable you to continue participating in the activities that make life enjoyable? Is purchasing a home compatible with your plans, such as raising kids or business? These are the difficult questions that people occasionally need to ask themselves. If buying a home requires you to give up items that you are unable or unwilling to give up, it could be best to wait. Only you can say for sure.
Lastly, you should consider the housing market in your current area or where you plan to move. Is purchasing a house an expensive investment that doesn’t make sense financially? Do you want to buy it assuming that its value will rise with time? Remember, when the real estate market crashed during the 2007 Great Recession, most homeowners lost. And so, consider these questions: do I see myself staying in the same area for a more extended period? If the economic situations change, will they affect my financials? If you still have doubts, it’s best to wait for the right time.
You have a steady income
This may seem self-evident, but determining how stable your income is sometimes tricky, especially with the current economic uncertainties. When it comes to income, not only should you feel secure about your pay for at least a few years, but you should also be able to show a track record of consistent work in the past.
Lenders will ask you to present two years of your pay stubs or tax returns as proof of income. They’ll also require you to show evidence of the money you’ll use for the down payment deposited in your bank account for at least two months. This demonstrates that you have the funds necessary to fund your mortgage. If you’re relying on gifts from friends and family to assist with a down payment, ensure that you receive them before applying for the mortgage.
If you’re self-employed and do not have a consistent source of income, obtaining a mortgage can be even more difficult. In this instance, documentation is critical. Assemble two years’ worth of financial records that will enable a lender to assess your income.
Have you made up your mind to buy a home? Perhaps, yes—but only if you have the funds or can afford it. However, the concept of “afford” is more complex than just referring to your current balance. As you make your estimates, keep in mind other aspects of your financial situation and personal preferences, such as those presented above. Taking them into account now can help you avoid costly blunders and economic troubles in the future. Still, if you find the ideal home in the perfect location at the perfect price, there is only one opportunity to act!