Buying a home is a big decision that can have a considerable impact on your finances and your future. If you’re thinking about buying a home, you’ll want be to well-informed and adequately prepared before taking the plunge!
Here are three important steps to get your finances in order before home ownership, and also a couple helpful tips.
Read more: Why you should buy a house below your means
1. Get your credit in order
Your credit score is one of the most important factors in the home buying process, and the difference between great and mediocre credit can mean the difference of thousands of dollars. For example, if someone with mediocre credit wanted to buy a $200,000 home and is offered an interest rate of 5% while a borrower with excellent credit is offered 3.5%, that is a difference of nearly $56,000 in interest!
If you’re not sure what your credit score is, you’ll want to know so you can do some groundwork in case it’s not quite what you want it to be. In order to do this, you can get your free credit score by going to myFICO.com. Additionally, you’ll also want to take a look at your credit report by going to AnnualCreditReport.com. But if you want a free copy of both your credit score and credit report, go to CreditKarma.com. If you’re buying a home as a couple, you’ll want to pull each person’s credit to see who is the best person to qualify for the loan.
If you’ve had some bumps along the way related to credit, you’ll want to clean those up before a home purchase. It can take anywhere from 30 to 45 days to clear up a discrepancy on a credit report — so if you’re considering buying a house, the sooner you tackle any credit issues, the better!
If your credit score is high, or above 760, that’s great. There’s likely not a lot you can do to improve your credit score any more. But, if your credit score is 620 or less, lenders will consider you as a sub-prime borrower, or more risky. And, due to this risk, they will offer you higher interest rates over someone with a higher credit score.
- Fix any errors on your credit report (Here’s how)
- Pay bills on time every month
- Get credit card balances down
- Use credit cards, but always pay them off in full (balance of $0) every month
2. Pay off debt to reduce your debt-to-income ratio
If you’ve never heard the phrase ‘debt-to-income ratio,’ it’s a financial term credit card companies and mortgage brokers use to determine how risky a borrower is. Though it’s a part of your credit score, lenders also use this measurement when deciding if you make enough money to cover your future mortgage obligations each month.
A debt-to-income ratio is calculated by dividing all the money you owe each month (credit card bills, other monthly bills, student loans, other monthly debt obligations etc.) by your monthly income. According to the US Consumer Financial Protection Bureau, lenders do not want to see this ratio over 43%. Ideally, you want it to be as low as possible.
To reduce your debt-to-income ratio, you’ll have to pay down or settle debts such as credit cards, car notes and other personal loans — and/or increase your income.
3. Prepare your paperwork
When applying for a mortgage, getting all the necessary paperwork together can be a bit of a process.
Though paperwork requirements for mortgages before the housing bubble and subsequent crash used to be a lot more lenient, now lenders want to be sure to cover all the bases.
Typically, mortgage lenders require two current pay stubs, two to three months of bank statements, the last two years’ worth of tax returns and documentation surrounding any large sums of money that you paid or were paid to you, such as a financial gift from a family member.
Having these documents ready to go can help speed up the mortgage process and avoid any slowdowns, as the omission of a necessary document can halt the mortgage underwriting process.
Other important financial considerations
Those these are not required, the below financial tips can help you pay less over the long-term and give you peace of mind as you become a homeowner.
Put enough money down to optimize your monthly mortgage payments
Though some loan programs only require 3% down, others require a down payment of at least 10%. And, if you want to start out on a great foot when it comes to getting the best monthly mortgage payment, put enough money down so that you won’t be required to carry PMI, or private mortgage insurance.
PMI is something banks require for mortgage amounts more than 80% of the value of a home to insure against default. But, this can cost you between 0.3% and 1.2% of your loan amount on an annual basis. So, it’s a good idea to put at least 20% down on your home to avoid PMI whenever possible.
You’ll also want to decide what kind of loan is best for you. Will a 10-year, 15-year, or 30-year loan be best? In any of these cases, how much down payment will you need to afford your monthly payments? Though a 30-year loan will give you lower monthly payments, you’ll also be paying more in interest over the life of the loan. For a $200,000 home, the difference between a 30-year fixed-rate mortgage and a 15-year fixed-rate mortgage is over $50,000.
So, once you decide how much you can spend per month and how much you need to put down, you can focus on saving. You might want to consider saving your down payment in one of these places so you can earn a little interest while you’re waiting.
Have a sizeable emergency fund
It’s something that isn’t necessarily fun to think about, but it’s always a good idea to plan for the unexpected. If at all possible, before you take the leap into home ownership you’ll want to have a good-sized emergency fund to cover unforeseen circumstances, such as a home repair, job loss or medical emergency.
In a best case scenario, you’d have three to six months of living expenses stashed away. The idea is that in the event of a job layoff or medical situation, you’d have enough money to cover you mortgage and basic living expenses as a bridge to help you get to the other side of the situation. This is to help you avoid defaulting on your loan and loosing your home! An emergency fund is very important when it comes to home ownership.
For next steps toward home ownership, you may also want to check out Clark’s First Time Homebuyer Guide here. Happy house hunting!