Buying a home is both exhilarating and scary. It means you are setting down roots and ready for the next chapter in life. On the other hand, it also means you’re taking on the largest debt you’ll possibly ever have to pay.
The financial realities of preparing to buy a home can come with a lot of stress, uncertainty, and questions: will I qualify for a loan? How much will I qualify for? Do I have enough for a down payment? The list goes on.
According to Glenn Brunker, president of Ally Home, learning as much as possible about the homebuying process before making a decision will help you feel comfortable with the investment you’re about to make. Knowledge is the best way to avoid unexpected costs that can turn your dream home purchase into a nightmare.
1. Do you have a stable income?
This may sound like a no-brainer, but figuring out how secure your income is can be deceptively tricky to determine, especially with the economic impact of the COVID-19 virus. You should not only feel comfortable that your income is secure for at least the next few years, but also be able to demonstrate a history of stable employment in the past.
Lenders will ask to see at least two years of tax returns or pay stubs as proof of income. Lenders also like to see the money you will use for a down payment deposited in a bank account for at least 60 days. It tells them you have the money to finance your mortgage. If you’re depending on gifts from family and friends to help with a down payment, make sure you get it well before you apply for a mortgage and deposit it.
If you’re one of the 57 million Americans who are self-employed and don’t have a steady paycheck, getting a mortgage can be extra challenging. In this case documentation is key. Make sure you’ve collected two years worth of bank statements that will allow a lender to verify your earnings.
“Do you feel comfortable with your current employment or your source of income?,” asks Bill Banfield, executive vice president of capital markets at Rocket Mortgage. “Because if you didn’t feel comfortable with it and you weren’t sure what was going to happen, you might feel like now’s not the right time.”
2. Do you want to stay in the same area long-term?
Are you looking to buy in an area you envision living in for five or more years? Raising a family? Growing old? Consider: “Do I see myself living in this home, in this geography? Will my job remain in this geography over the next two, three, four years?” notes Brunker.
A home is a big long-term investment. According to the National Association of Realtors, the median length of homeownership in the U.S. is 13 years and the typical tenure has been going up over the last decade.
If you may only be living in an area for a few years, determine if it makes financial sense to buy by considering closing costs, which can range between 3% and 4% of the home’s sales price, as well as how much renting would cost.
You can use a rent vs. buy calculator to compare the cost of renting versus the cost of buying a home in your area to see if and when a home purchase is more economical than renting.
3. Are you comfortable managing debt?
People who have a demonstrated history of being able to manage their debt are more likely to get more favorable terms on a home loan.
Paying your monthly debts on time and using your available credit wisely will lead to a higher credit score. The higher your score the less risky you appear to a lender, which in turn will qualify you for a lower interest rate. A good credit score according to FICO is 700. For the best rates, however, a score of 740 or higher is needed.
For those who have no credit history — sometimes known as a thin file — it may be impossible to obtain a mortgage. To start building a responsible credit history consider a low limit credit card or a secured loan.
In addition to your credit score, lenders will also look at your debt-to-income ratio. A DTI ratio compares your total monthly debts (including your new mortgage) to your gross monthly income, and is used by lenders to determine your ability to repay the money you’re borrowing.
Most lenders prefer a DTI of around 28%, while others may accept a ratio as high as 50%. Generally speaking, the lower your DTI, the more comfortable you’ll be with the mortgage payment. A high DTI can not only increase your interest rate but also limit the amount of money you’ll be able to borrow.
Use Money’s debt-to-income ratio calculator to figure out your current DTI and determine how much house you might be able to afford while keeping your ratio at a sustainable level.
4. Do you have an emergency fund?
An emergency fund can tide you over if you are out of work or help defray the cost of unexpected expenses. Most experts recommend having enough cash to live on for three to six months in a savings account — and homeowners may want more.
Homes require maintenance and repairs, especially when buying older homes that may need upgrades. Being able to buy the house but then not have the money to repair it will only make your financial situation worse.
Homeowners spent an average of $3,192 on maintenance and another $1,640 on emergency repairs last year, according to HomeAdvisor. While newly-built homes may not need repairs right away, building up a fund for the future is a wise idea. A good rule of thumb to follow when budgeting for home repairs, according to Realtor.com, is to set aside between 1% to 4% of the home’s value, with a higher percentage being set aside for older homes.
5. Do you have enough cash for a down payment?
You may have heard that in order to buy a home you need to have 20% of the purchase price for a down payment. But according to Banfield, needing to put 20% down on a home is “a modern-day fallacy.” Many lenders that will accept down payments as low as 3%. In fact, the average down payment in 2020 was 6%, according to Rocket Mortgage.
For prospective homebuyers, coming up with a down payment can be daunting, says Jess Kennedy, co-founder of online lender Beeline. Having to amass tens of thousands of dollars is difficult.
Banfield recommends that you align your down payment with your goals for the home once you’ve closed.
Does the home need a lot of work? Do you need to buy appliances, install new carpeting, or repair a roof? A smaller down payment may be necessary to avoid taking out another loan or wracking up a credit card debt. The right home improvements can also make your home more valuable and increase your equity.
Keep in mind, however, that borrowers who put less than 20% down are required to pay private mortgage insurance. PMI protects the lender from losing money in case you default. The cost of PMI is usually added to your monthly mortgage payment, and can range between 0.5% to 2% of the loan amount. (Once you have paid enough of the loan to reach 20% equity, your lender should remove the PMI.)
Of course, putting as much as possible down up front will also save you on interest over the life of the loan. For example, you want to purchase a $200,000 home. You have a good credit score and you qualify for a 3% interest rate on a 30-year fixed rate mortgage. If you put 20% down on the home, you’ll pay a total of $82,844 in interest over the term of the loan. If you put just 6% down, your total interest payments would be $97,342 — over $14,000 more. A higher down payment can also mean a lower interest rate to begin with.
6. Do you know how much you can afford to spend on a home?
Knowing how much house you can afford means having a clear idea of not only how large your monthly payments will be, but also closing costs, insurance, and taxes. Compare how your current housing costs relate to a new mortgage payment, whether you’re upgrading to a new home or a renter looking for your first home.
A good way of getting an idea of how much home you can afford is to use a mortgage calculator. By using this tool, you can input information, such as down payment amounts and interest rates, to see how your monthly payment would change. In turn, you’ll get a better idea of how much you feel comfortable paying.
Most financial experts recommend the 28/36 rule when determining affordability. This means that you should spend only 28% of your gross monthly income on mortgage payments and 36% on your total debt.
7. Are you willing to make sacrifices to become a homeowner?
Kennedy believes that in addition to being comfortable with your financial ability to pay a mortgage, you should also consider how a home fits into your lifestyle.
For example, do you like eating out every weekend? Do you go on vacation every year? Will the financial cost of a mortgage allow you to continue doing the things that make life fun? Does buying a home fit into your future plans like starting a family or a business?
“These are kind of hard questions people sometimes need to be asking themselves that elicit an emotional response,” notes Kennedy. If buying a home means cutting out things that you are unwilling or uncomfortable giving up, it may be best to wait. Only you can tell.
Fine tune your financial life this year with Money’s expert advice on investing, retirement, building credit, and more. It even comes with a handy checklist. Best of all? It costs you nothing.