LB Note: This week's post is a syndication of a piece I wrote for HouseLogic and The National Association of Realtors. This article has been lovingly republished with permission.
Preparing your finances for home ownership begins the day someone decides they actually want to buy a home. After all, saving for a down payment doesn’t just happen overnight! So, how do you best prepare your finances in advance to handle the most expensive purchase of your lifetime?
Below are five areas to tackle in order to ensure home buying success, and these steps can be completed months or years in advance of a first home purchase. To assist in preparing your finances for home ownership, use this worksheet in order to track progress and keep all of your to-dos straight.
Step #1 – Prepare Your Credit
Everyone knows good credit is needed in order to qualify for a mortgage, but preparing your credit also encompasses an important component of financially preparing for home ownership — debt payoff.
Paying off debt, especially student loans and high-interest credit cards, not only frees up money in the budget for down payment savings, it also raises your credit score by lowering your overall debt. Debt payoff is also important for lenders when determining your debt-to-income (DTI) ratio (total monthly debt payments divided by gross monthly income), the primary number lenders look at to determine how much home you’ll qualify for.
Lenders can qualify an individual with up to 43% debt-to-income ratio, though lenders are more likely to make a loan if it’s lower. The debt-to-income number is important for first-time buyers to know as many are struggling with five-figure student loan burdens, which can severely impact their DTI ratio.
The best way to tackle debt is to use the debt snowball method. List all of your debts (credit cards and student loans for now) in order of highest interest rate and throw all extra money at that amount. When this amount is gone, then go to the next one. Use the accompanying worksheet to list your debt and track your pay off status.
Step #2 – Save for a Down Payment
If you opt for a conventional mortgage and want to avoid private mortgage insurance (PMI), which protects the lender in case you default, you’d typically need to put down 20% of the purchase price. It could take years to save up the proper funds for a home down payment. This is why many buyers opt for putting down less than 20% or prefer an FHA loan, where a down payment as low as 3.5% of the purchase price is possible depending on your credit.
You’ll still need money in the bank no matter which type of loan you think you’ll go with, so it’s important to begin saving as early as possible.
Paying off debt will make saving easier over time as you’ll have more money to allocate to your down payment fund.
You may also want to consider:
- An expense audit, where you cut subscription services and negotiate with your utility providers to lower your costs. Then you automatically put the money saved into your down payment savings account. You’ll never miss it.
- Halting retirement savings for a period in order to contribute more to your down payment funds, but only if you feel comfortable doing so for the short term.
- Funneling any “found” money, such as work bonuses or holiday cash, into your down payment fund. The temptation not to spend is real, but once in your new home, you’ll be glad you sacrificed.
- Getting a side hustle. Putting even $100 extra away each month can make saving for a home much faster (and easier).
Step #3 – Prepare Your Budget
Have you thought about what your budget will look like post-closing? The expense audit (see above) will help make some room, but to see if you can truly afford a home, try building out a sample budget of what your monthly expenses will look like after you buy a home.
Mortgage calculators can help you get a rough estimate of what your monthly mortgage payment will look like. I recommend adding 2 to 3 times utility rates if upsizing from an apartment into a home.
Step #4 – Shop for a Mortgage
Rate shopping for a mortgage is an important step, so don’t go with the first rate you’re offered (unless it ends up being the most competitive, of course). Shopping for the most competitive interest rate is one of the few ways to actually save money on a home, because the lower the interest rate, the less money you’ll pay over the life of the loan.
Rate shopping is now super quick (thanks, Internet!) and doesn’t impact your credit score, so the few minutes you spend rate shopping will pay off big time for your future self … to the tune of tens of thousands of dollars.
Step #5 – Consider Closing Costs
Don’t get blindsided by closing costs — you’ll need to save for these too. Typically, you can multiply the purchase price of the home by 3% to 5% and get a rough estimate of how much you’ll need to bring to closing. Even if the seller offers to pay some (or all) of the closing costs as part of the sale, having this money in the bank – just in case – will assure the lender you’re ready to take on the responsibility of a mortgage.