So you’ve decided to take the plunge into the world of homeownership. Congrats! Purchasing a home is likely one of the biggest financial investments you will make in your lifetime, and it makes sense to do a little homework to make the process easier. In my 13 years as a financial planner, I have worked with many clients to help them transition from renting to owning their home.
Here are five things to do before you start looking at houses.
1 - Check your credit
Your credit score will be one of the most important factors when you want to qualify for a mortgage loan. It not only affects your ability to get the loan, but your score has an effect on the overall cost as well. In other words, the better your score, the lower your interest rate. To get a sense of where you stand, you can go to annualcreditreport.com to get a free copy of your credit report from all three of the major credit bureaus (Experian, Equifax, and TransUnion). Check for errors and file a dispute if there are any items on the report that are inaccurate.
Just because you pay your bills on time does not mean you will have a great credit score. Other factors like the amount of debt you have relative to your available credit limits and the age of your oldest open credit line will factor into your score as well. Either way, you will need to have a score above 720 in order to get the best rates. If you have any negative items, don’t worry! You may still be able to qualify, but at a slightly higher interest rate. Check with a mortgage officer to get the details. They should be able to pull your actual credit score and let you know if there are any glaring issues that will prevent you from getting a mortgage. You can also check for apps like Credit Karma that give you an estimate of your credit score, but be wary of entering sensitive information anywhere online and never enter your credit card info. You should be able to get a score without paying for it, but there is no shortage of online vendors that will try to charge you or sign you up for some type of credit monitoring service in order to get your credit score.
2 - Evaluate your cash flow
Before you get on the hook for tens or maybe hundreds of thousands of dollars, you should evaluate your income and liabilities to determine a responsible amount to borrow for your first home. Many first time homebuyers make the mistake of overextending themselves and later get into trouble if they lose a job or experience some other financial hiccup. It is better to go smaller for your first home, and then upgrade down the road. As a general rule, you do not want to have more than 35-40% of your monthly income taken up by debt payments. This is measured by the Debt-to-Income ratio or DTI.
DTI =Total monthly debt payments (including the new mortgage) / Gross monthly income.
At 4%, every $100,000 borrowed on a 30-year mortgage will carry a monthly payment of about $477. Figure that in with your other monthly payments like student loans, credit cards, and car loans to come up with your projected DTI. This will help you to determine a reasonable price range as you start your home search.
Another general rule is that you should not spend more than 28% of your monthly income on housing costs including the mortgage, property taxes, and insurance costs. This is called the “front end ratio”. When determining a maximum limit for your mortgage payment, I like to use the rule of a monthly payment no higher than one week’s worth of pay.
3 - Get your documents ready
The great recession of 2008 was largely driven by banks that started making loans with little or no financial documentation required. As a result, getting a mortgage today will require some fairly significant paperwork and proof of income. Typically, mortgage lenders will request two recent pay stubs, the previous two years' W-2s, tax returns and the past two months of bank statements -- every page, even the blank ones.
4 - Get pre-qualified for a mortgage
Before you can make an offer on a home, you will likely need to be pre-qualified for a mortgage. You may have already talked to a mortgage lender while you were checking your credit, and getting pre-approved is as easy as making a phone call. Your mortgage lender will gather some basic income information and pull your credit if they have not done so already. You will get a letter stating how much you are pre-approved to borrow contingent on providing appropriate documentation of your stated income before closing. Keep in mind that this amount will likely be more than you want to actually spend on a home. Use your Debt-to-income ratio and front-end ratio as a guide to what will be comfortable when you start making those monthly payments.
5 - Figure out your down payment
As first-time homebuyers, you will be able to purchase a home with little or no cash up front. This can be a good thing, but if you don’t put up at least 20% of the purchase price, you will have to pay PMI or Private Mortgage Insurance. This can be rolled into the loan or added to your monthly payment, but it can be expensive and use up valuable dollars from your monthly housing budget. To avoid the additional cost, you can plan ahead and save up enough to avoid the additional insurance. You may also be able to pay the PMI up front in a lump sum instead of having it added to your monthly payment. The cost is typically between 1-2% of the total loan amount which is much less than the 20% required to avoid the insurance all together. In addition to that, there will be some closing costs that you will have to pay out of pocket, but sometimes, you can have this rolled into the mortgage as well. Ask your mortgage lender about specific loan programs for first time homebuyers.
ow you are ready to find a good realtor and start looking at homes! Focus on staying within your price range and keep your eyes peeled for a great deal. The process can seem daunting at first, but by taking the time to get organized, you can be calm and confident as you begin your search for the perfect home.
Be on the lookout for future posts from us! In the remainder of this blog series, you will hear from experts with more great tips on getting the most out of your first home purchase.
