Homeowners and renters alike believe owning a home provides a safe place to raise a family and a path towards reaching their financial goals. 95 percent of homeowners and 72 percent of renters agree that over time, owning a home makes more sense than renting.
Indeed, the median net worth of homeowners is 80 times that of renters, according to the U.S. Census Bureau. When you start paying off a mortgage, you build equity, which can help support you in retirement. You can even borrow against your home equity if times get tough. And after your hour home appreciates, you can sell it and keep the profits or put the money towards a larger home for your family.
However, there are several barriers to homeownership that make it difficult for people to escape the cycle of renting.
- Most home loans require a large down payment, and it can be difficult to save up thousands of dollars when you’re devoting a large percentage of your income towards rent.
- A low credit score can make you ineligible for a mortgage, or it can mean you’ll pay a higher interest rate, which could make home buying unaffordable for you.
- Home prices continue to increase, and the demand for starter homes is high. It can be difficult for families to find an affordable home on the median U.S. income.
Purchasing a home is a big step toward building wealth, but it comes with many prerequisites. Prospective home buyers need to make sure they’re financially prepared for all associated costs. Here’s how to tell if you’re ready to make the leap.
Are Your Savings on Track?
Saving for a downpayment isn’t the only thing you have to worry about. You’ll also want to make sure your debt is under control, you’re making progress with your retirement savings, and you have enough cash to protect yourself in an emergency or potential unemployment.
Do You Have Debt?
If you’re only able to make the minimum payments on your debt, you’re not ready to buy a home. Lenders will look at your debt-to-income ratio when assessing your eligibility for a home loan, and most won’t be able to issue a qualified mortgage if your DTI is higher than 43 percent. Your DTI expresses the ratio between your monthly debt payments and your gross monthly income. For example, if your household’s gross income is $4,000 but you spend $2,000 on your student loans, auto loan, and other debts, your DTI would be 50 percent.
Most lenders prefer a DTI below 36 percent, and if you can pay down debt even further than that, you may qualify for a better interest rate. It’s a good idea to pay off all high-interest debt, like credit cards and payday loans, before you consider purchasing a home.
Are You Saving for Retirement?
It is widely debated whether stocks or real estate are the better investment, but both are important. If your employer offers a 401(k) plan with matching, you should contribute the maximum that they’ll match. Anything leftover can go towards saving for your down payment. If your employer doesn’t offer a retirement plan, use a retirement calculator to determine how much to put away in an IRA each year.
Do You Have an Emergency Fund?
What would happen if you bought a house and suddenly lost your job right afterwards? Will you have wiped away your emergency fund on your down payment? If that’s the case and you have nothing to keep you afloat, you could end up defaulting on your mortgage, which can result in losing your home. To avoid this disaster, make sure you’ll have at least three months worth of expenses saved in an emergency fund after your home purchase.
Do You Know How Much You Can Afford?
The last thing you should do is go out and visit homes without an idea of what you can afford. Avoid getting emotionally attached to a house before you’ve set your budget.
Can You Afford a Down Payment?
In 2019, the median down payment for first-time homebuyers was just six percent. When applying for certain Government-backed mortgages, you only need to make a 3.5 percent down payment, and state down payment assistance programs can reduce that requirement even further. Creditworthy borrowers may also be able to put as little as three percent down on a conventional mortgage. There are even some companies that offer down payment assistance in exchange for future equity. And if you can qualify for a VA home loan, there’s a $0 down payment option.
However, keep in mind that making a low down payment means you’ll pay more in interest over the life of the loan. In addition, FHA loans require that you pay mortgage insurance for the life of the loan. And if you apply for a conventional loan and put down less than 20 percent, you’ll need to pay private mortgage insurance until you’ve built up enough equity.
Start with the amount you have saved and calculate how much you can afford to borrow with each loan type. You can also use this calculator to estimate how much you can afford based on your income.
Can You Afford a Monthly Mortgage Payment?
Assess whether you can continue to contribute to a retirement fund and keep up with your debt payments once you’ve taken on the costs of homeownership. If your mortgage payment will be higher than your current rent payment, do you have a plan to cover the difference, such as a better budgeting strategy or a second source of income?
Most experts say you shouldn’t spend more than 28 percent of your income on your mortgage payment, so calculating this amount is a good starting point. But you also need to have a sense of your typical spending and outstanding debt, which both influence the mortgage payment you can afford.
Can You Afford the Closing Costs?
You can expect to pay between three percent and six percent of the home’s sale price during closing, so you’ll need to have that amount saved in addition to your down payment. Closing costs cover things like title insurance, escrow fees, and property appraisal fees.
Are You Prepared for Other Homeownership Costs?
You’ll need to purchase homeowners insurance, pay property taxes, and cover your own home maintenance costs after the sale, so you need to ensure that these expenses fit into your budget. The average homeowners insurance premium was $1,249 in 2018, but you may pay more than that, depending on the home and where it’s located.
Most experts also recommend budgeting about one percent of your home’s value each year for maintenance costs. So if you’re buying a $200,000 house, make sure you have about $2,000 per year built into your budget for maintaining your property.
Is Your Credit Score in Good Shape?
It’s possible to get a government-backed mortgage with a credit score as low as 500 if you make a 10 percent down payment. But most lenders will require a credit score of at least 580 for VA and FHA loans. If you’re looking to get a conventional mortgage, you should have a FICO score of 620 or higher.
However, keep in mind that the lower your credit score, the higher your interest rate will be on your mortgage. That means you’ll pay more over the life of the loan, which affects how much house you can afford. It’s best to take steps to improve your credit before you apply for a home loan.
How to Improve Your Credit Score
If you don’t have a credit history, you’ll likely need to start by applying for a secured credit card or credit-builder loan. You can also sign up for Experian Boost to get credit for your on-time utility and telecom payments. If you have bad credit, the following tips may help you improve your score:
- Dispute any inaccuracies: You can access a free copy of your credit report at AnnualCreditReport.com. Look for accounts that aren’t yours or that are incorrectly labeled as delinquent as well as missed payments that are older than seven years old. If you have any accounts in collections, you should contact the original creditor to see if you can pay the balance and have it removed from collections.
- Pay down debt: Not only will paying down debt help improve your DTI ratio, but it will also result in a higher credit score.
- Get a higher credit limit: If you can ask your credit card issuer for a higher limit, you’ll improve your credit utilization ratio, or the amount of available credit that you’re using. Applying for a new credit card is another great way to increase your credit limit, but you should avoid doing so right before applying for a mortgage, since this will cause a small and temporary dip in your credit score.
Have You Chosen a Home Loan?
Not all home loans are the same. Each type of mortgage has different eligibility requirements. The right home loan for you will depend on your credit score and amount you have saved for a down payment.
Home Loan Types
While government-backed loans are easier to qualify for, they often come with higher APRs. Conventional mortgages can be more difficult to get, but they cost less. Here’s how the most common home loan types compare.
| Conventional Fixed Rate | FHA Loan | VA Loan | USDA Loan | |
| Minimum Down Payment | 3% | 3.5% | $0 | $0 |
| Credit Score Required | 620 | 580 (or 500 for a 10% down payment) | 580 | 640 for most lenders |
| Mortgage Insurance? | Only for down payments less than 20% | Yes | No | No; but a funding fee and annual fee are required |
| Other Requirements? | DTI less than 43% | Must be primary residence | Active duty military, veterans, and eligible family members | Check here |
When choosing a conventional loan, you’ll also have options when it comes to your term and how you pay interest. Conventional mortgages are available with fixed or adjustable interest rates and most commonly come in 15-year or 30-year terms. You’ll pay less over time by choosing a shorter term, but your monthly mortgage payment will be higher.
Choosing a Lender
Some lenders may be able to offer you a lower APR than others, so it’s important to compare rates and terms. In fact, research from Freddie Mac indicates that borrowers save an average of $1,500 over the life of your loan just by getting one extra quote. And borrowers who get five quotes from different lenders save an average of $3,000.
You can prequalify with multiple lenders without damaging your credit score. This will give you an APR estimate. However, if you’re going to apply for pre-approval with multiple lenders, which will give you a more accurate rate, you should do so within a two week period. Most credit scoring models treat all applications within this period as a single hard inquiry, so you’ll minimize the hit to your credit.