Clients often ask me what one can do to best prepare for buying a house, especially for the first time. If you are considering making such a purchase, there are some things you can do to ensure you are best positioned to act when opportunity strikes.
Review and Improve Your Credit Score
Having a strong credit score will allow you to receive the best rate among mortgage lenders, which translates to a lower monthly payment. It is always a good idea to obtain a copy of your credit report and review any negative items that may be affecting your score. Typical items that can negatively impact your score include:
- On-Time Payment History
- Derogatory Reports (Collections, Bankruptcy, Tax Liens)
- Debt Utilization
- Frequent Credit Inquiries
Your credit report gives lenders insight into your financial history and paints a picture of how responsible you will likely be if they extend a loan to you. Therefore, on-time payment history is very important, but they will also look to see if you have had any bills go to collections or if you have multiple credit inquiries. This may signal to lenders that you mismanage your debt. In addition, the amount of debt you have outstanding compared to what is extended to you (known as the utilization ratio) also affects your credit score. The higher your utilization ratio is can be a drag on your score. The ideal ratio is thought to be 1:3, meaning you use one third of the credit extended to you. Reviewing your report will allow you to identify any negative factors so you can rectify where necessary. Once you make positive changes to your credit, it still takes time (about 2 years) for you to see the improvements reflected in your score. If you are thinking of buying a house within the next 1-2 years, it is important to correct any issues sooner than later to give your credit score time to increase.
Clean Up Debt
Cleaning up some debt will help increase free monthly cash flow, better preparing you to take on the costs of owning a home. This reduction in debt will also help you to qualify for a loan. Generally speaking, lenders use the 43% debt-to-income rule, which is a guideline set forth by the Consumer Financial Protection Bureau that recommends total debt does not exceed 43% of the applicant(s) gross monthly income. This debt will include the new mortgage payment of principal, interest, home insurance and property taxes, plus any other debt payments such as student loans, auto loans, etc. Lenders may impose their own debt-to-income guidelines, but this standard is a good rule of thumb to use when considering how you will qualify for a mortgage. When trying to pay down debt, target the highest interest rate loans first, like credit cards.
It is important to recognize that just because the lender may use the 43% rule as a measure of what you can afford, this may not match your personal comfort level of what you want to pay. Consider your ability to save and have emergency reserves. You want to make sure that just because you can buy a house at a certain price point it does not impede your ability to meet other goals.
Also consider the additional costs that are associated with owning a home. For example, the electric and heating bill may differ considerably if you are moving from an apartment to a house. Furthermore, if you are comparing buying a home to a rental situation, you must also factor a budget for unexpected expenses that you would be responsible for, such as repairs. The takeaway here is that it is more involved than simply comparing the monthly mortgage payment to your monthly rent, and all costs must be considered.
Save For a Down Payment
Once you determine what you can afford, you should consider what type of home you want. For example, single-family homes will often have different costs associated with the property than a condominium. Condos and some communities have homeowner association fees (HOA fees) that are monthly dues you must pay in addition to your mortgage payment. Because you must account for this added cost, it typically reduces the purchase price of the home you are shopping for. Conversely, owning a single-family home will likely have lumpy expenses, such as when something needs to be repaired or replaced, versus the ongoing monthly expense.
When you know your price point, you can figure out how much to save. A standard down-payment is 20% of the purchase price because lenders prefer a maximum loan of 80% relative to its value. The benefit to being a first-time homebuyer is that there are many programs available where a 20% down payment is not required. It is important to note, however, that while you may be able to qualify for a loan with little to no down payment, you will still have to pay private mortgage insurance (PMI), which is an additional monthly cost that provides the lender with protection, until you reach their desired loan-to-value threshold.
Shop Mortgage Lenders & Get Pre-Approved
Do not be afraid to shop around and ask questions. Consumers have many options today which are worth exploring to find the right fit for you. When presented with rates, you might want to ask if there are points involved and how much that will cost you. If you are going to be paying PMI, you can inquire into what options they have. For example, some lenders may account for PMI by offering a slightly higher rate, or you may ask if you can pay PMI upfront and make it part of closing costs. This may have little impact to the monthly payment. Once you are comfortable with a lender, obtain a pre-approval. Pre-approval letters allow you to make a competitive offer, with the seller understanding you will be able to follow through and finance the purchase.
Having your financial ducks in a row will empower you to be in a competitive position when making an offer on a home. With supply being low in our current environment, it is even more important to be prepared.
Kristina Mello, MBA serves as Senior Advisor and Director of Financial Planning at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at firstname.lastname@example.org.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Kristina’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm or our parent company, Focus Financial Partners. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference. Certain statements contained herein may be statements of future expectations and other forward-looking statements that are based on SPIA’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. In addition to statements which are forward-looking by reason of context, the words “may, will, should, expects, plans, intends, anticipates, believes, estimates, predicts, potential, or continue” and similar expressions identify forward-looking statements. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements. SPIA assumes no obligation to update any forward-looking information contained herein.