If you’re planning to buy a house within the next few months, determining whether you’re financially prepared to take such a major financial step is extremely important in order to avoid making a decision you’ll regret someday. One way to decide whether you’re financially ready to buy a home is to analyze a few essential aspects before you start house-hunting. These are:
When it comes to buying a house, thinking that you can afford a certain home style and size could be very different from what you can actually afford. Besides the fact that overcommitting to a mortgage payment basically means that you may fail to meet other financial obligations, it will be very difficult to find a lender willing to offer you a bigger mortgage than you can afford, at a reasonable interest rate.
To estimate how much home you can afford, it’s essential to understand the golden rule of mortgage lending, commonly referred to as the 28/36 rule. In general, lenders approve the applications of the potential borrowers who spend less than 28% of their gross monthly income on total housing expenses (e.g. monthly mortgage principal, interest, property taxes, homeowner’s insurance, and homeowner’s association or condo fees) and less than 36% on all debts, including car loans, student loans, other personal loans, credit card payments, housing costs, alimony, etc.
So, if you expect to pay $1,200 in monthly principal and interest, plus $400 in property taxes and homeowner’s insurance premiums, the total would be $1,600 per month. Thus, your household’s gross monthly income should be at least $5,720 to qualify for a mortgage ($1,600 / $5,715 = 27.99%). If you also have a $300 student loan payment and a $250 monthly car payment, you would need to earn at least $5,975 in order to qualify for a mortgage under the 28/36 rule ($2,150 / $5,975 = 35.98%).
Although most lenders use the 28/36 ratio when assessing mortgage applications, you may still qualify for a mortgage with a higher ratio if you have a good credit score. However, stretching this ratio too far can be dangerous. In a nutshell, a higher ratio indicates that you may have difficulties repaying your mortgage on time, or in full, while covering other outstanding debts and regular payments that you must make.
If your income isn’t high enough to qualify for a conventional mortgage, you may opt for an FHA loan or VA loan instead. The home loans backed by the FHA and VA have more relaxed qualifying standards.
Down Payment and Closing Costs
While it’s possible to buy a home with little or no money down, many financial experts advise against this. In addition to other factors, such as your creditworthiness and income level, the amount you’re able to put down upfront affects the interest rate the lender is willing to offer you. Although saving for a larger down payment may be challenging, the larger the down payment, the smaller your interest rate and loan balance will be. This will translate into:
- a lower loan-to-value ratio, which increases your chance of getting a mortgage;
- more equity built in your home;
- lower, more manageable monthly payments, which make it easier to pay off your mortgage.
A 20% down payment on a house can also help you avoid paying private mortgage insurance (PMI) when applying for a conventional mortgage. If you can’t afford a 20% down payment, there are some other types of home loans, such as the FHA loan, which require as little as 3.5% down, depending on the credit situation of each applicant. Additionally, VA loans don’t require a down payment as long as the sales price of the property doesn’t exceed the appraised value.
Regardless of the type of home loan you may qualify for and the amount you intend to put down, you’ll still need some money in the bank for closing costs. Usually, the average closing costs range between 2% and 5% of the purchase price, and include a credit check, an appraisal, and a title search. For a $250,000 home, for instance, you should expect to pay between $5,000 and $12,500 in closing costs, in addition to the down payment.
Before you start shopping around for a mortgage, it’s advisable to get a free copy of your credit report and review it. If you find information that is incomplete or inaccurate, you can submit a dispute to the credit bureau, which produced the report, online or by mail. Reporting inaccuracies is important because some errors in your credit report could lead to a lower credit score, which may prevent you from getting the mortgage you need in order to purchase the home you want. Besides checking your credit report, you should also try to improve your credit score before applying for a mortgage. Because your credit score plays an important role in qualifying for a mortgage, you should try to improve it if it’s less than 750. A score of 750 or higher can turn you from a potential applicant into an attractive borrower.
Undoubtedly, homeownership has many perks. However, remember that you will need to cover not only your monthly mortgage payments, but also the cost of maintenance, emergency repairs, and renovations over the life of the mortgage. Most financial experts recommend saving between 1% and 4% of the home’s value for maintenance and repairs, separate from your regular emergency fund.
Taking out a mortgage to buy a home is a major commitment. However, it may be one of the best decisions you can make in your life. Assuming that you stay in the home for at least 5 years and qualify for a fixed-rate mortgage, your monthly mortgage payments should remain the same for the life of the loan unlike the rental rates, which are projected to increase over time. For many homebuyers, that’s a good enough reason all on its own to ditch renting and buy a home.