Are you considering becoming a first-time home-buyer? This is a big milestone in your life, congratulations!
With a new home comes a lot of responsibility and unknowns. So, before you jump in headfirst, educate yourself on how to buy a home, including making sure that you’re financially ready.
Check out our 6-step process to help see if you’re ready.
1. How is my financial health?
When’s the last time you assessed your financial health? Think about how much you bring in compared to your expenses. Do you live comfortably or is it a struggle? Are you not sure? Pull out your bank and credit card statements for the last few months. Do you have money left over each month or do you live paycheck-to-paycheck?
What about your consumer debt? Do you have a lot of it? Lenders like it when consumers have less than 30% of their available credit lines outstanding. Do you fit into that or are you in over your head in debt?
It’s important to assess your financial health and make sure you’ve got a good footing before taking on the responsibility of home ownership. You want to make sure you have a healthy cash flow and manageable debt levels.
2. Do I have a healthy emergency fund?
The average person needs 3 to 6 months of living expenses saved in an emergency fund. This money should sit separate from your ‘spending money.’ Call it your rainy day fund or whatever you want to call it, but don’t spend it unless it’s an emergency.
When you own a home, the list of emergencies that could happen is a mile long. Water damage, furnace breaking, and pipes bursting are just a few examples. If you don’t have a healthy emergency fund, you may suffer financial distress trying to fix the problem and keep up with your bills.
Before you buy a home, make sure you have a fully funded emergency fund. It should be separate from your down payment and closing cost money. This is only for future emergencies, should they happen.
3. What’s my credit score?
Your credit score is the first thing lenders look at. Think of it as their first impression of you. What will they think as they evaluate your ability to make a home purchase?
If you have a low credit score, the lender may deny your application. If you have an average credit score, you may qualify for some programs, such as the FHA loan, but at a higher interest rate and/or less lucrative terms.
Who gets the best interest rate and best terms? The borrowers with the best credit do. Pull your credit report before you apply for a loan. You can get a free copy here. Look at your trade lines. Do you have late payments reporting? Are your credit lines overextended (over 30%)? Use this time to fix anything that’s wrong.
If you find errors on your credit report, contact the credit bureaus, and provide proof of the errors. They have 30 days to respond. Act early so your credit score has time to change before you talk to a lender.
4. How much home can I afford?
Here’s the most important step. What can you afford? You’ll be able to afford more on paper than real-life – tap into those real-life scenarios.
Banks pre-approve borrowers based on their gross monthly income (income before taxes). This is dangerous, and quite frankly not very realistic. We budget based on our monthly take home pay and we pay bills based on that take-home pay. Use this dollar amount to figure out how much you can afford.
Do you like ‘rules’? Don’t budget more than 30% off your monthly take-home pay for your housing. Now, remember, housing means more than your mortgage’s principal and interest. Also consider your monthly real estate taxes, homeowner’s insurance, homeowner’s association dues, and mortgage insurance (if applicable).
The last thing you want is to become house poor. If most of your monthly income pays for the house, where does that leave the rest of you? How do you buy food, have fun, or go on trips? Buyers’ remorse is real and painful. Take this step seriously to avoid feeling it.
5. How much down payment do I need?
The down payment holds many first time homebuyers back. They assume they need 20% down on a home so they don’t even try. While a 20% down payment is a great goal and if you have it, definitely put it down, but it’s not the only way.
A 20% down payment prevents you from going ‘underwater’ or owing more than the home’s worth. If the housing crisis of 2008 taught us anything, it’s that home values can fall fast. With 20% or more down, you give yourself a cushion should it happen again.
If you don’t have 20% down, don’t worry. You’ll pay mortgage insurance if you choose a government-backed loan or Private Mortgage Insurance (PMI) if you have great credit and qualify for conventional financing. The insurance adds to your mortgage payment, though, so make sure you include it in your budgeting.
6. What type of loan is right for me?
Here’s the biggest decision – choosing the loan. Here’s an overview of your options.
- Conventional loans – This is the ‘good borrower’s’ loan that requires good credit scores (usually 660 or higher), at least 5% down, stable employment, and no recent derogatory credit. With a down payment of less than 20%, you pay PMI but only until you owe less than 80% of the home’s value.
- FHA loans –A Federal Housing Administration Loan (FHA loans) have flexible guidelines including credit scores as low as 580 and a 3.5% down payment. In the face of the early 2020 pandemic, you may find that lenders tightened up their requirements, asking for credit scores higher than 580, though. FHA loans require mortgage insurance for the life of the loan, but offer relaxed underwriting guidelines.
- VA loans – Eligible Veterans may be able to secure 100% financing (no down payment) with a credit score as low as 620, in some cases. There is no mortgage insurance, and the underwriting guidelines are as flexible as they come for first time home-buyers.
Have you been considering purchasing your first home? Did you think to consider any of these six steps? Buying your first home is a great way to build equity and increase your net worth, but make sure to do so responsibly. Educate yourself and have a good financial foundation before committing to this major milestone.
Take the time to go through these steps and determine where you stand.
Carolyn Rowland is a CERTIFIED FINANCIAL PLANNER™ passionate about empowering individuals to take control of their financial landscape. “We often tend to place our own priorities on the back burner for others, resulting in sacrifices we don’t often realize we’re making.”Carolyn believes in taking a values-based approach to financial planning. “Together we’ll define what matters most to you, what you want your life to look like, and develop a plan that fits your lifestyle.”CC
Carolyn Rowland is in the Milwaukee WI, area.