Location is often cited as the most crucial factor when buying a house. While this is true, there is a list of financial prerequisites that need to be addressed before anything else.
These financial issues impact all other aspects of your home-buying process, including how much house you can purchase, in which neighborhood and how soon.
Thinking deeply into these financial issues will help you avoid potential pitfalls that may otherwise haunt you long after you’ve moved into your “dream home.”
Are you financially ready to buy and own a house? It’s an obvious question, but one that most first time-time home buyers rarely give enough thought to. If you think you’re ready to sign that contract and secure your dream home, first look yourself in the mirror and ascertain your financial capability to own a house.
A common mistake most people make is thinking about their mortgage and mortgage insurance only when planning to buy a house. As a first-time homebuyer, it’s important to factor in other costs of homeownership, including upfront costs, HO3 insurance, property taxes and maintenance fees.
Buying and owning a house is a life-changing experience. However, starting this journey when you’re not financially fit opens up many unfortunate possibilities, including losing the home to the lender and a financially wrecked future.
Our first recommendation before starting this process is to have a steady income. It will be much easier to acquire a home loan once you demonstrate that your income is steady and you have enough room in your budget to accommodate another large expense.
On that note, if you have an unstable source of income, it’s advisable to have 6-12 months of savings to cater to any eventualities. Having another source of income is another smart idea. That way, you can tap into it and continue with your mortgage payments in case a misfortune befalls your primary source of income.
Understand Your Debt-to-Income (DTI) Ratio
Your debt-to-income ratio is among the first things lenders consider when determining your financial ability to pay for a house. DTI ratio is a percentage expression of how much of your monthly income goes to your recurrent monthly debts.
There are two figures that lenders factor in when determining a borrower’s DTI:
- Front-end DTI ratio– you arrive at your front-end DTI ratio by dividing the total of your monthly house-related expenses by your gross monthly income. Monthly housing expenses include mortgage principal and interest payments, home insurance premiums and taxes. Lenders prefer dealing with people with a front-end DTI ratio not higher than 28%.
- Back-end DTI ratio– this is a percentage of your total monthly debts divided by your monthly gross income. To calculate your back-end DTI ratio, add up your monthly debt obligations, including house-related expenses, credit cards, student loans and child support. Divide the total by your gross monthly income and multiply by 100. A good back-end DTI ratio to qualify for a mortgage is 36%.
If these ratios aren’t working in your favor, you should first focus on improving your financial situation and lowering your debts before applying for a mortgage.
How Much Downpayment Can You Afford?
In real estate, a downpayment is the amount of money you pay out of pocket towards the price of a house and then take out a mortgage for the remaining amount. This payment is expressed as a percentage. For instance, if you bring $60,000 for an $800,000 home, your down payment is 7.5%.
How much you bring as a downpayment will vary depending on the type of mortgage. The down payment is usually 3-20% for a conventional loan, although the average first-time buyer pays around 6%.
How much you decide to put down depends on your financial situation. But keep in mind that a lower down payment will mean higher monthly payments plus higher interest rates and vice versa. Also, if your down payment is lower than 20%, your lender may require you to take private mortgage insurance, which adds to your monthly burden.
Ability to Pay Your Mortgage Closing Costs
Down payment may be the biggest roadblock to homeownership. But it’s not the only cost that you need to worry about. There will be some closing costs to bring to the table, and they can surprise you.
These are processing expenses incurred throughout the home-buying process apart from the mortgage. Typical closing costs include:
- Loan-related fees, such as application, loan origination fees, prepaid interest, and attorney’s fees.
- Mortgage insurance fees like mortgage insurance application fee, upfront mortgage insurance and FHA mortgage insurance if the FHA insures your house loan.
- Property-related fees, for instance, appraisal, property tax, and home inspection fees.
- Title fees- title search fee, owner’s title insurance and lender’s title insurance.
Closing costs typically range between 3% and 6% (average) of the mortgage. So, if you’re facing a $250,000 home purchase, you should be prepared to pay $7500-$15000 in closing costs.
How much you pay in closing costs will vary from state to state and depending on the house’s location. The type of loan you take will impact these fees, too.
So, you may want to shop around and use your negotiating power to lower some of the fees. Also, you’ll be smart to pay these costs out of pocket. Some lenders may be “kind enough” to let you roll the payments into your mortgage, but there’s a catch- a higher interest rate.
Your Credit Score
Lastly, how good is your credit score? Your credit score directly impacts how much you pay as mortgage interest rates. Lenders look at this score alongside your Debt-to-Income ratio to determine your ability to pay off the loan.
Usually, a higher credit score attracts lower mortgage interest rates and vice versa. While a 100-point difference may sound minuscule, it may mean a difference of thousands of dollars in interest on the same mortgage.
Today, most lenders rely on the FICO (Fair Isaac Corp.) credit system to determine mortgage rates. Using this scoring system, lenders offer the best interest rates to borrowers with 760 points and above. Therefore, if you’re planning to buy a house, it will be in your best interest to access your credit report and address any issues before you start house-hunting.