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If you’re thinking about buying a house, you’ll want to take a careful look at your finances to make sure you’re ready for this new commitment.
In fact, your finances are so important that you’ll want to start working on them well before you’re ready to apply for a mortgage. That way, if you need to improve your finances or your credit, you’ll have some time.
We’ll delve into tips about how to get your finances ready to buy a home so you can prepare for the process.
- Step 1: Know what lenders are looking at when assessing your finances
- Step 2: Take stock of your credit scores and credit reports
- Step 3: Save for your down payment: Bigger is better
- Step 4: Measure your debt-to-income ratio: Getting to 43%
- Tips for choosing a home you can afford
Step 1: Know what lenders are looking at when assessing your finances
When you apply for a home loan, lenders want to assess whether you’ll be able to pay them back. They’ll check to see that you have a steady income and look at how much cash you have available to cover a down payment, closing costs, taxes and other expenses. Recent banking activity, investments and other aspects of your finances will come under the microscope too.
If you’re a candidate for a no-down-payment loan, such as a VA loan through the Department of Veterans Affairs, you’ll need documentation to prove it.
Lenders will also check your credit to assess your history of paying your debts and look at how much outstanding debt you have.
Different lenders may look at different things when checking your finances, but the goal is the same — to help decide whether to risk lending you money and how much interest to charge. Here’s a list of what lenders are likely to consider.
- FICO® credit scores and credit history
- Down payment amount
- List of assets (stocks, real estate, etc.)
- Income and employment history
- Tax returns
- Bank statements for two to three months
- Desired loan amount compared to value of home
- Total debt compared to income — your debt-to-income ratio
- Rental history (if you’re currently renting or have rented in the past)
To improve your chances of getting a home loan with the best possible terms, you should save as much as you can for your down payment, get your debt-to-income ratio under 43% and do what you can to improve your credit scores. Specifically, we’re talking about the scores compiled by Fair Isaac Corp., known as FICO, which are the mortgage-industry benchmark.
Step 2: Take stock of your credit scores and credit reports
It’s not possible to say exactly how to raise your FICO® scores — everyone’s personal situation is different — but there are a few practices that can usually help, especially if you adopt them a year or more before you apply for a mortgage.
- Pay your bills on time — Your credit scores will fall if you’ve missed payments on a credit card or another debt.
- Use less of your available credit — Your credit utilization ratio, which measures how much debt you’ve taken on compared to what’s available to you, is an important factor in your scores. Using less than 30% of your available credit may lift your scores. Paying down your debts may also lower your debt-to-income ratio, another measure that doesn’t affect your credit scores but is used by banks to assess your creditworthiness. (We’ll explain later.)
- Hold off on opening new credit accounts — When you apply for credit, a lender will initiate a hard credit inquiry, which will have a temporary negative effect on your scores.
- Maintain a mix of credit accounts — Your credit scores are affected by what kinds of credit accounts you have, how old they are and how many of them you have. If you’re managing a mix of different types of credit without trouble, you’ll look less risky to lenders. Note that you shouldn’t open new accounts just for the sake of creating this mix (see point above).
If you have poor credit and stick with these approaches, your credit scores are likely to rise over a period of months. If your credit improves, lenders may see you as a better risk and charge you a lower interest rate on your mortgage.
Why should you worry about your credit scores? Imagine getting a $250,000 mortgage that lasts 30 years and has a fixed interest rate. Take a look at the table below to see how credit scores affect how much you could pay just in interest (not counting the actual money you borrowed) over the life of the loan. You can plug in your own information on FICO’s site to get a better idea of what your interest payments could be.
|FICO® score||APR||Total interest paid|
760 to 850
700 to 759
680 to 699
660 to 679
640 to 659
620 to 639
Note: Rates change frequently. The rates in this example were selected on Oct. 7, 2020.
Step 3: Save for your down payment: Bigger is better
You should save as much as you can for a down payment. A bigger down payment means you’ll own more of your new home from the start. This makes you a lower-risk borrower in the eyes of lenders and usually translates into a lower interest rate on your home loan.
Another reason to put down more cash is to avoid private mortgage insurance, or PMI. Most lenders will require you to buy PMI — which protects the lender in case you default on your loan — if your down payment is less than 20% of the purchase price of your home.
The cost of PMI depends on the type of mortgage you get, how much you put down and some other factors, but usually costs between 0.5% and 1.5% of the loan amount each year and can add up to thousands of dollars.
Plus, you’ll want to factor in additional closing costs, which can include home inspections, an appraisal and escrow costs, like homeowners insurance and property tax payments.
Step 4: Measure your debt-to-income ratio: Getting to 43%
Your debt-to-income ratio, or DTI, — which measures your outstanding debt as a percentage of your income before taxes — is used by lenders as another way to gauge your ability to repay your mortgage.
Your DTI ratio is calculated by adding up all your current monthly debt payments (think student loans, personal loans, credit cards) and your proposed mortgage principal, interest, taxes and insurance payments, and then dividing that number by your gross monthly income (your income before taxes and other deductions).
For a qualified mortgage — a home loan that meets certain regulatory requirements put in place in 2014 to protect lenders and borrowers — you’ll need to have a DTI ratio of 43% or less.
Lenders can extend loans to borrowers who have a DTI ratio higher than 43%, but you generally need a compensating factor like high cash reserves, and even then it’s rare. Lenders consider a higher DTI risky for both you and the lender, as it suggests to them that you may struggle to pay your mortgage and keep up with all your other debts.
If your DTI ratio is too high for lenders’ comfort, you’ll need to lower your debt or increase your income, or both. Since changing jobs or demanding a raise mid-mortgage application may not be practical, you may want to focus on paying down debt.
There are differing opinions about the best way to tackle the job. Some experts recommend paying off your smallest debt first — which research has shown can be effective. Some say it’s better to start with the highest interest loans — that way you pay less interest over the long term. Still others say that paying down your debt with the biggest monthly bill is the best way to lower your DTI quickly.
Whichever way you decide to go, keep in mind that the goal is to lower the amount of debt you have as a percentage of your income, so choose a method that you can commit to and that effectively moves you in that direction.
Tips for choosing a home you can afford
It may take a while for you to save for a down payment, lower your DTI ratio or improve your credit scores. But if you work hard and stick with it over time, you may begin to see some rewards, like easier loan approval and better loan terms.
In the meantime, here are some things to consider as you think about what home you’d like once your finances are ready.
Set a budget
To figure out how much you can afford, consider getting preapproved for a mortgage. But when you do, remember that the lender is making a mostly mathematical calculation and not taking into account your comfort level or preferences. Make sure you’re comfortable with the amount you plan to borrow, even if the lender says you can borrow more.
Your mortgage payment isn’t the only expense you’re responsible for.
Narrow down location and neighborhood
Before you begin looking for a home, take some time to think about the type of environment you want to live in — city, suburbs or rural.
Next, narrow your search to a few neighborhoods. Here are some things to consider.
- Safety — Some websites offer crime statistics by area. If you’re especially concerned about crime, check with the local police department.
- School district — Houses in good school districts typically have higher property values. Look up ratings of schools in the area. But don’t rely on ratings alone. Check out online reviews or talk to parents who send their children to local schools.
- Activities — Find out whether there’s a park nearby. Can you get to hiking trails quickly? What about playgrounds, pools or playing fields?
- Convenience — Do a test run of your morning commute and check the drive time to the local grocery store. Time spent on the bus or driving to the store adds up and will affect how you spend your time when you move into your new home.
Type of home and other considerations
You’ve got the location and neighborhoods. But what type of home do you want — single-family, townhouse, condo or apartment? Here are some other considerations.
- Condition — Move-in ready or fixer-upper? Consider how much you’re spending, whether you’re handy or hate the sight of a screwdriver, and how long you’re willing to wait to move in.
- Resale — If you’re planning to stay in your home for a shorter time period, resale value will be more important than if you’re planning to stay long term.
- Other features — Central air conditioning, swimming pool, garage, granite countertops, hardwood floors, walk-in closets. Have some fun figuring out what you can and can’t live without — and how much it will cost you.
Can’t find what you’re looking for in your price range? A good real estate agent can help you determine whether your wish list is realistic. If it’s not, you may need to compromise.
As you get your finances ready to buy a house, think through these items as a quick checklist.
- How’s your credit? What steps can you take to improve it before you apply for a mortgage?
- How’s your debt load?
- How much house can you afford?
- What type of mortgage loan is best for you: conventional, FHA, VA or USDA?
- How big of a down payment do you plan to make?
- What’s your budget for a monthly mortgage payment?
- What home features are must-have? What could you skip or upgrade later?
- How long do you plan to live in this home?