A house is not a necessary asset; unlike, say, a retirement (savings) account. You can still become wealthy whether you rent an apartment or live on a boat. For many Americans though, owning a home is one of their biggest financial goals – and long-term investments.
That’s why, before you go house hunting, take these important financial steps to buying a house so that your dream home feels like an asset, not a liability.
1. Build your credit score
The math is simple: the lower your credit score, the more you’re going to pay. That is, if you aren’t denied altogether. If you have less than stellar credit, you can expect to pay a higher interest rate, a larger down payment and additional fees.
Consider that the minimum required credit score for a conventional mortgage backed by Fannie Mae or Freddie Mac is 620. And, the lowest credit score to buy a house with an FHA loan is 580.
Before you start speaking to real estate agents, take a look at your credit reports and get any mistakes fixed. If your score isn't where you want it to be, start taking steps to fix it: pay off bad debt, such as credit cards, and avoid opening additional lines of credit until after you’ve closed on your home.
2. Determine how much home you can afford
A common rule of thumb is that you can’t afford a home if the monthly payment exceeds around 30% of your monthly income. Lenders will take this debt-to-income ratio into consideration when deciding to approve or deny your loan application. You can use an online mortgage calculator to get an estimate of the monthly payments on homes you have in mind. Then, you can determine if it passes the 30% threshold.
For a true test, start saving the difference between the estimated monthly payment and what you pay now in housing costs. If that increased expense starts to get uncomfortable, then you know the home is outside your price range.
3. Save for a 20% down payment
For nearly all home loans, you’ll need to provide a down payment. Why 20% when some lenders will accept a down payment as low as 3%? While you may get approved with a down payment in the low single digits, a 20% down payment has many potential benefits: it increases your chances for approval and lets you compete against buyers paying with cash; it will lower your monthly payment and your interest rate; and it allows you to avoid private mortgage insurance (PMI).
4. Don’t forget about closing costs
Lost in the excitement of getting the home you want is this additional expense. In addition to the down payment, you’ll need money to pay for closing costs. They aren’t cheap – typically a few thousand dollars, depending on where you live. You may, however, be able to negotiate the seller to pay some of the closing costs.
5. Build a sizeable savings account
A sizeable savings account helps you in two important ways. Firstly, it convinces lenders that you can afford the home. In fact, it may even help you earn more favorable mortgage terms. Secondly, you’ll have cash available for any potential repairs or maintenance that is needed once you move in.
6. Plan for a 15-year mortgage vs. a 30-year mortgage
Many home buyers opt for the 30-year mortgage because the higher monthly payments of the shorter-term, 15-year mortgage seem unaffordable. In the long run, the 15-year mortgage saves you more money. For one, you’ll pay off your mortgage sooner, which frees up income to put toward other financial goals, such as retirement. Additionally, interest rates on 15-year mortgages are often lower.
7. Consider the cost of living
One final step to buying a home is to research the cost of living in your desired neighborhood. You may be able to afford the home, but can you afford to live there? Will you feel pressured to maintain a certain lifestyle? Instead of relaxing in a new home, you may be too busy racing to “keep up with the Joneses.”
Buying a home is anything but a simple process. It involves a lot of paper work, time and financial considerations. However, the steps to buying house becomes easier when you have your financial house in order first.