Home ownership is a dream for many, but the reality isn't always quite what they expected. There are more expenses to consider than just your down payment and monthly mortgage payment. And just because you can afford to buy a home doesn't mean you should do it. Before you start applying for mortgages, here are four questions you should ask yourself to make sure you're ready to purchase a home.
Can you afford it?
There are several costs associated with buying a home. The most obvious is the monthly mortgage payment. This shouldn't cost more than 28% of your gross monthly income as a general rule. Meanwhile, your total debt should not exceed 36% of your gross income. Staying within this range will ensure that you can comfortably afford your monthly payments.
Then there's the down payment. If you put less than 20% down on a home, you will have to pay private mortgage insurance (PMI). This costs between 0.5% to 1% of the total loan amount per year until you reach 20% equity. So if you have a $100,000 loan, you could end up paying $1,000 in PMI each year on top of your standard mortgage payment. But if you're OK with that, you can still purchase a home with less than 20% down.
Federal Housing Administration (FHA) loans only require 3.5% down, and if you qualify for a USDA or VA loan, you may not have to put any money down at all. But you will have to pay mortgage insurance on FHA and USDA loans. On conventional loans, this ends when you reach 20% equity, but with FHA and USDA loans, it continues for as long as you have the loan. VA loans do not come with mortgage insurance, regardless of the down payment.
The less money you put down, the higher your interest rate will be. Figure out how much of a down payment you could comfortably afford and then play around with the numbers. Use a mortgage calculator or run different scenarios by your lender to see how a larger or smaller down payment would affect your monthly premiums.
Don't forget that you'll have to pay closing costs, too. These usually total 2% to 5% of the purchase price. This amount typically does not go toward your mortgage balance. Your lender may enable you to roll the closing costs into the mortgage amount, but then you'll be borrowing more.
Your lender should give you a loan estimate explaining all of the costs of purchasing a home. Read it carefully and make sure you understand how much you'll be expected to pay at closing and over the lifetime of the loan. If you can't afford this amount, you may want to think about making some changes, like increasing the down payment if you can afford to do so or considering a less expensive home. Or you may want to wait until you've saved up more money before you buy.
What's your credit score?
Mortgage lenders look at your credit reports and scores in order to gauge how responsible you are with your money. A low credit score (about 620 or below) is a red flag that may suggest you have trouble paying back what you borrow. This can make lenders decline to work with you out of fear they'll end up losing their money. If you want to secure the lowest possible interest rates, your credit score must be about 760 or higher. But you should still be able to secure a loan even if your credit score is in the low to mid-600s. FHA loans only require a minimum credit score of 580, but if you're applying for a conventional loan, it's best if your score is at least above 620.
Before you begin applying for a mortgage, it's a good idea to check your credit reports. You can access them for free through AnnualCreditReport.com. Try to see it through the eyes of a lender. Late payments, maxed-out credit accounts, and repossessions or foreclosures on your account can indicate that you're living beyond your means.
If your credit report has a number of black marks on it, you're better off waiting to apply for a mortgage until your credit improves. Make an effort to pay bills on time, eliminate some debt, and consider getting a secured credit card to build up a good payment history. This will not only increase the likelihood of getting a mortgage, but also give you access to better interest rates.
How long do you plan on being in the area?
If you only plan on staying in the area for a year or two, it may not be worth spending all of that money on closing costs and a down payment. If you have to sell it in a hurry, you may have to settle for taking a loss on the home in order to get out of it.
As a guideline, you should only buy a home if you plan to live in it for at least five years. This gives your home time to appreciate in value and spreads out the up-front costs of buying a home. A home can be a great long-term investment, but renting is a much better option if you'll only be there for the short term.
How are the rest of your finances?
Everyone should have an emergency fund that covers at least three months' worth of living expenses. Chances are, you'll have a home appliance break down on you after a while, or a roof will need replacing, or you'll need to file a homeowners insurance claim. If you don't have any savings to absorb these financial blows, you risk falling behind on your mortgage payments or racking up lots of debt.
If the home you're interested in would put a strain on your budget, you may want to consider something more affordable or wait until you've built up more savings before you purchase it. That way, you won't have to worry about losing the roof over your head.
Home ownership is a worthy goal, but it's not the right move for everyone. It's important to make sure that you're financially ready for a home and that you'll be in the area for long enough to make the high up-front costs worthwhile. It doesn't hurt to play around with numbers to see what you can afford, but think through your options carefully before you hand over any money.