Homeownership has long been the American Dream, but before you take part in it, you’ll need to make sure you’re ready to buy a home. Here are some important financial steps to take on the road to purchasing a place of your own.
1. Pay down existing debt
Chances are you've racked up some amount of debt in your lifetime, whether it's of the auto, student loan, or credit card variety. The more debt payments you have to contend with on a monthly basis, the harder it will be to swing a monthly mortgage payment on top of them. Therefore, if you have a lot of debt, paying it off is a must.
A good way to know if your debt level is healthy is to look at your debt-to-income ratio, which measures your monthly obligations relative to your earnings. To qualify for a mortgage, you generally need that ratio to be at or below 36%. So, if you bring home $3,500 a month, but your car payments, student loan payments, and credit card minimums total $1,500, you're looking at a debt-to-income ratio of 43%, which means you're better off waiting to buy. But if you pay down enough of that debt to reduce your obligations to $700 in outstanding monthly payments, then you’re looking at a 20% -- much better.
2. Boost your credit score
You need a decent credit score to qualify for a mortgage, especially if you're hoping to snag a favorable interest rate on that loan. If your credit score is poor, it's a sign that you shouldn't be seeking to take out a mortgage in the first place. But if your credit is great -- namely, in the mid-700s or above -- then you’re in a pretty good position to buy.
If your credit score needs a boost, make a point to pay all incoming bills on time. Your payment history is the single most important factor in determining your score, and on-time payments are what bring it up. And just like paying off debt can help your debt to income ratio decrease, so too can it help your credit score improve.
3. Have a 20% down payment on hand
Unlike homeowners insurance, which protects you, PMI is designed to protect your lender in the event you're unable to make your mortgage payments. The cost of PMI is generally 0.5% to 1% of your home loan's value, so that with a $200,000 mortgage, you're looking at an extra $1,000 to $2,000 a year. That's a lot of money to tack on to your homeownership costs, especially when you consider the many other expenses associated with buying a home, like maintenance, repairs, and your property tax bill.
If you can't come up with that 20% down payment, cut back on expenses for a year to hit that threshold. Or, find alternative ways to boost your income.
4. Have emergency savings
As a homeowner, you need emergency savings for when disasters strike, like your heating system malfunctioning or your roof needing a major repair. If you have enough money for a 20% down payment but forking over that cash will leave you with an empty bank account, then it's clear you're not ready to buy a house. But if, following your down payment, you still have enough money to cover the equivalent of at least three months' worth of essential living expenses, then you’re all set.
Just don't forget that in addition to your down payment, you'll be liable for closing costs on your mortgage. You'll most likely need to pay to move, too. So just make sure you have a healthy cushion before buying, and if you don’t, sock away more cash before moving forward.
5. Get established in your career
It takes time for homes to appreciate in value, and it also takes a few years of living in a home to recoup the amount you spend on mortgage closing costs. If you're not settled in your career, and there's a chance you might have to pick up and move to another state to get a job in your field, then waiting to buy a home could be a smart move. If you buy a home, spend $4,000 on closing costs, and then encounter a situation where you have to relocate a year later, you may end up losing money if your home's value doesn't increase during that time. That’s why you should really spend a year or two in your current job or industry before committing to buying a place of your own.
Don't rush into homeownership
Eager as you may be to start house hunting for your dream home, you’ll need to make sure you’re really ready to buy. And if you’re not:
- Pay down some of your existing debt.
- Boost your credit score.
- Sock away funds for a down payment.
- Build an emergency fund.
- Get settled professionally.
Once you've checked these items off your list, you'll be better positioned to explore the housing market and find a home to call your own.
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