Don’t wait until you’re ready to move to start
preparing financially to buy a home.
If you’re like the vast majority of home
buyers, you will choose to finance your purchase with a mortgage loan. By
preparing in advance, you can avoid the common delays and roadblocks many
buyers face when applying for a mortgage.
The requirements to secure a mortgage may seem
overwhelming, especially if you’re a first-time buyer. But we’ve outlined three
simple steps to get you started on your path to homeownership.
Even if you’re a current homeowner, it’s a
good idea to prepare in advance so you don’t encounter any surprises along the
way. Lending requirements have become more rigorous in recent years, and
changes to your credit history, debt levels, job type and other factors could
impact your chances of approval.
It’s never too early to start preparing to buy
a home. Follow these three steps to begin laying the foundation for your future
home purchase today!
CHECK YOUR CREDIT SCORE
Your credit score is one of the first things a
lender will check to see if you qualify for a loan. It’s a good idea to review
your credit report and score yourself before you’re ready to apply for a
mortgage. If you have a low score, you will need time to raise it. And
sometimes fraudulent activity or erroneous information will appear on your
report, which can take months to correct.
The credit score most lenders use is your FICO
score, a weighted score developed by the Fair Isaac Corporation that takes into
account your payment history (35%), amounts owed (30%), length of credit
history (15%), new credit (10%), and credit mix (10%).1
Base FICO scores range from 300 to 850. A
higher FICO score will help you qualify for a lower mortgage interest rate,
which will save you money.2
By federal law, you are entitled to one free
copy of your credit report every 12 months from each of the three major credit
bureaus (Equifax, Experian and Transunion). Request your free credit report at https://www.annualcreditreport.com.
To qualify for the lowest interest rates
available, you will usually need a FICO score of 760 or higher. Most lenders
require a score of at least 620 to qualify for a conventional mortgage.3
If your FICO score is less than 620, you may
be able to qualify for a non-conventional mortgage. However, you should expect
to pay higher interest rates and fees. For example, you may be able to secure
an FHA loan (one issued by a private lender but insured by the Federal Housing
Administration) with a credit score as low as 580 if you can make a 3.5 percent
down payment. And FHA loans are available to applicants with credit scores as
low as 500 with a 10 percent down payment.4
Your Credit Score
There’s no quick fix for a low credit score,
but the following steps will help you increase it over time.5
1. Make Payments on Time
At 35 percent, your payment history accounts
for the largest portion of your credit score. Therefore, it’s crucial to get
caught up on any late payments and make all of your future payments on time.
If you have trouble remembering to pay your
bills on time, set up payment reminders through your online banking platform, a
free money management tool like Mint, or an app like BillMinder.
2. Avoid Applying for New Credit You Don’t Need
New accounts will lower your average account
age, which could negatively impact your length of credit history. Also, each
time you apply for credit, it can result in a small decrease in your credit
The exception to this rule? If you don’t have
any credit cards—or any credit accounts at all—you should open an account to
establish a credit history. Just be sure to use it responsibly and pay it off
in full each month.
If you need to shop for a new credit account,
for example, a car loan, be sure to complete your loan applications within a
short period of time. FICO attempts to distinguish between a search for a
single loan and applications to open several new lines of credit by the window
of time during which inquiries occur.
3. Pay Down Credit Cards
When you pay off your credit cards and other
revolving credit, you lower your amounts owed, or credit utilization ratio
(ratio of account balances to credit limits). Some experts recommend starting
with your highest-interest debt and paying it off first. Others suggest paying
off your lowest balance first and then rolling that payment into your
next-lowest balance to create momentum.
Whichever method you choose, the first step is
to make a list of all of your credit card balances and then start tackling them
one by one. Make the minimum payments on all of your cards except one. Pay as
much as possible on that card until it’s paid in full, then cross it off your
list and move on to the next card.
Credit Card 1
Credit Card 2
Credit Card 3
4. Avoid Closing Old Accounts
Closing an old account will not remove it from
your credit report. In fact, it can hurt your score, as it can raise your
credit utilization ratio—since you’ll have less available credit—and decrease
your average length of credit history.
Similarly, paying off a collection account
will not remove it from your report. It remains on your credit report for seven
years, however, the negative impact on your score will decrease over time.
5. Correct Errors on Your Report
Mistakes or fraudulent activity can negatively
impact your credit score. That’s why it’s a good idea to check your credit
report at least once per year. The Federal Trade Commission has instructions on
their website for disputing errors on your report.
While it may seem like a lot of effort to
raise your credit score, your hard work will pay off in the long run. Not only
will it help you qualify for a mortgage, a high credit score can help you
secure a lower interest rate on car loans and credit cards, as well. You may
even qualify for lower rates on insurance premiums.6
SAVE UP FOR A DOWN PAYMENT AND CLOSING COSTS
The next step in preparing for your home
purchase is to save up for a down payment and closing costs.
When you purchase a home, you typically pay
for a portion of it in cash (down payment) and take out a loan to cover the
remaining balance (mortgage).
Many first-time buyers wonder: How much do I need to save for a down
payment? The answer is … it depends.
Generally speaking, the higher your down
payment, the more money you will save on interest and fees. For example, you
will qualify for a lower interest rate and avoid paying for mortgage insurance
if your down payment is at least 20 percent of the property’s purchase price.
But what if you can’t afford to put down 20 percent?
On a conventional loan, you will be required
to purchase private mortgage insurance (PMI) if your down payment is less than
20 percent. PMI is insurance that compensates your lender if you default on
PMI will cost you between 0.3 to 1.5 percent
of the overall mortgage amount each year.8 So, on a $100,000 loan,
you can expect to pay between $300 and $1500 per year for PMI until your
mortgage balance falls below 80 percent of the appraised value.9 For
a conventional mortgage with PMI,
most lenders will accept a minimum down payment of five percent of the purchase
If a five-percent down payment is still too
high, an FHA-insured loan may be an option for you. Because they are guaranteed
by the Federal Housing Administration, FHA loans only require a 3.5 percent
down payment if your credit score is 580 or higher.7
The downside of getting an FHA loan? You’ll be
required to pay an upfront mortgage insurance premium (MIP) of 1.75 percent of
the total loan amount, as well as an annual MIP of between 0.80 and 1.05
percent of your loan balance on a 30-year note. There are also certain
limitations on the types of loans and properties that qualify.10
There are a variety of other government-sponsored
programs created to assist home buyers, as well. For example, veterans and
current members of the Armed Forces may qualify for a VA-backed loan requiring
a $0 down payment.7 Consult a mortgage lender about what options are
available to you.
Qualify for the
best rates and no mortgage insurance required
private mortgage insurance costing 0.3 - 1.5% of the mortgage annually
insurance premium of 1.75% of loan amount and annual fee of 0.8 - 1.05%
If you’re a current homeowner, you may have
equity in your home that you can use toward your down payment on a new home. We
can help you estimate your expected return after you sell your current home and
pay back your existing mortgage. Contact us for a free evaluation!
Closing costs should also be factored into
your savings plan. These may include loan origination fees, discount points,
appraisal fees, title searches, title insurance, surveys and other fees
associated with the purchase of your home. Closing costs vary but typically
range between two to five percent of the purchase price.11
If you don’t have the funds to pay these
outright at closing, you can often add them to your mortgage balance and pay
them over time. However, this means you’ll have a higher monthly payment and
pay more over the long term because you’ll pay interest on the fees.
ESTIMATE YOUR HOME PURCHASING POWER
Once you have the required credit score,
savings for a down payment and a list of all your outstanding debt obligations
via your credit report, you can assess whether you are ready and able to
purchase a home.
It’s important to have a sense of how much you
can reasonably afford—and how much you’ll be able to borrow—to see if
homeownership is within reach.
Your debt-to-income (DTI) ratio is one of the
main factors mortgage companies use to determine how much they are willing to
lend you, and it can help you gauge whether or not your home purchasing goals
are realistic given your current financial situation.
Your DTI ratio is essentially a comparison of
your housing expenses and other debt versus your income. There are two
different DTI ratios that lenders consider:
Also called the housing ratio, this is the
percentage of your income that would go toward housing expenses each month,
including your mortgage payment, private mortgage insurance, property taxes,
homeowner’s insurance and association dues.12
To calculate your front-end DTI ratio, a
lender will add up your expected housing expenses and divide it by your gross
monthly income (income before taxes). The maximum front-end DTI ratio for most
mortgages is 28 percent. For an FHA-backed loan, this ratio must not exceed 31
The back-end ratio takes into account all of
your monthly debt obligations: your expected housing expenses PLUS credit card
bills, car payments, child support or alimony, student loans and any other debt
that shows up on your credit report.12
To calculate your back-end ratio, a lender
will tabulate your expected housing expenses and other monthly debt payments
and divide it by your gross monthly income (income before taxes). The maximum
back-end DTI ratio for most mortgages is 36 percent. For an FHA-backed loan,
this ratio must not exceed 41 percent.13
This handy tool will help you determine your
home purchasing power depending on your location, annual income, monthly debt
and down payment. It also offers a monthly mortgage breakdown that projects
what you would pay each month in principal and interest, property taxes, and
The Home Affordability Calculator defaults to
a back-end DTI ratio of 36 percent. If the monthly cost estimate at that ratio
is significantly higher than what you’re currently paying for housing, you need
to consider whether or not you can make up the difference each month in your
If not, you may want to lower your target
purchase price to a more conservative DTI ratio. The tool enables you to scroll
through higher and lower price points to see the impact on your monthly
payments so you can identify your ideal price point.
(Note: This tool only provides an estimate of
your purchasing power. You will need to secure pre-approval from a mortgage
lender to know your true mortgage approval amount and monthly payment
I Afford to Buy My Dream Home?
Once you have a sense of your purchasing
power, it’s time to find out which neighborhoods and types of homes you can
afford. The best way to determine this is to contact a licensed real estate
agent. We help homeowners like you every day and can send you a comprehensive
list of homes within your budget that meet your specific needs.
If there are homes within your price range and
target neighborhoods that meet your criteria—congratulations! It’s time to begin your home search.
If not, you may need to continue saving up for
a larger down payment … or adjust your search parameters to find homes that do
fit within your budget. We can help you determine the right course for you.
LAYING YOUR FOUNDATION TODAY
It’s never too early to start preparing
financially for a home purchase. These three steps will set you on the path
toward homeownership … and a secure financial future!
And if you are ready to buy now but don’t have
a perfect credit score or a big down payment, don’t get discouraged. There are
resources and options available that might make it possible for you to buy a
home sooner than you think. We can help.
find out if you’re ready to buy a house? Give us a call! We’ll help you review your options, connect you with one of our trusted
mortgage lenders, and help you determine the ideal time to begin your new home
above references an opinion and is for informational purposes only. It is not intended to be financial advice.
Consult a financial professional for advice regarding your individual needs.