Should I Buy a Home?
- Take the necessary steps early to review your credit reports to correct errors and improve your score. Timely payments and reduced debt balances pay dividends in the home buying process.
- Whether you are seeking a mortgage of many hundreds of thousands of dollars or something more modest, there are numerous financing options available to meet your needs.
- Down payment assistance in the form of homebuyer grants and closing cost assistance can be a great way to help close financial gaps.
So after giving it a lot of thought, making a short list of your favorite neighborhoods, checking and re-checking your finances, you’re ready to transition from renting to owning.
Congratulations! Homeownership is a big decision, and whether you’re looking to move near-term or further down the road, you’ve already taken the most important step of beginning the planning process. Before you start packing your boxes, let’s step back and review the five steps that every aspiring homeowner should take.
Determine Your Home-Buying Budget
Determining your home buying budget, sometimes referred to as the amount of house you can afford, is one of the first steps on your home-buying journey. This budget defines the maximum percentage of your gross income that you can spend on monthly housing expenses, and by extension, your maximum mortgage.
A useful rule of thumb in determining this amount is the '28/36' rule. The 28/36 rule outlines how much debt you can take on relative to your gross income and still be approved for a traditional mortgage.
The ‘28’ part of the rule is the maximum percentage of monthly gross income that you should spend on required housing expenses. This includes your mortgage payment, property taxes, insurance, and any homeowner association fees that might apply such as common maintenance fees for a condo or a townhome, or subdivision fees for a single-family home.
Gross monthly income is defined as your pre-tax income before income taxes, social security contributions, health insurance premiums, or other deductions are taken out.
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Using an example, imagine that your annual salary is $120,000, which translates into a monthly gross income of $10,000 per month. The ‘28’ part of the rule would then say that your mortgage plus your property insurance, property taxes, and homeowner association fees should be no more than 28% of $10,000, or $2,800. Importantly, unlike most exams where your goal is a high score, under the 28/36 test, your performance strengthens as your score decreases, from 27% to 26%, to 25%, and so on.
Recommended Read: Mortgage Pre-Qualification vs. Pre-Approval
The second half of the 28/36 rule is the ‘36’ portion. The ‘36’ component caps your total monthly debt payments relative to your gross income. Meaning, no more than 36% of your gross income should be spent on debt— from your mortgage to your car note to credit card payments and everything in between. In short, if it’s a required debt payment, it counts towards the 36% cap.
So again using the example of the monthly gross income of $10,000, the 36% test says that your mortgage plus all debt payments cannot exceed 36% of $10,000, or $3,600 a month. Anything higher than that potentially disqualifies you from a standard mortgage, requiring you to consider other mortgage options.
Determine Which Mortgage Works Best
The most common type of mortgage is a conventional loan mortgage. Conventional mortgages work well for homebuyers with a minimum FICO credit score of 620-640. The popularity of traditional mortgages is largely due to their low down payment requirement of as little as 3%.
Conventional mortgages are available for virtually all home types, from single and small multi-families of up to four units to townhomes and condos. Additionally, conventional mortgages can be used for fixed interest rates and adjustable-rate loans.
Federal Housing Administration (FHA) Loan
If your credit score is below the 620-640 range, a viable mortgage option is an Federal Housing Administration (FHA) loan. Loans insured by the Federal Housing Administration are designed to assist low and moderate-income borrowers.
Borrowers with a credit score of 580 or higher are eligible to make a 3.5% down payment, and borrowers with a credit score of 500 to 579 can qualify with a down payment of 10%.
Veteran’s Administration (VA) Loan
If you are a veteran, a surviving spouse of a veteran, or a member of the National Guard or Reserves, then, subject to minimum service periods and other requirements, a Veteran’s Administration (VA) loan is an ideal choice. VA loans, which are guaranteed by the Veterans Administration, offer several benefits including no down payment, no minimum required credit score, no maximum loan amount, and no private mortgage insurance requirements.
Jumbo loans should be considered if you are buying a house that costs more than $647,200 in most areas of the country, with the exception of certain high-priced areas where the jumbo loan threshold is $970,800. Jumbo home loans generally require minimum FICO scores upwards of 700 along with a larger down payment.
Strengthen Your Credit Score
Credit scores, which are used to determine credit card and auto loan interest rates, have their biggest impact on mortgages, both in terms of the required down payment amount and the interest rate. As such, reacquainting yourself with your credit score and making improvements where possible is a high priority.
Credit score reports from credit reporting agencies are a good place to start in identifying errors and arming yourself with banking and other statements to dispute them. Once you’ve updated your credit reports, you can make additional enhancements to your score by paying down balances on credit cards and other debt and paying monthly bills on time.
Recommended Read: Tips on How To Improve Your Credit Score
Build a Homeownership Budget
When buying a home, attention is often focused on those costs incurred at the front end of the buying process, most notably, the down payment. But the expense of homeownership and how much to budget for home repairs can sometimes be overlooked in the process, particularly for new homeowners making the transition from renting.
One rule of thumb that’s used to help estimate the amount that should be set aside for maintenance is the 1% rule. Under the 1% rule, multiply the cost of your house by 1% and set aside this amount every year in a bank account to pay for routine and unexpected repairs.
For example, if the cost of your house was $200,000, then you would set aside 1% of $200,000, or $2,000, each year for maintenance. Like any good guideline, the amount you reserve should be adjusted based on your real-world circumstances. Older houses, houses with an older roof, or homes that have furnaces or hot water heaters that are on their last legs, should budget a higher percentage of closer to 3-4%.
Down Payment Assistance
Down payment assistance programs exist in every state and are usually offered at the state, county, and city levels. Down payment assistance, in the form of grants, forgivable loans, and deferred loans, is mainly directed towards first-time home-buyers, which are homebuyers who have not purchased a home recently or ever.
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For instance, in 3-5 years, or who have not bought a home in the target city, county, or state associated with the program, may qualify. The amount of assistance varies widely by location and can be determined through a conversation with your lender along with your own online research.
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