Lenders give lower rates to borrowers with the lowest amount of debt, highest credit scores, and sizable down payments. Preparing financially ahead of time will help you avoid unexpected costs, get the best rates, and make the right choice about what home to buy.
Focus on these four major areas now to financially prepare for a home purchase:
- your credit score
- how much you can afford
- saving your down payment
- and accounting for closing costs
- Check on your credit score
You’ll want to know what your credit score is and take any necessary steps to give it a boost before jumping into searching for homes. Your credit score will be a key indicator that mortgage lenders use to determine how much you qualify for and what your interest rate will look like.
You can get one free copy of your credit report per year at annualcreditreport.com.
Your lender will likely take both yours and your spouse’s credit score into account, so make sure to check both if you’re married or have another co-buyer.
Most lenders are looking for a credit score of 640 or higher. However, the Federal Housing Administration (FHA) does offer financing options to borrowers with a score as low as 500.
If your score is low, take steps to improve it. A few simple tips are to pay off your current credit card balances, stop using them completely for two months before applying for a mortgage, and avoid applying for any new cards or loans until after closing.
There are plenty of other strategies for giving your credit score a boost, too. This article from MoneyUnder30 walks you through how to raise yours step by step.
- Figure out how much you can afford
A crucial first step is to determine how much house you can actually afford. Taking the time to crunch the numbers now will give you an idea of what kinds of homes you should be looking at, how big of a loan you will need to take out, and how much you’ll be putting down.
If you’re currently renting, you might want to consider whether buying a home is a better choice financially, or if it’s better to continue renting. Use the Home Buyer Guidance Rent vs. Buy Calculator to help you compare the total cost of renting vs. buying over a period of time.
Our Affordability Calculator helps figure out how much house you can afford taking into consideration your location, income, down payment, monthly debt, and credit score.
You can also use our Mortgage Calculator to get an estimate of how much you can expect to be paying monthly based on your home value, down payment, interest rate, and other details.
An important metric you’ll want to know about is the DTI ratio. This compares your total monthly debts, including mortgage and insurance payments, to your monthly pre-tax income. Lenders use your DTI ratio to determine how much you can borrow.
Generally, your housing expenses shouldn’t exceed 28% of your monthly income, so the max DTI you want to have is 28%. You can figure out yours with this calculator.
You can also use the debt-to-income ratio in reverse to figure out what your house budget should be by multiplying your income by 0.28.
- Save a down payment
Although it’s possible to buy a home with a small down payment (or even none at all), the bigger payment you are able to make, the better the mortgage rate you’ll be able to get. Lenders look at your LTV, or loan-to-value ratio, which is affected by your down payment. The more you put down, the lower your LTV.
Generally, it’s best to aim for putting 20% (or even more) of the purchase price down to get the best rates from lenders. However, you can still be approved with smaller down payments, in some cases down to 3.5%. One thing to note is that for smaller down payments, you will likely need to get PMI (private mortgage insurance).
With an FHA mortgage, you’ll need to put down 10% if your credit score is 500-580, or as little as 3.5% if your credit score is over 580.
If you or your spouse is an eligible active duty or retired service member, you can qualify for zero down payment Mortgage from VA.
- Be ready to pay closing costs and other expenses
In addition to your down payment, you’ll also need to be ready to pay between 1-3% of the loan amount in closing costs and fees. Don’t overlook saving this extra chunk of money to have on hand when it’s time to seal the deal!
Taking the time to think about what your budget should look like and to get your finances in order now will pay off down the road by reducing the amount of interest you pay. You’ll also be putting yourself ahead of other less prepared buyers in a competitive market by taking these steps before diving into the home search.
Next up:
In the next part of this series, we cover how to find a realtor, plus alternatives for home buying without an agent.