Buying a home is likely one of the most complex and expensive transactions you’ll ever make.
If you think you’ll want to make that leap in the next year or two, you can save yourself real money and avoid unpleasant surprises if you use the next several months to prepare your finances and explore your options.
“Time is a gift,” said Avi Adler, a Realtor at Long & Foster Real Estate.
Here are five steps to get you started.
Before hunting for your dream home, take stock of your income, savings, expenses and debt.
Figure out what percentage of your gross income you save every month, how much goes to housing, what you pay in debt (credit cards, car loans, student loans, etc.) and how much you spend on discretionary items (like travel, entertainment, dining out and streaming services).
Mortgage lenders will consider lots of different metrics and circumstances when assessing your creditworthiness. But debt to income (DTI) is a big one. Ideally, you want to spend no more than 43% of your gross income on housing and other debt, and preferably no more than 35%. And, optimally, your housing payments alone won’t exceed 28% of your income.
But if you’re well above those thresholds before even shopping for a new place, “Look at your budget and figure out what your priority is. Are there expenses you can cut because buying a house is a bigger goal for you now?” said certified financial planner Sara Zuckerman, founder of Reset Financial Planning.
2. Check your credit reports and credit scores
Two other factors lenders will consider are your credit history and credit score.
First, check your credit reports. You can get free copies from each of the three major credit bureaus (Equifax, Experian and TransUnion) through annualcreditreport.com.
“Doing so allows you to better understand your current credit health and check for any potential fraud or inaccuracies,” said Margaret Poe, head of consumer credit education at TransUnion. If you find something wrong, you can dispute it, Poe said, and the dispute investigation can take up to 30 days.
(Use this list from the Consumer Financial Protection Bureau to see what to check in your credit report and how best to report mistakes you find.)
Next, order your credit score. The scores most commonly used by mortgage lenders come from FICO. You can get a free FICO score based off your Equifax report; or, for $29.95, you can get FICO scores based on each of the credit bureau’s reports, which include FICO scores specific for mortgage lending considerations. (Unless you want to pay for monthly updates, cancel your subscription after making your first purchase; otherwise, it will automatically renew.)
Typically, you’ll get the best mortgage rates if your FICO score is 720 or higher. If it’s below 620 it will be much harder to secure a loan. If you’re buying a home with someone else, the lender may consider the lowest score between you, said Eddie Seiler, an associate vice president at the Mortgage Bankers Association.
“The good news is that your FICO score is dynamic, and it changes with your credit behavior, so your FICO score today doesn’t have to be your FICO score tomorrow,” said Joe Zeibert, the company’s vice president of mortgage and capital markets.
The difference in your mortgage payments when you secure a loan with a high score versus a low one can be significant. “You’re talking several hundred dollars a month,” Adler said.
A key way to improve your credit score is to reduce your credit card debt. That means paying off any balance you’re carrying, and then paying off future charges in full and on time every month.
You also want to avoid making big purchases or otherwise using up a large percentage of your credit limit before seeking a mortgage.
Here’s why: Even if you always pay your credit card off every month, that won’t necessarily be reflected in the instant score lenders may pull up, especially if they do so before your bill is due or your payment is received. “The minute they pull your credit score, it is going to [reflect] what is on my credit card that day,” MBA’s Seiler said.
So how long should you use your credit card sparingly? “Because there are many variables that affect an individual consumer’s credit score, we can’t say a specific number of months,” FICO’s Zeibert said. “The advice we can give is to do your best to get your utilization as low as possible leading up the purchase of your home.”
Another tip: Don’t open new lines of credit like store cards for at least a year before seeking a mortgage. “They look at the average age of [a credit account],” Seiler said, noting that new credit lines may suggest you’re under financial stress.
4. Budget for a down payment, closing costs and your expenses after buying a home
Another way to reduce your monthly mortgage payment is to make as big a down payment as possible. The bigger your down payment, the less you need to borrow.
Whatever money you have set aside for that purpose should be in a high-yield savings account or very short-term CD so that you can earn a reasonable return before you start home shopping, Zuckerman said.
While 20% of a home’s purchase price is still the down payment gold standard, if your savings fall short of that, consider other funding sources that may be available to you. While a gift from family or tapping your retirement savings may be options, also look into whether you qualify for any state-based home-buying assistance programs.
Another expense that will come due before your home purchase is finished is closing costs, which conservatively might range between 2% to 4% of the purchase price, Adler said. While you may be able to roll that amount into the mortgage, it will be less expensive if you can just pay them out of pocket, but you will need to budget for that. Or, if you qualify for a homebuyer assistance program, some of them may pick up as much as 80% of the closing cost tab, depending on your income, Adler noted.
Lastly, don’t forget to budget for your living expenses after finally closing on your house. “Think through not just the mortgage but the costs after,” Zuckerman said.
After making your mortgage payment (which includes interest, property taxes and insurance every month), you will need money to pay all your other bills, plus home maintenance and utilities.
Deciding how much house you can afford ultimately is not just about the mortage. “It’s about affording the home once you’re in it,” Seiler said.
(To help you think through these and other issues, you might seek advice from a housing counselor near you.)
Since lenders will ultimately determine how much home you can buy and what your monthly payments will be, get a few lenders’ preliminary takes on your situation, Adler recommended.
Ultimately, he said, you’ll want to get a mortgage pre-approval letter, but not before you’re ready to shop in earnest, because they usually are only good for 60 to 90 days.
