As the housing market rebounds and home prices—and interest rates—start to rise again, now would be a good time to start thinking about getting into your own home. Finding the house you like in the neighborhood you like is still the paramount consideration, but financial considerations are also a big part of the equation.
How do you know if you’re ready to take the plunge? To start, here are 3 important questions you’ll need to answer before getting serious about buying a home.
1. Do you understand your credit history?
Your credit rating is important, but lenders will be looking at your entire credit history when considering you for a loan. How you stack up determines not just whether you will get a loan but how much you will have to pay for it.
The good news is that a rebounding housing market also means somewhat easier terms to qualify for a mortgage. Immediately after the mortgage crisis of 2008, even people with good credit scores in the 700s sometimes had trouble getting loans. Currently, the minimum score for someone applying for a conventional mortgage—one that will be backed by the federal agencies Fannie Mae and Freddie Mac—is 620.
But if your score tracks lower than that, don’t despair. The minimum score for Federal Housing Administration (FHA) loans can be as low as 500 in some cases. And there are ways to massage your credit score before embarking on your housing search.
Beyond just the score, potential lenders will be looking at your debt-to-income ratio—that is, what percentage of your pretax gross monthly income goes to paying existing debt—as well as your employment history. They are looking to see if you can make the monthly mortgage payments and are likely to remain so over the 15-30-year life of the loan. A desirable debt-to-income ratio, including the new mortgage payment, is about 36%. The housing-to-income ratio itself should be about 28%. Note that these are just guidelines and are not carved in stone.
2. Do you know how much you can really spend?
One of the big mistakes home purchasers made in the run-up to the 2008 financial crisis was to borrow the maximum lenders said they were allowed. For many reasons, banks were eager to lend the money and sometimes even bent their lending criteria to encourage people to borrow. Adjustable-rate loans with teaser rates to start often lured borrowers into loans that were too much for them once the artificially low rate expired. That is less the case now but it’s important to remember that ultimately it is you who has to take the responsibility for a loan.
The debt-to-income ratio is a useful guideline, but, there are many other monthly expenses to take into account—groceries, childcare, clothing, transportation, internet-cable, travel, entertainment and others. If you don’t already budget your monthly expenses, it would be useful to do a reality check on where your monthly income goes. On the other hand, the deduction for mortgage interest will reduce your tax bill, allowing you in some cases to reduce your withholding and increase your take-home pay.
Besides the actual price of the home—which may be above or below the listing price, depending on the local real estate market—there are several other considerations in computing the monthly cost.
Among the variables to consider are a 15-year versus a 30-year mortgage. The shorter term will mean higher monthly payments, but you will pay off the loan more quickly, build up equity much faster and pay far less in interest over the life of the loan. Then there is the question of a fixed-rate mortgage over adjustable rate. The adjustable rate will be lower at the beginning because it is less risk for the lender, but it could go higher, even much higher, as the loan rate is adjusted to market conditions over its life. Most borrowers have taken advantage of the historically low rates in recent years to opt for fixed rate to lock in a good rate for the life of the loan.
How much money you can put down can also affect the amount of the mortgage and the monthly payment. If you can put down the ideal 20%, then you can also save the cost of mortgage insurance, which the lender will require when the down payment falls below that threshold. In any case, it is difficult to get a conventional mortgage with less than 10% down. FHA loans, which are insured by the federal government, require only 3.5% down. Loans through the Veterans Administration sometimes require no money down at all.
The rate you get will depend on your credit score, your credit and employment history, any other assets you may have and other financial considerations. If you don’t get the best rate, you can still lower it by purchasing “points”—upfront money to lower your interest expense. Points are 1% of the purchase price and you can purchase up to 4 points. Unlike the down payment, the points are tax-deductible because these represent prepaid interest. Whether you go this route or not depends on how much money you can put down at closing and how long you plan to be in the house. It can take several years to recoup the saved interest from buying points, so it is probably not a good option if you think you will be moving in a few years.
It’s important to keep in mind that property taxes and homeowners’ insurance will also be part of your monthly payment, feeding into an escrow account to make the payments for these when they fall due.
Finally, the dreaded closing costs. The buyer can expect to pay from 3% to 5% of home’s price in closing costs. These include such things as attorney fees, title transfer, mortgage fees, points, prepayments for the initial mortgage and escrow charges, and other fees and charges. Lenders are required to provide a “good faith estimate” of these charges when you apply for a loan so there are no nasty surprises. Buyers are largely spared the commissions for the real estate brokers—even the buyer’s broker—since these are usually paid by the seller.
3. Can you cover the “extra” expenses?
The 1986 comedy “The Money Pit” still pops up on cable because the nightmare vision of what can happen to new, unsuspecting homeowners is still very relevant. Your home inspection might tell you the roof is OK, but not necessarily that it will need repair within a year. Or the HVAC. Or any of the multitude of things that keep a home functioning and comfortable. Older houses—especially those described as “fixer-uppers”—may need substantial renovation to meet your expectations. In short, you want to be careful not to totally deplete your resources in buying the house because you may be facing significant maintenance costs sooner than you think. Some loans will provide extra funds for renovation, or a separate home equity line of credit may be available.
There are many costs associated with moving into a house beyond the purchase price and closing costs. There are the moving costs themselves, but also the costs for additional furniture and furnishings. Bathrooms, kitchens, plumbing or electricity may require updating or upgrading. Outside the house, too, there may be urgent landscaping issues or repairs needed for fences, sidewalks, driveways and more.
There are various rules of thumb for how much home maintenance might cost. One is 1% of the purchase price per year on average. Another is $1 per square foot a year on average. But these are just rules of thumb and actual costs could diverge substantially depending on the age of the home and previous maintenance.