Over 70% of Americans consider homeownership to be an important part of the American Dream, but buying a home can be one of the most expensive, albeit rewarding, decisions you’ll ever make.
In 2020 the economy around owning a home took off. Low mortgage rates and rising home values made it not only attractive for sellers looking to make a profit, but home buyers hoping to secure that low rate on a new home. The trend has slowed a bit in 2021 with home inventories shrinking and rates slowly starting to move back up. For those that can afford it, now still seems like a good time to buy. But there are things that you need to know before going shopping for your dream home.
Cost is a big factor. It will help to know the upfront and ongoing costs of homeownership and how they fit in with your budget.
Upfront costs may include:
0% - 20% for a down payment
2% - 5% for closing costs
$200 - $600 for inspections
Ongoing costs may include:
mortgage payments
maintenance and repairs
utilities
homeowners association or condo fees
For many people, the biggest obstacles to homeownership are low credit scores and paying off current debts. To prepare for future homeownership, you should check your credit score. Most lenders require a 680 score to qualify for a good rate and low fees. A score below 680 could result in you paying a higher interest rate and high fees to obtain a bank loan.
A post on themortgagereports.com (https://themortgagereports.com/23319/7-mortgage-programs-low-minimum-credit-score) has great information about types of loans you can obtain with a score below 680.
Improving your credit score will save you a lot of money and stress. If you need to find out what your credit score is, check your credit report for free at www.annualcreditreport.com and make sure the information on your report is accurate. Even a small difference in the interest rate could mean you pay thousands (even tens of thousands!) more or less in interest over the life of the loan.
Another factor in obtaining a mortgage is your debt-to-income ratio (DTI). DTI is the ratio of your all your monthly debts divided by your gross income. Most lenders like your DTI to be below 50% to qualify you. Focus on making on-time payments on all bills and make at least the minimum payments on your debts (but the more you can allocate toward debt payments, the more quickly your credit score may improve over time). Check out my post on why you should make more than the minimum payment on your credit card debt.
Don’t get into further debt. Examine your current spending and create a budget:
Pay down your debts to improve your debt-to-income ratio.
Save up for a down payment and other up front costs
When you’re ready to buy a home, you’ll need a big cash cushion for the down payment, closing costs, and an emergency fund to cover unexpected home repairs. If you plan to pay property taxes separately from your mortgage, you’ll need enough cash to cover one or two lump sum tax payments per year as well.
Your down payment plays an important role when you’re buying a home. A down payment is a percentage of your home’s purchase price that you pay up front when you close your home loan. Lenders often look at the down payment amount as your investment in the home. Not only will it affect how much you’ll need to borrow, it can also influence:
Whether your lender will require you to pay for private mortgage insurance (PMI). Typically, you’ll need PMI if you put down less than 20% of the home’s purchase price.
Your interest rate. Because your down payment represents your investment in the home, your lender will often offer you a lower rate if you can make a higher down payment.
So how much of a down payment will you need to make? That depends on the purchase price of your home and your loan program. Different loan programs require different percentages, usually ranging from 5% to 20%.
Loan-to-value ratio The amount of your down payment helps give your lender the loan-to-value ratio (LTV) of the property. LTV is one of the main factors – along with debt-to-income-ratio and credit score – that a lender considers when deciding whether or not to extend you credit.
Your loan-to-value ratio indicates how much you will owe on the home after your down payment, and is expressed as a percentage that shows the ratio between your home’s unpaid principal and its appraised value. The higher your down payment, the lower your loan amount will be and the lower your loan-to-value ratio will be. Here’s the formula:
Loan amount ÷ appraisal value or purchase price (whichever is less) = loan-to-value (LTV) For example:
The home you want to buy has an appraised value of $205,000, but $200,000 is the purchase price
The bank will base the loan amount on the $200,000 figure, because it’s the lower of the 2
You have $40,000 for a down payment, so you need a $160,000 loan to meet the $200,000 purchase price
Your loan-to-value equation would look like this: $160,000 ÷ $200,000 = .80
You multiply .80 by 100% and that gives you an LTV of 80%
Private mortgage insurance (PMI) If your down payment is lower than 20%, your loan-to-value ratio for conventional financing will be higher than 80%. In that case, your lender may require you to pay private mortgage insurance, because they’re lending you more money to purchase the home and increasing their potential risk of loss if the loan should go into default. Keep in mind that private mortgage insurance will increase your monthly payments.
When you consider how much to put down on your home, think about your lender’s requirements and what a higher or a lower down payment will mean for you. Is it worth it to you to pay private mortgage insurance each month in order to receive the other benefits of homeownership? Or would it make more sense for you to save for a larger down payment and avoid PMI, even if that means waiting longer to buy a home? Knowing the financial impact of each choice can help you make your decision with confidence.
If you’re having trouble saving for a down payment, you should know that certain lenders participate in programs that could enable you to qualify for down payment assistance. Ask your lender whether you might qualify for one of these programs.
