When you're considering buying your first home, you're probably full of excitement about achieving the American dream. Unfortunately, this dream could turn into a nightmare if you haven't made sure that you're financially ready for the costs of becoming a homeowner. You don't want to fall in love with a house before you've done the practical thing and made certain you're prepared for home ownership. Before you call a realtor, take these 5 steps to get all your ducks in a row:
1. Calculate what you can comfortably spend
The last thing you want to do is make yourself "house poor" by spending more of your income on a home purchase than you should. The "affordability standard" for housing is that you should spend no more than 30% of your income on housing costs (including insurance and property taxes), while many mortgage lenders prefer that your housing cost is no greater than 28% of your income.
Your outstanding debts can also impact the amount you can spend on a home. Most lenders want a total debt-to-income ratio—including your mortgage payments and other debts—to be around 36% or less, although you can still get a standard mortgage with a ratio as high as 43%.
This means if your income is $50,000, you could reasonably afford about $1,170 per month for your total housing costs if you stuck to the 28% rule—assuming you didn't have a substantial amount of other debt that would push your total monthly payments above the recommended 36% of income. If we also assume you can pay 20% down and qualify for an interest rate of 4%, then you could potentially afford a home price of up to $250,000. That may or may not be a realistic price in your area, and you may want to aim lower if you have other sizable debts.
2. Save a down payment of 20%
In our example above, we factored in having a 20% down payment when calculating the price of the home you could afford. Paying at least 20% of the value of the home up front is vital because it allows you to avoid private mortgage insurance (PMI). PMI insures your lender in the event that you're unable to make payments and the lender must foreclose on you. On a $200,000 loan, PMI could cost you $100 a month or more, depending on how much you paid up front—and you could be paying it for several years.
You're stuck with PMI until you pay your loan down to 78% or less of the home's original value. Once you prove to your lender that you've reached that milestone, your lender is required to drop the PMI requirement.
If you don't have a down payment, not only will you waste thousands of dollars on PMI and additional interest payments, but you'll also put yourself at substantial risk. When you make a 20% down payment on a home, the value of the house would have to fall more than 20% for the home to be worth less than you owe on it. If you only make a tiny down payment, however, even a slight downturn in the market could mean you're underwater—i.e., your home is worth less than you still owe the bank. This makes it difficult or impossible to sell unless you can bring cash to the real estate closing for the difference between what your house sells for and what you still owe.
3. Save an emergency fund of 3 to 6 months' worth of living expenses
When you're a homeowner, you are responsible for everything that goes wrong in your house. Instead of calling a landlord when the furnace breaks or the pipes freeze, you have to call—and pay for—a repairman. If the problems are costly to fix, or can't be fixed, you're the one on the hook. If you don't have money set aside to cover maintenance, repairs, and replacements, then you'll have to use credit. You don't want to be paying interest on your new fridge for the next 10 years, so make sure you have an emergency fund to cover the many costs of being a homeowner.
Not only can an emergency fund help you pay for surprise repairs, but it can also ensure that you don't lose your home in the event that an illness, job loss, or other crisis puts a major strain on your household finances. If you cannot pay your mortgage because your income has taken a hit, you could be foreclosed on, lose your house, and end up with ruined credit. You don't want this to happen, so save up enough money to pay the mortgage for several months in case something goes wrong.
4. Get pre-approved for a mortgage loan
When you have your financial house in order, it's time to prove to the bank that you're ready for the responsibility of taking on a mortgage. You want to get pre-approved by your chosen financial institution before you start shopping for a home. Getting pre-approved means you'll have a clear idea of what the bank will lend you so you don't shop outside of your price range. You'll also be taken much more seriously by real estate agents and any potential sellers to whom you make an offer. Some sellers won't even consider offers from someone who isn't pre-approved because there's no way to know whether the financing will be available to complete the sale.
If you want your bids to be competitive and you want to know you're shopping for houses that are priced right, provide your financial information to the bank before you start house shopping and get a pre-approval letter to take with you.
5. Find a buyer's agent
Although you can technically buy a house without an agent, it's usually a bad idea to try it, especially if it's your first home. An agent can help you spot red flags that should send you running away from a prospective home. Agents know the market and can help you make a reasonable offer so you don't overpay, and they can also guide you through the steps of the buying process, like getting a home inspection.
You'll want to be sure you find a buyer's agent, rather than letting the seller's agent represent both you and the seller. A buyer's agent is focused only on your interests and has lots of experience helping home buyers find the house of their dreams. If you've already made sure you're financially ready before calling a realtor, your agent can help you make the buying process low-stress and successful.