Homeownership. It’s the American dream. It is also the biggest investment most people will make in their lifetime. Consider, the median price for a starter home in the first quarter of 2020 was $233,400. Making the dream a reality is a major financial commitment that requires goal-setting, research and planning. Where should your journey to homeownership begin? Here are three good places to start.
#1. Know how much you can afford.
One of the biggest mistakes is buying more home than you can afford. It’s a risky decision that can ruin your financial health.
So, where do you begin? First, determine a monthly mortgage payment range you can comfortably afford. A popular point of reference says it should not exceed 35 percent of your gross monthly income. Your current rent payment is another good place to start.
Next, take into consideration your personal financial situation. Do you have significant credit card debt or other financial obligations such as a student loan or a car loan? Are you planning to start a family in the near future? Do you enjoy expensive hobbies or luxury vacations?
Use this information to calculate what mortgage lenders call a debt-to-income ratio to determine how much of a home loan you can afford. Add up all of your monthly debt payments and divide them by your gross monthly income (the amount of money you earn before taxes and other deductions are taken out). For example, if you pay $1,500/month for your mortgage, $350/month for a car loan and $400/month for the rest of your debts, your monthly debt payments are $2,250. If your gross monthly income is $6,000, then your debt-to-income ratio is 37.5 percent.
#2. Know your credit score.
Along with a low debt-to-income ratio, mortgage lenders also look at a number of other factors when determining loan qualification and interest rate, including credit scores and job history. A higher (meaning “better”) credit score can lower the interest rate for a conventional loan, resulting in a lower monthly mortgage payment and huge savings over the life of the loan.
NerdWallet does the math to illustrate how a 100-point difference in credit scores can affect a mortgage payment. Take a 30-year, fixed-rate loan of $240,000. A 780 FICO credit score might get you a 4% interest rate and monthly payment of about $1,164 a month, not including taxes, insurance or homeowners’ association fees.
Conversely, a FICO credit score in the 680-699 range could increase your interest rate to about 4.5% and the monthly payment would jump to $1,216. A difference of $52 a month may not seem like much, but over the course of a 30-year loan, it could add up to more than $25,000.
You can get free copies of your credit reports once a year from each of the major credit reporting bureaus by visiting www.AnnualCreditReport.com. If your score is not where you want it to be, use these 4 steps to improve your credit score before applying for a home loan.
#3. Know the hidden costs of homeownership.
You can expect that the costs associated with buying your new home will be clearly explained along the way, beginning with the real estate agent and up to the mortgage closing. The base costs of a home loan are the principal, interest, taxes and insurance. Then, there is the cash needed for the down payment – ideally 20 percent of the home price – plus closing costs and possibly inspection and appraisal fees.
Once you have the keys to your new home, buyer beware. The cost of owning a home doesn’t end with your mortgage loan. Financial experts recommend budgeting 1-2 percent of your mortgage balance as a yearly maintenance and repair fund.
The true costs of owning a home include many expenses that first-time home buyers never had to consider as renters. Here are just a few of the hidden costs of homeownership to consider when budgeting for a future home purchase:
- Homeowners’ association and condo fees: If your home is part of a homeowners’ or condominium association, you will be required to pay a monthly or quarterly fee. The association also can charge a special assessment for projects such as repaving a parking lot or repairing a roof.
- Lawn care: Whether you hire a professional or handle the yard work yourself, there will be costs involved. Basic gas-powered lawn mowers start at $230 or more; not to mention other lawn needs such as edgers, leaf or snow blowers, fertilizers and miscellaneous hand tools.
- Maintenance and repair costs: These can be as wide ranging and unexpected as plumbing and electrical repairs, gutter and chimney cleaning, replacing a roof or removing a dead tree.
The possibilities are really endless. Here are some money-saving strategies for 12 more top costs that new homeowners face.
Whether your American dream has a white picket fence or high-rise view of downtown, Dorothy was right: There’s no place like home. Having a financial management plan that can make your dream a reality is priceless.