Purchasing a home is an exciting, yet stressful, time of life. Whether you are buying your first home or your fifth, there is much work to be done before you get to the closing table that can help smooth over the process and create a sense of ease and confidence as you make one of the largest purchases of your life. The best way to set yourself up for success in purchasing a home is to be sure that you have prepared your finances accordingly. We are going to review 3 key areas to consider when preparing to purchase a home: income, debt, and savings.
Income is arguably the most vital element when it comes to purchasing a home. It should be said that income is not relevant for folks who purchase their homes completely with cash, but the vast majority of people pursue a mortgage to help them purchase a home. Thus, most people find that their income is crucial to getting approved for a mortgage and moving forward with the purchase of their home. One of the main formulas that a mortgage professional is going to use to determine if you are eligible for a loan is called the debt-to-income ratio, or DTI. Your debt-to-income ratio is calculated by adding up all of your monthly debt payments, like student loans, car payments, and credit cards, and then dividing that total monthly debt obligation by your total monthly income. Increasing your income, even by a small amount, can lower your DTI and give you a better chance of being approved for a loan.
A helpful thing to know about different types of income is that full-time salary income is less complicated to use when applying for a home loan than commission-based income or self-employed income. This is because you can use full-time salary income to qualify for a loan as soon as you receive your first paycheck, even if you do not have a long work history at your current job. No matter what sort of income you receive, lenders are always going to ask for a 2-year work history when you apply for a loan, so it is best if you are able to stay consistently employed. If a mortgage underwriter sees that you are losing or quitting jobs frequently, that gives them grounds to deny your loan because it makes you seem like a risky borrower.
If you are self-employed or in a commission-based job, the mortgage underwriter is going to look at your income over the last two years and average it out. That means if you started your business two years ago and made $10,000 in your first year and $70,000 in your second year, the underwriter will average the last two years and calculate your average income as $40,000/year. Additionally, if you have only been doing your business for 18 months, you will not be able to use your business income to help you qualify until you have been doing that job for 2 full years. The same goes for part-time work and overtime pay, each of which must have a two-year history before it can be used to help you qualify. Because of this, it is best to plan ahead regarding your income when purchasing a home. If you currently have a salaried job but want to start your own business, it might be best for you to purchase a home before you make that change or you will have to wait 2 full years to use your self-employed income. Or maybe you have been working an additional part-time job for the last 20 months to help you save up, you might want to wait 4 more months to purchase a home because then you can use your part-time income to help you qualify.
The next critical element of preparing your finances for the purchase of a home is your debt. As mentioned before, your debt is used to calculate your debt-to-income ratio as a part of getting approved for a loan. Any opportunity you have to decrease your debt can help lower your DTI and give you better odds of loan approval or even allow you to be approved for a larger loan than you originally thought. When getting a mortgage, the main factor taken into account with your debt is your monthly debt obligation, or how much you have to spend every month on all of your required debt payments. Knowing this can help you focus your resources where they can have the biggest impact. It may be better for you to pay off a smaller debt where you can get rid of a monthly payment than to pay towards a larger debt where the monthly payment will stay the same. Both can bring peace of mind, but eliminating the small monthly payment will increase your chances of loan approval.
Finally, the third critical element of preparing your finances for buying a home is your savings. It is important for you to know ahead of time how much money it will actually cost to purchase a home. There are some loans that allow 0% down payments that are most often reserved for military veterans or housing in very rural areas, so most people end up needing a down payment between 3-5% of the purchase price of the home. On top of the down payment, you will need to have funds available for closing costs. Closing costs include things like the appraisal, title insurance, recording of the deed, and loan origination expenses that typically add up to about 3-4% of the purchase price of the home. That means you will want to have saved up between 6-9% of the purchase price of the home. As you can see, this is far below the often-referenced myth of a required 20% down payment, but it may be more than you see promoted on flashy advertisements that say “buy a home with 3.5% down” and forget to mention the closing costs.
As a friendly reminder, you will want to have some funds set aside to either pay for movers or at least buy pizza and drinks for your friends that come to help.
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