Homeownership can be a fantastic investment over the long term. The idea is that you lock in the price of your home, pay it down over time, and the value of your home should increase. The goal is that by the time you near retirement, your home may be nearly or completely paid off, and it has increased in value.
However, this long-term investment comes with one important factor: you will be able to maintain monthly payments, as well as needed maintenance on the home, without stretching yourself financially thin. This is typically considered spending more than 30% of your income to housing costs, and now, more than 25% of middle-class households are in this category.
This is a slippery slope. If someone loses work or an unexpected bill comes up, it could put a household in a financial bind. To avoid this, it’s vital to run the numbers to see if you’re financially ready to dive into homeownership. Here are the financial aspects to consider when evaluating if you’re ready to be a homeowner:
Credit score and credit report
Your credit score is your financial report card given to you by banks. A credit score can range from 300-850, the higher it is, the better. And when it comes to buying a house, a higher credit score will likely give you a lower interest rate on a mortgage.
A credit report is a detailed list of all your credit activities, with both good and bad remarks. This is what banks will refer to when you’re looking for a mortgage lender.
Even if you decide that homeownership isn’t the best option, it’s important to look at this report at least yearly. This is because there may be errors on your credit report that are negatively impacting your chances of qualifying for a mortgage, credit card, auto loan, or other financial product. You can get your credit report annually for free here. If you happen to find an error, it’s best to report it to the correct credit reporting agency.
Debt-to income
One of the first metrics a bank or other financial institution will measure is your debt-to-income ratio. This is calculating your gross income against how much debt you currently have. Here’s how it works:
Let’s say you make $4,000 per month. If you currently have $1,000 in debt payments between a car loan and credit cards, your DTI is 25%. Lenders want to see potential home buyers stay under 43%. So if you’re currently close to 43%, it’s probably best to pay down your existing debt before taking on a home loan.
Saving for a home
If the previous two points are an easy hurdle, that’s a good sign. Now, it’s evaluating how much you have saved up for the upfront costs. These include the initial down payment and closing costs. This will vary widely based on how much you plan on spending on your home purchase. A down payment can range anywhere from 3-20%, and closing costs are typically 3-5% of the home price.
So if you aim to purchase a $400,000 home, you will need:
Between $6,000 and $80,000 for a down payment
Between $12,000 and $20,000 for closing costs
It can be tempting to keep your down payment as small as possible, but this will likely bring your monthly payment higher. So the more you can put down, the less your monthly payment will be.
