Purchasing a home is one of the most complex and costly transactions you may ever make. If you’re considering taking this step in the next year or two, preparing your finances now can save you money and prevent surprises. “Time is a gift,” says Avi Adler, a Realtor with Long & Foster Real Estate.
Here are five steps to help you prepare:
- Review your financial situation: Before searching for your dream home, assess your income, savings, expenses, and debt. Determine what percentage of your gross income you save monthly, how much goes toward housing, what you pay in debts (such as credit cards, car loans, student loans), and how much you spend on non-essential items (e.g., travel, entertainment, dining out, streaming services). Mortgage lenders will assess various metrics, but debt-to-income ratio (DTI) is crucial. Ideally, housing and other debts shouldn’t exceed 43% of your gross income, with 35% or lower being preferable. Housing payments alone shouldn’t be more than 28% of your income. If your current budget surpasses these limits, “review your priorities and see if there are expenses you can reduce since buying a home is a major goal now,” advises Sara Zuckerman, certified financial planner and founder of Reset Financial Planning.
- Check your credit reports and scores: Lenders also look at your credit history and score. Start by reviewing your credit reports, available for free from Equifax, Experian, and TransUnion via annualcreditreport.com. “This helps you understand your credit health and check for fraud or inaccuracies,” says Margaret Poe, head of consumer credit education at TransUnion. Dispute any errors as needed. Next, obtain your credit score, particularly your FICO score, which lenders typically use. Scores above 720 qualify for the best rates, while scores below 620 can make securing a loan challenging. If buying with a partner, lenders might consider the lowest score. Improving your credit score, such as by reducing credit card debt, can make a significant difference in your mortgage payments.
- Lower credit card utilization: Pay off outstanding balances and avoid large purchases that use a high percentage of your credit limit before applying for a mortgage. Even if you regularly pay off your card, lenders may check your score before your payment is recorded, which could affect your rating. Keeping credit usage low leading up to your home purchase is essential. Additionally, avoid opening new credit accounts for at least a year before seeking a mortgage.
- Budget for a down payment, closing costs, and post-purchase expenses: A larger down payment reduces your mortgage amount, so keep your savings in a high-yield account or short-term CD. While a 20% down payment is the gold standard, consider other funding sources if needed, such as family gifts or homebuyer assistance programs. Closing costs, ranging from 2% to 4% of the purchase price, will also be due before the transaction completes. Lastly, remember to budget for ongoing living expenses, including utilities and home maintenance, once you’ve bought the property.
- Consult lenders and get pre-approved: Lenders will determine how much house you can afford and what your monthly payments will be. Seek preliminary input from multiple lenders, and once ready, secure a mortgage pre-approval letter, which typically lasts for 60-90 days.
