Shannon McLay is a financial planner who left a “traditional” financial services firm to start her own company, NextGen Financial, to help clients in their 20s and 30s get financially fit. Through her blog, Financially Blonde, her book and her company, Shannon is committed to making financial fitness fun, easy and accessible for others. If you would like your personal finance story or article to be feature on Vosa let me know here.
The American dream of homeownership took a turn for the dramatic in 2008 with the blow up of Bear Sterns and the realization that home mortgages (albeit subprime or low quality mortgages) could take down the entire banking system in the United States.
As most extremes lead to other extremes, this catastrophe led to increased and tighter regulations where mortgages were concerned. We went from an environment where anyone with a social security number could get a mortgage to a high level of scrutiny for even the highest credit quality applicants.
As a financial advisor, I have witnessed the pain of home buying or re-financings alongside my clients. And after witnessing the challenges, I want to make sure that others are prepared for the process if they are about to go through it. The best way to tackle any challenge is to prepare for it, and here are some steps I believe everyone needs to go through before buying a home.
5 Things You Must Do Before Buying a Home
1. Ask yourself, are you ready for homeownership?
I know this sounds like a flippant question, but it is actually the most important step of the process. Other than having a child and getting married, buying a home is one of the most emotional financial decisions you will make. And when emotions are on the line, it is important to truly think through the process rationally.
Two clients of mine recently had their first child, and they felt as though they needed to provide a larger home for the child. Even though, she could barely walk, this child was impacting my client’s financial decision-making process. When we walked through the numbers and spoke about the logistics, though, we realized that they would wipe out their savings and some retirement money just to buy the home.
After further discussion, we determined that it would be best for them to create an aggressive savings plan over the next three to four years to continue to save for the home, and look into the possibility of renting a home. I would like to see them wait until their daughter is ready for school to determine whether or not they should buy the home. They may end up sending her to private school, and in that case, they should not pay higher school taxes in an area where they are not taking advantage of the schools. Or she may have special needs (like my son) and need a specific school district to provide the best services for them.
I know that having a child may “cramp” your current living arrangements, but putting yourself in financial distress for some extra space is a far worse solution.
2. Know your credit situation
What does your credit look like? I recently blogged about the fact that lower credit can add costs to your financing needs, especially homeownership.
Once you apply for the mortgage, unless you sell the home or re-finance, your credit score at the time you apply will be the credit score that is attached to your rate for the life of that mortgage. A lower credit score could add thousands of dollars in additional interest payments over the life of your mortgage.
Just like you want to make sure you look your best for a first date, you should look your best from a credit standpoint for a mortgage. And if you are applying jointly, it is important to know that the mortgage provider will take the lower of the two credit scores when determining your interest rate for the mortgage. If you have not looked up your credit recently, I highly recommend, Credit Karma, they are not only free, but they will give you a report card with advice on how to improve your credit if you need to.
(Brent here: MyFico is another good option for finding and montoring your credit score.)
3. What does your debt to income look like?
Other than your credit score, the bank will also look at your debt to income ratio.
A fellow blogger, Grayson from Debt Round Up, guest posted on Frugal Rules about debt to income ratios. Most mortgage providers do not want to see you with a debt to income ratio higher than 28% when you apply for the loan. The maximum allowable debt to income ratio per federal regulations, though, is 43%.
The DTI is calculated pre-tax, so if you take your annual salary, multiply it by .28 and divide by 12, you will get your allowable monthly mortgage payment. If you make $50,000 a year, your allowable payment would be $1,166, which would include mortgage, interest and taxes.
4. Do you have enough cash?
Again, because of the changes in legislation, unless you qualify for some sort of exemption, you should be prepared to have at least 20% of the total home value for your down payment for the home.
In addition, you should have additional cash for closing costs or legal expenses as necessary.
For my clients who are buying a home that has been previously occupied, I advise them to have an additional $10,000 in cash for improvements that may be necessary for issues not initially detected by the home inspector.
5. Does your state/region have “quirks” you need to know?
Some states/regions were impacted harder by the downturn in 2008/2009 and as a result, the lending restrictions are more intense when buying or re-financing a home.For example, if you are buying or re-financing a home in some areas of Florida, instead of needing 20% cash as a down payment, your lender may require you to have 25% cash.
Before you get your hopes set on the “perfect” home for you, confirm with your lender what their lending requirements are for the area. Other potential “quirks” could involve legal expenses or escrow requirements. If you have never purchased a home in your area, make sure that you understand the full costs that will be required of you at closing. If you are thinking about a $200,000 home, a 1% additional cost could mean another $2,000 in cash you will need at closing.
The home buying process has certainly changed over the last six years, and before you make this large investment for you and your family, make sure that you understand all of the nuances so that you are not negatively impacted by your home.
Have you recently purchased a home? How did you find the process? Are you looking to buy a home? If so, do you feel prepared?