Some buyers buy their property because they want in on the homeownership dream; others because they want to grow a family, for investment purposes, or simply because they no longer want to pay rent. Whatever your situation may be, it’s important to be clear about the reasons for purchasing the home you want.
Many reasons that could prevent you from being ready to become a homeowner.
As with any major purchase, you should start by preparing a budget so you can plan and be ready for the full costs of homeownership.
Use the below questions to determine if you’re ready for homeownership.
Questions to ask yourself:
- Am I prepared for homeownership?
- Is my credit score above 700?
- Do I have steady, reliable income?
- Are my savings enough to cover the down payment and closing costs?
- Do I know how much house I can afford?
If you can answer all five questions with definite “yes,” you are ready to become a homeowner.
Am I Prepared for Homeownership?
It’s important to remember that the costs of owning a home go beyond just being able to afford the mortgage payment. Additional costs will include property tax, home insurance, utility bills, maintaining the home, and more.
Buying a home is one of the biggest purchases most people will make in their lives, so you have to get it right. When you do it right, the home can become a vehicle where you can build lasting wealth, whereas when you do it wrong, it can adversely impact your finances for years to come.
Ask Yourself – Should I Buy or Should I Rent?
Buying makes sense when both affordability and your desired lifestyle coincide. In other words, if according to your lifestyle, owning a home makes sense and you can afford it, then buy but you will need to set up realistic expectations and be clear about what set of priorities are important to you.
Being a homeowner can provide a sense of stability, and pride while you build equity over the long-term; renting, on the other hand, gives you more short-term flexibility to be in control of your finances.
Setting Your Priorities and desired lifestyle
Before starting the search process, decide what type of home suits you best. Will you need to commute to work? Are you planning to grow or start a family? What type of home matches your price level?
If your debt load is low, work is stable, and you plan to live in the home for at least the next 3 – 5 years, then you may be suited to become a homeowner. However, you will have to build a set of priorities and be able to compromise on the following:
- Price of the home + extras
- Location of the home
- The physical condition of the home
Find Out How Much House You Can Afford
When it comes to the mortgage payment, the rule of thumb is your housing costs (including the mortgage) should be no more than 1/3 of your household income. For example, if take-home pay for the household is $6,000 per month, which means you can afford a mortgage payment of $2,000 per month, but no more.
If the mortgage payment is more than 1/3 of your after-tax income, likely you can’t afford it; that’s when financial difficulty starts and you have to make cuts in other expenses which then affects your lifestyle. There are other expenses you will continue to have such as food, clothing, and entertainment.
Other simple rules you can use to know how much you can afford in less than 2 minutes.
- Choose a total payment that is close to the same amount you pay in rent.
- Select a property that has a price no higher than 3 – 5 times your annual income, depending on how much deposit you’ll be bringing in.
Home affordability rules lenders use
Most lenders impose limits or thresholds that their clients must meet to be approved for a mortgage loan. The main ones are the 32/43 ratios, which means no more than 32% of the before-tax household income goes towards covering housing expenses and once you add monthly debt payments, the total cannot exceed 43%.
Affordability Rule # 1: The Gross Debt Ratio (GDS)
The first home affordability rule lenders use is your total monthly housing costs should not exceed 32% of your gross monthly income. Housing costs include your mortgage payment (principal + interest), property tax, utilities, home insurance and 50% of your condominium payments if you pay condominium fees.
Lenders will add up all your housing costs and compare the total to your gross monthly income. If housing costs are higher than 32% of your gross monthly income, you might not be approved for the mortgage loan.
Consider this example: You’re applying for a mortgage loan for $500,000 at 3%.
Now imagen you and your spouse have a combined gross monthly income of $9,000 per month.
GDS Ratio = Total Housing costs / income
That means you have a GDS ratio of 30% ($2,700 / $9000), which means you are under the 32% limit.
Affordability Rule # 2: The Total Debt Ratio (TDS)
When lenders look at your monthly expenses, they are particularly interested in your debt obligations such as car loans, student debt, lines of credit and credit card payments. (Note that ordinary living expenses like food and utilities don’t go into this calculation.)
The TDS rule states your total monthly debt payments plus your monthly housing costs should not exceed 43% of your gross monthly income.
TDS ratio = (housing cost + debt payments) / income
The bottom line is when your income is higher and your debt payments are lower you have high chances of being approved for a mortgage loan.
Using our earlier example of monthly gross household income of $9,000, that means you have a TDS ratio of 39% ($3,500/ $9000), which is below the 43% limit.
Some lenders will approve mortgage loans even if the TDS ratio is higher than 39%. Some go even as high as 49%, but you will need to have a strong compensating factor such as these.
Compensating factors for high TDS ratios
- High credit score
- 20% down payment
- Own other properties and you have built good equity on them
- 5+ with your current employer or you have a strong employment history with no gaps
- You bought the property you are buying at a reasonable price
Now the easiest way to find out how much house you can afford is by using a home affordability calculator.
Mortgage Calculator vs. a Home Affordability Calculator
A mortgage calculator helps you find out the amount of your mortgage payment; for example, if you already know the amount of mortgage you will borrow, you can use a mortgage calculator to calculate what your regular payment will look like.
A home affordability calculator, on the other hand, lets you find out what mortgage you can afford and can potentially be approved for by a lender.
Five strategies to qualify for a bigger mortgage loan:
- Pay off your credit card balance. The higher your debt obligations, the less amount you will have available to cover for the mortgage payment. For example, if you have a credit card balance of $3,000, the lender may add a monthly payment of $300 to cover the credit card debt. If you pay off the credit card all of a sudden you qualify for a bigger loan.
- Show a higher income. Having higher incomes means you could get a bigger loan. This could mean adding a co-applicant like a spouse or family member, but it also could mean adding additional sources of income from a side gig you may have.
- Put 20% of down payment to avoid paying mortgage insurance. If your down payment is lower than 20% you will have to pay for mortgage insurance as well. So, putting a 20% down payment not only will help you avoid having to spend extra money on mortgage insurance, but it will also mean you can buy a bigger, more expensive home.
- Shop around. You should get quotes from 3 – 5 lenders. Don’t process a full application with all of them; tell them you are shopping around and ask for their best rate. Having a lower rate means your mortgage payment will be lower and that translates into being able to afford a bigger mortgage loan. However, you’ll have to make sure you can afford the mortgage even if rates go up in the future.
- Increase your credit score. Not only does a higher credit score helps you get a bigger mortgage loan; it also helps you get a better interest rate. To increase your credit score make sure you pay your bills on time, keep a low balance (if any) on your credit accounts, and don’t buy other big-ticket items during the entire home buying process.
So, how much house can you afford?
If you are not sure, send me a note at Contact us, describe your situation and I will personally create a home buying analysis for you; this will include an estimate of how much house you can afford.
Is my credit history above or below 700?
How does your credit score affect whether or not you are approved for a mortgage?
Credit is a key factor in the home buying process. Unless you one of the few people with enough cash to buy a home outright, you’ll need to apply for a mortgage, and you can’t get a mortgage unless you have good credit.
You don’t need to have a perfect credit history to be approved for a mortgage. It’s the most recent credit history that counts the most. So if you have missed payments and a low credit score today, that’s something that can definitely be fixed.
Here is what you should do over the next 6 – 12 months
- Pay your bills on time
- Keep your credit card balance well below the limit, lower than 30% of the limit
- Do not cancel accounts that have a long good history
- Do not change your job or change your mailing address
The following is a breakdown of what credit scores mean, and how they affect your ability to get a loan approval.
Credit score above 750
If your credit score is above 750, you’ll have no problem being approved for a loan. Lenders will actually compete to loan you money, which means the best rates would be available to you, and your options are many.
Credit score 700 – 749
A credit score that’s from 700-749 is considered very good credit; you would also generally have little to no trouble getting approved for new credit. You can get the best mortgage rates, but you will need to do your homework and negotiate for the best rate.
Credit score 640 – 699
With 640-699 lenders would approach the application with caution, and look very closely at your debts. You can still expect to get a mortgage approval, but the options would not be many compared to if the credit score was above 700.
Credit below 640
With anything below 640, lenders would not approve the loan. However, there is no need to panic; there is definitely ways and techniques you can use to increase your credit score to your desired number.
Some B lenders will approve a mortgage loan to applicants with a credit score that is below 640 but at a much higher interest rate.
Here is an example:
Ben has a credit score of 730
Mike has a credit score of 650
They earn $70,000 each, they are the same age, with similar jobs, and both are in the market to buy a house. Would their mortgage rate be the same?
Not a chance!
If approved for a loan, Mike would pay a much higher interest rate than Ben because the lender would see Mike’s profile as a higher risk.
Here are the three main credit bureaus where you can get a copy of your credit report
Do you have a stable reliable income?
Lenders use your credit report to evaluate your wiliness to pay and your income represents your ability to pay.
But what is stable reliable income?
In general, lenders look for a consistent stream of income for at least the last two years. However, that does not mean you have to have the same job for the last two years.
If you are an IT administrator in a technology company, and then 6 months ago move to another company, as an I supervisor in the manufacturing field, that would be acceptable in the eyes of the lender.
That would be considered an odd, but acceptable move.
However, if you are an IT administrator and 6 months ago you moved to another job as a marketing associate that would not be considered a consistent record.
What if I am self-employed or have my own business?
Lenders know that many new businesses fail; this means there is a higher risk that you may not be able to pay the mortgage, which affects stability.
Down payment and Closing Costs
The down payment is the amount of money you put towards the purchase of the home, and which will be deducted from the purchase price; the rest is covered by the mortgage.
The size of your down payment will vary based on the value of the property and based on your state/province, but in most places that minimum down payment is 5%. Here is an example of what deposit you’d need if you are buying a property valued at $500,000 and wish to put down 5%, 10%, or 20%.
The smaller the deposit the higher amount of mortgage you will need and the more interest you will pay over time. Also, if you can put down a deposit of 20% you won’t need to pay for mortgage insurance.
Mortgage insurance protects the lender in case you default on the loan. For self-employed home buyers or the ones with poor credit, the lender may require you to buy mortgage loan insurance, even if you have a 20% down payment.
Get serious with saving for your down payment
The first step is to have a deposit goal amount in mind and get started on a saving plan. Here are some essential tips that will help you to start saving for your down payment:
- Track your spending. To be able to save, you have to understand how you are spending your money. Tools such as The Budgeting Binder Planner will help you get started.
- Set a budget. Using the budgeting binder planner you will need to set realistic goals for monthly savings, how to optimize your spending habits.
- Pay off expensive debt. Expensive debt such as credit card debt can keep you from achieving your financial goals. That means paying off those debts will become the highest priority to get started on the right path.
- Automate your savings. The easiest way to save is by automating the process. Have your employer deposit your pay into two separate accounts; one of those accounts will be a saving or an investment account that you don’t use to cover day-to-day spending.
Get help with your deposit
The following tips require to count on family wealth; so if you’re one of the lucky ones out there, here it goes:
- Cash gifts. Some millennial home buyers get to boost their deposit by using gifted funds from their parents. You will need to provide the lender with a letter signed by the person giving you the gift stating that the money is a gift and not to be repaid.
- First-time home buyer. Your local government might have grants for first-time home buyers. If you qualify, you can use the grant to form part of your deposit.
Remember to budget for closing costs
Closing costs will be in addition to the down payment and you will need to pay those costs upfront.
Some of these costs are easy to forget. I must admit, the second time I bought a property, somehow I had forgotten all about land transfer tax. A few days before the close I got the surprise that I needed an extra $11,670 to cover the land transfer tax.
What’s even more interesting is that the lender should have spotted that during the mortgage application but it did not come up. So how did I come up with an extra $11,670? I don’t recommend any home buyer to do this, but I used a line of credit.
Once the transaction closed, I paid the line of credit as fast as I could, but that is precisely the kind of debt that can make things very difficult for new homeowners.
Closing costs will include the following:
- Home Insurance:This covers potential damages to your home, such as in case of fire.
- Mortgage Insurance: Will be required if your down payment is lower than 20%.
- Land Transfer Tax: This is tax paid to the city for the transfer of land ownership.
- Property Tax:Payable to the city.
- Underwriting Fee:May be charged by the lender to evaluate your application.
- Appraisal:A professional appraiser provides an opinion about the market value of the home.
- Home Inspection:You, the buyer will pay the home inspector to verify the condition of the property.
- Lawyer fees. You will pay your lawyer to handle the legal aspects of the property purchase.
Complete a Home Buyer’s Online Course
Knowledge is power! To succeed in the home buying process you’ll need to know what to expect at every step of the way. You should check out our Home Buyer’s Online Course.
This is an interactive course designed in an easy to understand format; you will learn the eight steps you will need to take to achieve a successful homeownership.