When you're buying a home, mistakes can be costly. This step-by-step guide will help you figure out how much house you can afford, avoid common pitfalls, and check yourself before you wreck yourself.
The journey to buying a home can be one of the most daunting but rewarding decisions of your life. If you’re ready to become a homeowner, now’s the time to get your finances in shape and figure out how much house you can afford.
I've identified eight steps to buying a home. Let's learn how to avoid common pitfalls, use key affordability formulas, and get the best deal possible on your next home purchase.
How to buy a home you can afford
- Prepare your credit for mortgage approval.
- List the features you want and need in a home.
- Figure out what you can afford.
- Get preapproved for a mortgage before shopping.
- Find a great real estate agent.
- Make a reasonable purchase offer.
- Work through contract contingencies.
- Close the deal.
Let's take a closer look at each step.
1. Prepare your credit for mortgage approval
Unless you have loads of cash, you’ll need to finance a portion of your home’s purchase price. Mortgage lenders review several aspects of your finances, including how much you have for a down payment, your income, outstanding debt, and credit.
Without a good credit score, you’ll either be turned down for a mortgage or charged a high interest rate. Even paying 1% more interest than you have to for a home loan means getting charged an extra $50,000 on a $200,000 30-year mortgage! So, if your credit isn’t in good shape, take the time to improve it before applying for a mortgage.
Even paying 1% more interest than you have to for a home loan means getting charged an extra $50,000 on a $200,000 30-year mortgage!
If you’re not sure what’s going on with your credit, visit annualcreditreport.com for free copies from each of the three nationwide credit agencies (Equifax, Experian, and TransUnion). Review your credit reports carefully and dispute any errors, such as accounts that aren’t yours, incorrect loan balances, or invalid late payments.
Be sure to read or listen to 6 Steps to Build or Repair Your Credit Before Buying a Home for specific tips to get your credit in tip-top shape.
2. List the features you want and need in a home
Before you start looking for a home, think about what you truly need versus what you want. For instance, is having a condo with a short commute more critical than having a house with a big yard? Would being on a quiet cul-de-sac take priority over a home on a busy street with a gorgeous chef’s kitchen?
If you’re buying a home as a couple, each of you should make a must-have features list. Rank the features in order of importance and discuss them as soon as you become serious home buyers. Ironing out what you’re shopping for will make buying a home a much smoother and enjoyable experience.
3. Figure out what you can afford
Once your credit is in tip-top shape and you have a general idea about the home features you want, it’s time to figure out what you can afford. Consider how much you have available to put down and what a comfortable monthly payment would be.
Most lenders require you to put down at least 5% of a home’s purchase price. For instance, if you purchased a $300,000 home, you’d need to come to the closing table with $15,000, and your lender would contribute the remaining $285,000.
Depending on your financial and credit situation, it’s possible to qualify for a lower down payment. However, if you can put 20% or more down, you'll get additional benefits such as a competitive interest rate and not having to pay private mortgage insurance (PMI). In the long run, that can save you a lot of money.
By the way, if you want to learn more about what PMI is, check out How to Avoid Private Mortgage Insurance on Your Home Loan.
Remember that in addition to the mortgage payment, which is comprised of principal and interest, you must also pay property taxes and insurance. Those four components of your monthly payment are known as PITI for short. You may also have a monthly condo or homeowner association fee to cover.
There are also a variety of closing costs you typically must pay, such as a property appraisal, home inspection, title search, attorney’s fees, and any other expenses that are customary for homebuyers in your area. All of these must be factored into your budget and the cash amount that you can bring to the closing. In some cases, a portion of your closing costs may be added to your mortgage.
A general rule of thumb is that you can afford a mortgage up to three times your total annual household income.
A general rule of thumb is that you can afford a mortgage up to three times your total annual household income. However, everyone’s financial circumstances and goals are different. If you don’t have any debt, getting a mortgage that’s up to four times your income might work. And if you already have a lot of debt, you may need to borrow less for a home.
In general, lenders like to keep your debt-to-income ratio in the range of 36% to 42%, which includes the mortgage you’re seeking. For instance, if your gross annual income is $100,000, your annual debt payments plus your new mortgage shouldn’t exceed $36,000 to $42,000. Dividing by 12 gives you total monthly debt limits in the range of $3,000 to $3,500.
If you apply this debt-to-income ratio for your household income, subtract your existing debt, and what’s leftover may be a suitable mortgage payment. However, I’d urge you to be conservative. If you get the highest mortgage possible and don’t have enough breathing room to save for retirement or meet other financial goals, that would be a big financial mistake.
No matter if you buy or rent a home, a good guideline is to keep your housing cost under 30% of your gross income. If you can keep it under 20%, that would give you the best chance to save regularly for the future, pay down debt, and keep up with maintenance and unexpected repairs for your home.
No matter if you buy or rent a home, a good guideline is to keep your housing cost under 30% of your gross income.
If you can’t meet the debt limits that I’ve covered here, consider buying a less expensive home or waiting until you save a larger down payment or have a higher income.
4. Get preapproved for a mortgage before shopping
If you’re ready to start shopping for your dream home, don’t get sidetracked with online searches or tours with real estate agents until you get preapproved for a mortgage. A preapproval is a lender's commitment to give you a loan up to a certain amount for a period, such as 30 to 60 days.
If you go shopping for a home without being preapproved for a mortgage, you may be wasting time—yours, a real estate agent’s, and a seller’s. It can also save you the disappointment of falling in love with a home that isn’t in your price range.
Another advantage of being preapproved for a mortgage is that a seller will know that you’re serious—maybe more serious than a competing buyer who isn’t preapproved. When you find the perfect home, you’ll be able to complete the paperwork quickly and make the deal happen.
You need to buy a home that fits your goals, not one that will strain your finances to the breaking point.
Just remember that you don’t have to borrow the full amount that you’re preapproved for. Go back to the previous step and remember that you need to buy a home that fits your goals, not one that will strain your finances to the breaking point. You have the final say in what you’re comfortable spending on your home.
Getting a mortgage is a big commitment. If renting saves you money so you can accomplish your financial objectives, then that may be the way to go. But, if buying a home has more advantages, and you’re willing to put down some roots, then I’d encourage you to make owning an affordable home one of your goals.
5. Find a great real estate agent
Now that you have a mortgage preapproval in hand and know how much you want to spend, it’s time to find a great agent. Most agents earn commissions that are paid by sellers. So, as a buyer, you have the benefit of working with a real estate pro for free. Just remember that an agent represents the party who pays them, and they should disclose that information to you.
A good agent acts as both a project manager and a psychologist.
If you want an agent to represent you as a home buyer exclusively, you must work with a buyer's agent. They may charge you directly or split a commission with the listing agent who’s paid by the seller. A buyer’s agent has the same access to homes listed for sale that a seller’s agent does—but they owe you a fiduciary duty to work for your best interests in negotiations.
Choose an agent that's knowledgeable, personable, and seems like the best fit for you. A good agent acts as both a project manager and a psychologist. They help you navigate through a myriad of tasks and negotiations that must be completed before a seller gives you the keys.
6. Make a reasonable purchase offer
When you find a home that has the purchase price and the features you want, it’s time to make an offer. But first, make sure that it’s priced to sell. Ask your real estate agent to pull the listing and selling prices of similar homes nearby that sold within the last six months.
If comparable properties (or “comps”) have been selling for 5% less than the listing price, you’ll know to subtract at least that much from what the seller is asking. Depending on the market, you might offer even less to have some room for negotiation.
However, if you’re in a seller’s market, a low offer could mean that another buyer swoops in and takes the property with a higher offer. So, make an opening bid carefully and remember that a seller can reject your offer or come back with a higher counteroffer.
Once you’ve settled on an opening bid, it’s customary to put it in writing. Each state has a standard form for buying real estate that your agent will help you complete.
The sky’s the limit when you make an offer—but don’t go crazy. For instance, you could create a contract addendum that asks the seller to pay some or all of your closing costs. You could ask for the crystal chandelier that makes the dining room look picture perfect.
7. Work through contract contingencies
Once a seller accepts your offer or counteroffer, it’s time to work through each contingency in the contract. You or your agent must get a copy of the signed contract to your lender right away. They’ll require a home appraisal to determine whether the property is worth the price you’ve agreed to pay.
Lenders typically also require a land survey, which is a map of the property boundaries that shows where structures are located. The lender needs to know that the detached garage or fence isn’t sitting on the neighbor’s property by mistake, or vice versa, which would create significant problems down the road. Your lender will order those services and perhaps others, depending on what’s customary in your area.
Don’t let your emotions get the best of you during a home negotiation.
You'll be in charge of satisfying other contingencies, such as a satisfactory home inspection. If expensive repairs are found, you can ask the seller to repair them or to lower their price. If they don't agree, you can walk away from the deal without penalty, as long as that contingency is included in the contract.
If the deal doesn’t work out, remember that there will always be another home. Don’t let your emotions get the best of you during a home negotiation.
8. Close the deal
If you make it through all the contingencies in a real estate contract, you’re in the home stretch for closing the deal. Your agent will receive a Closing Disclosure from your lender or the escrow agent at least three days before the scheduled closing.
The disclosure is an important, five-page document that you need to review carefully. It lists the details of your mortgage loan terms, monthly payments, and each charge you must pay at closing. You'll need to come to the closing with a cashier's check to cover what you owe or wire funds for a remote closing.
One final task you and your agent should complete before you sign closing paperwork is a walk-through. That’s your last chance to look at the property and make sure nothing has changed.
The closing agent or attorney will go through the closing statement with you line-by-line. Be sure to ask questions if you don’t understand anything. Then you’ll review and sign piles of mortgage documents until your hand cramps. Congrats! You’re now the proud owner of a new home.
ABOUT THE AUTHOR
Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a trusted and frequent source for the national media. Her book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show. Stay in the personal finance loop! Listen and subscribe to the Money Girl podcast on Apple, Spotify, or wherever you get your podcasts.