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Ready for Homeownership? 8 Steps to Prepare Your Finances

If you dream of buying a home, you're facing a huge, expensive decision. Use these steps to prepare your finances, and in the process, discover whether homeownership is the right move for you.

By
Laura Adams, MBA
9-minute read
Episode #674
The Quick And Dirty

Buying a home is a huge step. Follow these steps to get financially prepared well in advance so you can avoid potentially costly mistakes.

  • Evaluate renting versus buying
  • Check your credit
  • Repair your credit
  • Check your debt-to-income (DTI) ratio
  • Calculate how much you can afford
  • Save a healthy down payment
  • Tap retirement accounts cautiously
  • Get a mortgage preapproval

Buying a home is a huge, expensive decision, no matter if you're a first-time homebuyer or have been buying and selling real estate for decades. Homeownership comes with financial upsides and risks, and for many people, it's an emotional transaction as well.

So how do you get fully prepared to buy a home? Getting ready should begin long before you start scrolling through online listings, going to open houses, or working with a real estate agent.

Today, I'll help you understand if homeownership is right for you, how much you can afford, ways to save for a down payment, and tips to get the most affordable mortgage possible. The more you know about the home buying process and prepare for it, the cheaper and less stressful it will be.

Here's more about each step you can use to prepare your finances to buy a home.

1. Evaluate renting versus buying

Before you start obsessively searching for your dream home, the first step is to make sure owning a home is the right move for you. There's no financial rule that says you must buy a home. In some cases, you're better off not becoming a homeowner.

In general, it's not wise to buy a home unless you're confident you will live in it for at least three years.

Whether you should own or rent depends on various factors, including:

  • Where you want to live. If you're in a large city, renting can be much less expensive than buying a home. 
     
  • How long you plan to live somewhere. In general, it's not wise to buy a home unless you're confident you will live in it for at least three years. That gives you enough time to recuperate your buying costs and prepare to sell the property.
     
  • What lifestyle you enjoy. For many people, being a homeowner allows them to enjoy hobbies, such as gardening or home remodeling, which they couldn't do as a renter. But renting may be more appealing to those who travel frequently or don't want to be responsible for the upkeep and ongoing maintenance of a home.

2. Check your credit

If you decide to explore homeownership, the next step should be doing a deep dive into your credit reports and scores. Staying on top of your credit is always important, but it's critical before buying a home because it's a primary factor that mortgage lenders use to evaluate you.

Not only does repairing and building credit help you get approved for a mortgage, but it's a critical way to qualify for a low-rate loan, which saves a massive amount of interest. 

For example, if you have excellent credit and get a $200,000 fixed-rate mortgage, you pay about $145,000 just in interest over the life of a 30-year loan. But if you have average credit, you'll pay close to $190,000 in interest, or $45,000 more, for the same loan!

Your credit scores get calculated using data in your credit reports, which frequently changes as new information gets added and old data falls off. Check your credit reports and get any errors, such as incorrect account balances, payment dates, or personal information, corrected as quickly as possible. 

You can access your information directly from the national credit bureaus: Equifax, Experian, and TransUnion. There are also many free credit sites, such as AnnualCreditReport.com, Credit Karma, and Credit Sesame.

3. Repair your credit

If you have black marks on your credit, such as late payments or accounts in collections, start making repair efforts at least six months to a year before applying for a mortgage. You can't remove accurate negative information, which stays on your credit reports for seven years, even if you pay off an overdue balance. However, the older a delinquent account gets, the less it hurts your credit scores.

Before submitting a mortgage application, consider paying off any past due balances or negotiating settlements with creditors. Getting caught up on late payments helps clean up your report, making you look less risky to a lender.

One word of caution is that if you have old past-due accounts, making a payment can restart the statute of limitations, resulting in legal risks. So, if you have a large amount of delinquent debt, consult with an attorney before you speak to your creditors or send a payment. 

Read The Statute of Limitations and 4 Options for Old Debt for more information about dealing with old debts wisely.

4. Check your debt-to-income (DTI) ratio

Before applying for a mortgage, figure your DTI and see what changes you may need to make. Mortgage lenders evaluate a few debt-to-income ratios to know how your expenses stack up against your income. It's a good indicator of how comfortably you could take on additional debt.

Most home lenders require your future mortgage payment to add up to less than 30% of your income. And for all your debts, including the new mortgage, a typical acceptable ratio is no more than 40%.

Most home lenders require the payment on the mortgage you're applying for to add up to less than 30% of your income. And for all your debts, including the new mortgage, a typical acceptable ratio is no more than 40%. If you exceed these lending limits, you may need to pay down debt balances. But every lender has different underwriting guidelines, and they may adjust DTI ratios based on your financial situation.

When you're preparing to buy a home, be sure to pay your bills on time, reduce your debt as much as possible, and avoid applying for new credit accounts, such as a credit card or auto loan. Those actions boost your credit and help lower your DTI.

5. Calculate how much you can afford.

The next step is to consider all the home-buying costs you'll have to cover. Check out Bankrate's How Much House Can I Afford? Calculator, which allows you to input your monthly income and estimated home expenses.

In addition to a mortgage payment, here are some additional expenses to keep in mind:

  • Property taxes are owed to the local government and vary depending on where you live. An average amount could be in the range of $3,000 to $4,000 per year.
     
  • Home insurance is required by mortgage lenders to protect the property from various disasters, such as fire, windstorms, and vandalism. The price depends on many factors, including the home's value, location, and amenities. An average premium could be in the range of $800 to $1,500 per year.
     
  • Private mortgage insurance (PMI) is another requirement when you pay less than a 20% down payment. The premium depends on your home's value but could add a range of $50 to $150 to your monthly mortgage payment until you have sufficient equity for your lender to cancel it.
     
  • Homeowner association (HOA) fees may be required in some neighborhoods or communities to pay for communal amenities such as a pool, boat dock, or landscaping. The cost could be $50 per month or much more.
     
  • Home maintenance should always be expected. A good rule of thumb is to save at least 1% of your home's value each year for upkeep. For example, if you have a $300,000 home, budget $3,000 per year to pay for potential repairs such as an HVAC system or a water heater that quits working.

6. Save a healthy down payment

If your goal is to buy a home, you've probably been thinking about how to save money for a down payment. To qualify for a mortgage, you must prove to a potential lender that you have enough savings to fund a down payment. 

Since lenders don't finance 100% of a home's price, the down payment affects the balance you owe, in addition to the proceeds from a mortgage. The more you can pay, the less risky you are to a lender. And the larger your down payment, the smaller your mortgage and monthly payments will be. 

While a down payment could be in the range of 5% to 20% of a home's purchase price, you may have additional upfront expenses to pay at the closing table, including:

  • Credit check 
  • Loan origination or underwriting fee 
  • Appraisal
  • Home inspections 
  • Mortgage discount points (which allow you to get a lower interest rate)  
  • Property survey 
  • Title insurance 
  • Deed recording

When you make a purchase offer on a home, one tip is to request that the seller pay some of your closing costs. You can also haggle with your mortgage lender not to charge specific upfront fees. In real estate, just about everything is negotiable, so don't be shy about asking for concessions. 

If you're a first-time homebuyer, a veteran, have a low income, or want to buy property in a rural area, it's possible to qualify for down payment assistance through these programs:

The benefits of down payment assistance programs vary depending on their rules and your circumstances, but they offer low or no down payment, making it much easier to become a homeowner. 

The money for a down payment can come from your savings or gifts from your family. And if you're already a homeowner, your down payment can come from the money you make when you sell your current home.

Here are some ways to save a down payment quickly:

  • Downsize your housing by moving into a less expensive place so you can save money for your down payment fund. 
  • Automate your savings by having a portion of your paycheck deposited into a dedicated savings account or setting up a recurring monthly transfer.
  • Bundle services to pay less for utilities such as cable, internet, and wireless plans. 
  • Shop your insurance if it's been a while since you compared prices for auto or renters insurance.
  • Save all extra money such as raises or bonuses at work, gifts, and tax refunds. 
  • Start a side hustle to create additional income to squirrel away for a new home. 

7. Tap retirement accounts cautiously

Another way to come up with a down payment on a home is to tap a retirement account, such as IRA or 401(k). While I don't recommend this option, some provisions allow it.

Another way to come up with a down payment on a home is to tap a retirement account, such as IRA or 401(k). While I don't recommend this option, some provisions allow it.

For a traditional IRA, you're allowed to withdraw up to $10,000 for a down payment if you're a first-time homebuyer. You must pay taxes on the withdrawal—but even if you're younger than 59½, you won't get hit with the 10% early withdrawal penalty.  

If you have a Roth IRA, you can withdraw your original contributions without owing taxes or a penalty, no matter your age. However, tapping the earnings portion of the account before age 59½ means that taxes and the early withdrawal penalty would apply. 

If you have a workplace 401(k) or 403(b), they typically allow "hardship" withdrawals, which include buying or repairing a primary home. However, making a distribution means paying income taxes and a withdrawal penalty if you're younger than 59½. Plus, you may get restricted from making contributions to your retirement account for six months.

Some workplace retirement accounts allow loans. You may be permitted to borrow half of your vested balance, up to $50,000. You must repay it with interest to your account within five years. However, the term may be longer for a home purchase. If you repay a loan on time, you don't have to pay income tax or a penalty on the borrowed funds. 

One of the biggest problems with taking a loan from your 401(k) or 403(b) is that if you don't repay it on time, the outstanding balance becomes an early withdrawal. That means you must pay income tax plus an additional 10% penalty if you're younger than age 59½.

While taking a loan or withdrawal from a retirement account may make sense for some home buyers, the best scenario is to have plenty of savings, so you don't need to touch your retirement nest egg in the first place.

If you leave your job or get fired, you'll probably have to come up with the entire outstanding loan amount within a short period, such as 60 days. So be sure to read your retirement plan document or ask your benefits administrator for all the details on taking a loan before signing up. 

To sum up, if you need to tap a retirement account to buy a home, taking a modest withdrawal from your Roth IRA is the best possible option. However, in general, I don't recommend draining a retirement account for any reason. It comes with too many downsides, including not being allowed to make new contributions for a period, missing employer matching, being left with a depleted retirement account, giving up the opportunity to build wealth. 

While taking a loan or withdrawal from a retirement account may make sense for some home buyers, the best scenario is to have plenty of savings, so you don't need to touch your retirement nest egg in the first place. Always speak with a financial adviser to carefully weigh the pros and cons of dipping into your retirement account for any reason. 

8. Get a mortgage preapproval

Once you've reviewed your credit, calculated how much you can afford, and have enough of a down payment, it's time to get pre-approved for a mortgage. You might apply with several potential lenders and compare quotes.

In a preapproval, a lender checks your credit, verifies your income, and approves various documentation. They offer a maximum loan amount and interest rate for a period, such as 30 or 60 days, while you find potential homes.

Remember that just because you qualify for a mortgage doesn't mean you should take out the maximum amount. It's a big commitment that has to fit in with your overall financial goals. For some, spending the full amount may be a wise decision. However, if it would leave you "house poor" with an exceptionally tight budget, consider spending less or delaying your home purchase until you've saved up a larger down payment.

About the Author

Laura Adams, MBA

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 frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous 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.