Let's say you've finally made the decision that it's time to buy that first home. You and your family are in a good place, with a steady job, ample savings and maybe even an idea of where you would like to live. But as you've heard time and again, homeownership isn't something anyone should just dive into. What exactly does it take to be prepared for the prospect of buying a home? Work with your local bank or lender to make sure you have all your financial ducks in a row prior to beginning the search for a new home.
Check (and improve) your credit
By now, you've probably heard a lot about credit scores, and might have been periodically tracking yours for a while. Homeownership is when your credit history will face perhaps its biggest test. As with loans for cars, college tuition and more, mortgage lenders will take a deep dive into your credit history to decide if they are comfortable with your history as a borrower. That requires pulling your credit report and running it through a system that ultimately grades your financial past in the form of a credit score.
"Try to keep your debt utilization rate under 7 percent for the best credit score."
As explained by the Consumer Financial Protection Bureau, there are several different methods of calculating a credit score, but they generally operate on the same basic principles. One of the most common scoring methods is the FICO model, which assigns applicants a score from 300 to 850 based on their credit metrics.
Lenders use credit scores not only as a pass-or-fail factor in extending a mortgage - they might also be willing to offer lower interest rates or down payment requirements for those with better scores. The CFPB found that applicants with FICO scores of 750 or higher generally were approved for the best loans.
It's now possible to view your credit report and score for free in many different ways. One of the most popular is through annualcreditreport.com, which allows users to view their reports from each of the three major credit monitoring agencies for free once per year. While rare, you should review the details of these reports to check for any errors, since they might negatively impact your credit score.
Your free credit report might not actually provide you with a calculated score, however. See if your bank or credit card offers a way to check your score for free, as is becoming more common.
If your credit score isn't within that mid-700s sweet spot, or your report contains a couple negative marks, there are a few ways to help improve it over time:
- Focus on paying down some of your debt, especially the highest-interest debt, as efficiently as you can. One of the biggest factors in determining credit scores is a ratio of all outstanding debt over available credit, know as the debt utilization rate. Borrowers with the best scores tend to have a debt balance of less than 7 percent of their available credit.
- Correct any errors that may be on your credit report.
- Try to resolve derogatory marks, which include any instances of late payment, default or charge-offs in the last few years. You might be able to get these marks removed by working with the lender to resolve outstanding issues.
The homebuying process can be made much easier when you know exactly how much you can afford. A great way to accomplish that is by getting preapproved for a mortgage. This involves an application process that may take some time, but the result is the equivalent of a seal of approval from a lender that can be very useful when negotiating with sellers.
It's important to point out that preapproval and prequalification are two very different things, despite similar names. Preapproval involves a detailed check of your credit history, bank records, employment status and much more. Preapproval often requires a fee that might be rolled into the cost of the mortgage, but what you get for all this is a detailed estimate of the size of the loan you could receive, along with information about associated costs. Prequalification may be similar, but it usually takes less time and is not treated with the same gravity as prequalification. Talk to your loan officer to find out more about exactly what their approval or qualification process involves.
Prepare for the down payment, closing and more
Using a mortgage to purchase a home lightens the cash burden for buyers, but they still need to have some on hand for the down payment, closing costs and other expenses related to moving.
- Down payments: Should you go high or low? Buyers are generally advised to put 20 percent of the home's purchase price down as cash upfront, but that can add up to a significant hurdle for many. It's possible to pay a much lower down payment through a number of programs and loan types, but remember that these usually require higher interest rates that increase the total cost of the purchase over time.
- Closing costs: This involves charges for things like application fees, taxes, homeowners insurance and many more expenses that come due before the home actually changes hands. Closing costs can add up to between 2 to 5 percent of the home's final sales price, so it's important to budget accordingly.
- But wait, there's more: Do you need to hire professional movers? Are there any big fixes or renovations that need to be completed prior to move-in day? When the dust has settled on the home purchase, there will still be some bills that need paying, so don't overlook these expenses.
Feeling overwhelmed yet? With help from a financial professional and plenty of diligent budgeting and planning, making room for these tasks can be easier than you might expect. But they also underscore why homebuying is not a process to rush through. Take the time to understand where your finances are and get them in top shape prior to looking at any more listings.
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