Personal Finance Coach: Tips for Purchasing Your First Home

June is National Homeownership Month. Elise Nussbaum demystifies the homebuying process for aspiring first-time homebuyers in her latest guest post, The Home Stretch.

The Home Stretch: Tips for Purchasing Your First Home

By Elise Nussbaum

Home. It’s sweet, it’s where the heart is, it’s your castle, and there’s no place like it. Is it any wonder that the idea of owning our own home exerts such a strong pull on us? As a financial coach, I find that the vast majority of my clients engage with the idea of homeownership in some way — maybe it’s a far-off dream, a short-term goal, or something that feels forever out of reach. If you are wondering what exactly it might take to get ready for purchasing your first home, read on as I demystify the process.

1. Check Your Credit

It’s always a good idea to keep an eye on your credit score, and never more so than when you’re planning a big purchase, such as a home. An interest rate difference of just 1% can mean tens of thousands of dollars over the typical 30-year span of a mortgage! Pay especially close attention to:

Collections: Do you have any collections or chargeoffs on your report? You will have a much easier time getting a mortgage if you can clear them from your report, or at least get the status updated to “paid collection” or “paid chargeoff” by making a payment arrangement with your creditors. A word of advice: negotiating for a lump sum payment will get you faster, cheaper results than setting up a payment plan.

Payment history: What is your payment history like? Ideally, you will want to show a strong history of on-time payments. If anything is showing as currently delinquent, it’s best to prioritize that account to avoid the debt getting charged off or sent to collections.

Credit utilization ratio: How much of your credit cards’ available credit are you using? This is called the “credit utilization ratio.” Lenders will want to see that you are using no more than 30% of your credit limit, and preferably no more than 10%. So if your credit limit on your card is $1,000, you definitely want your balance to be below $300, and if possible, below $100.

New credit applications: Consider any new credit offers very carefully. Every time you apply for a new credit card, your score takes a small, temporary dip. When you are thinking about applying for a mortgage, it’s wise to avoid opening up any new accounts, just to keep your score as high as possible.

2. Check Your Numbers (Debt-To-Income Ratio)

Credit score is not the only number that mortgage underwriters review — they will also want to calculate your debt-to-income ratio, abbreviated as “DTI.” They use this number to determine how much of a mortgage payment you can handle with your income. The first DTI ratio number is 28%, which means that your monthly housing expenses (mortgage, property taxes, homeowners’ insurance) should be no more than 28% of your gross income, your income before any taxes or other deductions.

For example, if your annual gross salary is $60,000, this stage of the underwriting process would look like this:

$60,000/12 months = $5,000 per month

$5,000 * 28% = $1400

Therefore, if you make $60,000 a year, you would be approved for a mortgage where your monthly payments, property taxes, and homeowner’s insurance would all come to no more than $1400/month.

There is a second DTI ratio, which is equally as important. This ratio takes into account your monthly housing costs, and also throws in any ongoing debt payments that you are making. While it is possible to be approved for a mortgage with a DTI ratio of 43%, lenders prefer to see a DTI of 36% or under. So for our individual making $60,000/year, the calculation would look like this:

$5,000 * 36% = $1800

In other words, your car payment, minimum credit card payments, and student loan payments should all be less than $400/month. If your debt payments are higher than that, see if there are any debts that you can pay off to reduce your monthly debt commitments, such as a credit card with a small balance.

A quick note about student loans: There is no real consistency around how banks figure student loan payments into your DTI ratio. Overall, they appear skittish about $0 loan payments, as someone might have on an income-based repayment plan, or as everyone with a federal loan has had over the last two years! It may serve you better in the long run to make modest payments towards your student loans — even if you are not required to do so — in order to make a case for using *that* number to calculate DTI and not, as they sometimes do, 1% of your total loan balance.

3. Work On Your Savings; Include Closing Costs In Your Plans

Lenders will typically want you to be able to put down 20% as a down payment. However, with the median home price in the United States hovering around $400,000, this can feel like an insurmountable barrier. You do have other options! Conventional loans will often allow you to put down 10% or 15%, with the addition of private mortgage insurance, an extra monthly fee that can be removed once your mortgage balance is 80% or less of your home’s value.

Another expense that first-time homebuyers are often unfamiliar with is the closing costs, which can run about 2% to 6% of the purchase price. There are grants available for first-time homebuyers to help, but, in general, you will want to build this into your homebuying budget.

4. Talk Early And Often With Your Partner (If Applicable)

If you are buying a home with your partner, talk things through. In many ways, buying a home with a partner can make things much easier: suddenly, that 28% DTI ratio is taking two incomes into account, which can greatly ease the path into approval for a mortgage. But there are a few questions to keep in mind:

Are two credit scores better than one? When you are applying for a mortgage with another person, the bank will consider both of your credit scores. What happens is this: the bank considers each partner separately, pulling three credit reports for each, and taking into account the middle score. They do this for each partner, and then base the interest rate on the partner with the lower middle score. For instance, if your credit scores are 620, 627, and 635, while your partner’s are 615, 617, and 628, the bank would consider only that 617 score. Practically, this means that your scores should be as close together as possible, and any resources you put in that direction should focus on the partner with the lower score.

Employee or contractor? If either you or your partner is a freelancer, you may have trouble convincing the bank to take both your incomes into account. They will want to see consistent income over the past two years, which can be difficult to show as a freelancer. In the end, if one partner has a salaried job with a salary that fulfills the bank’s requirements, it may make more sense to apply for the mortgage in just that partner’s name.

Are our goals aligned? You will also want to make sure that homeownership is a goal you both share. If you need to cut your expenses to save for a down payment, it is easier if you can support each other as mutual cheerleaders.

5. Consult Real Estate Professionals; Get Pre-Approved Now

Local realtors know the lay of the land (quite literally) and can help you set expectations as to what is available in your price range. A really good realtor will keep an eye out for homes that might suit you, and alert you if anything appealing comes on the market.

You may also want to talk to your bank and get a pre-approval letter now. Whether your homeownership timeline is measured in months or years, it can give you an edge in preparation.

Three months or less: If you feel ready to pounce on a home, having the pre-approval in hand will bolster your offer. At this point in the process, you should actually be shopping around and going through the process with a few potential lenders, to compare their offers. As long as you complete all applications within a 45-day time frame, it will only count as one hard inquiry on your credit report. The pre-approval letter is typically valid for 60 to 90 days. Then, you will need to go through the whole process again.

Longer than three months: If you are still in the contemplation stage, going through the process of pre-approval will show you exactly what will be needed to make the process work for you. You will see if you need to burnish your credit, save up more money, or eliminate monthly payments by paying off debt.

6. Explore First-Time Homebuyer Resources

The homebuying process can feel overwhelming, especially when it comes to the financial aspect. Fortunately, there are programs designed to help you through the process. The Federal Housing Administration offers low-cost loans that require only a 3.5% down payment, and each state offers resources such as low-interest loans or down payment grants to help its residents buy homes. Teachers, police officers, and firefighters can take advantage of HUD’s Good Neighbor Next Door Program. Organizations such as NACA (Neighborhood Assistance Corporation of America) can also help, with a mortgage lending program that assists low- and moderate-income home buyers, including no down payment, no closing costs, and no mortgage insurance, at a below-market fixed rate — without consideration of one’s credit score. Meanwhile TrustPlus partner Landed supports essential professionals in education, healthcare, and government unlock the financial benefits of homeownership through an innovative shared equity down payment program.

Talking to a financial coach can also be a crucial step in your homebuying journey. Your coach will be able to talk through with you, not just the numbers and ratios and programs, but also your underlying reasons for wanting to buy a home, and where. A coach will be able to convert your longing for homeownership into the motivation that you will need to make any lifestyle changes necessary in the meantime, as well as acting as moral support during an often-stressful process.