Should You Rent or Buy a Home?
First, you’ll want to think through whether you’re better suited to rent or buy a home. There are a lot of pros and cons to each scenario, and each will be dependent on your needs, wants, lifestyle, and more.
If you’re in this stage of decision-making, head over to our blog, Renting vs. Buying a Home, to learn some of the things you’ll want to consider!
How Much Can You Spend on a Home?
Another thing you’ll need to determine is how much home you can afford. While a pre-approval from a bank can tell you how much you qualify for, that may not be the best way to determine how much you can comfortably afford.
Let’s look at a few factors that can determine how much you can afford to comfortably spend on your home:
Understanding Your Budget
Overall, you’ll want to determine your current non-housing expenses. List out your regular expenses, from car payments and student loans to groceries and gas. Average out your non-fixed expenses over the course of a few months to get a true understanding of how much money you spend on essentials each month. Subtract that from your take-home pay from any jobs you work, allowances, or other income.
A non-fixed expense is any expense that varies from month to month. For example, your rent payment is typically the same each month, so it would be a fixed expense. The amount you spend on groceries and gas, however, will vary each month, making them a non-fixed expense.
How much is left? That will tell you how much you have left in your budget to fit a mortgage payment, entertainment and other non-essential expenses, and money to go to savings for emergency and other unplanned expenses.
If you know how much you can comfortably afford in payments each month, you may find that you can afford less of a house than you technically qualify for.
Here are a few resources for you to start budgeting:
Preparing for a Down Payment
You’ll also need to have some money set aside for a down payment. While a standard down payment on a home can be 20% (which would add up to $20,000 on a $100,000 home), there are programs that will allow for significantly smaller down payments – 3% or even no money down! Learn more about these types of programs here.
Whatever percentage you’ll be putting down, make sure you are doing what you can to set aside funds. See how you can start setting aside those funds in this blog!
And while we’re at it, may we recommend an IncredibleBank savings account 😉?
Ever heard of DTI? DTI stands for Debt-to-Income, and it’s a ratio that is used to determine how much debt you currently have in comparison to your income.
Lenders use DTI (amongst other things) to determine whether you qualify for certain types of loans. If your DTI is high, it means that a high percentage of the money you take in is already being used to pay for your existing debts, making it less likely that you can afford to take on more.
Typically, lenders will want to be sure that your DTI is under 50% including your new potential house payment, and some lenders will have limits that are lower. In fact, 43% is likely a more standard rate.
So, how do you calculate your DTI? You’ll want to take all of your debt payments (this should be for things like loans and credit card payments, and wouldn’t include things like gas, electric, and internet bills) and add them up. Next, you’ll divide that number by your total gross income (meaning before taxes and deductions). The number you get is your DTI.
For example, if your total gross income each month is $4,500, and your total debt payments add up to $1,400, you would have a 31.11% DTI.
Want to figure out what a 43% DTI would be for your income? You can also work backward. If you multiply your gross income by .43, you can determine how much money you should be spending on your debts. Again, if your total monthly income is $4,500, a 43% DTI would mean you could spend up to $1,935 on your debts (though of course, less debt is better!).
From here you can determine about how much you can spend on a home as well by taking that total ($1,935) and subtracting the rest of your debts. If the rest of your debts (not including a house payment) add up to, say, $650, it would mean you could spend up to $1,285 on housing.
Phew! That’s a lot of math. But here’s a list of the two main calculations we just did:
Total amount of debts ÷ Total gross income = Debt-to-Income Ratio
Ex: $1,400 ÷ $4,500 = 31.11%
Total gross income x .43 = Total amount of debt you can have to be at 43% DTI
Ex: $4,500 x .43 = $1,935
Total amount of debt you can have to be at 43% - Current debts not including housing= Total you can spend on housing
Ex: $1,935 - $650 = $1,285
One of the most important aspects of determining your readiness for homeownership is understanding your credit score.
A credit score is a number that helps lenders understand your history of using credit. So …
What factors make up your credit score?
Payment history.Do you typically make your payments on time? This part of your score takes into consideration whether you make your payments on time, the frequency with which you make late payments (if at all), and by how many days you are late (again, if you do have late payments). A tip to ensure on-time payments? Set up automatic payments if you can!
Credit utilization.Think of a credit card. If you have a credit limit of $1,000 and your balance is at $900, that’s a 90% credit utilization. Using 30% or less of your credit limits across all of your credit lines is a great way to keep this part of your credit score in good shape.
Length of credit history.How long have your credit accounts been open? The longer they’ve been open, the better. Obviously if you’re working on establishing your credit, this aspect of your score will take some time to build. But by managing your open accounts and avoiding unnecessary new credit accounts, you can continue to build this area of your credit score.
Diversity of credit.If you have multiple types of credit accounts (think credit cards, auto loans, student loans, etc.), you can demonstrate your ability to manage many different types of accounts and payments.
New credit.Your credit score also takes into consideration any recent credit pulls. Every time you get your credit pulled in order to apply for new credit, your credit score takes a slight hit. But don’t let this stop you from applying for credit when you truly need it. As long as you aren’t applying for multiple credit accounts at a time, you’re likely to only see a temporary and slight impact on your score.
Why does your credit score matter?
Your credit score will impact your ability to get a loan, of course, but it will also impact the rate and terms on your home loan. You may be able to qualify for a home loan with a relatively low credit score, but your interest rate and other terms may make your loan significantly more expensive.
It’s important that you understand your credit score and if necessary, take steps to improve it before you consider buying a home.
The Housing Market
Another major thing to consider when determining if you’re ready to buy a home is the current housing market. And there are several aspects of the housing market to think about:
Interest Rates.If interest rates are currently relatively low, that’s a positive sign. Higher interest rates mean higher payments and more money going toward paying interest. Low interest, then, is the opposite – lower payments and less overall money spent on interest.
Home Prices & Inventory.Is it a buyers’ market? A sellers’ market? A buyers’ market typically refers to a market in which the buyer has the advantage – lower home prices and/or higher inventory. A sellers’ market refers to a time period when home prices are higher and/or lower inventory. Low inventory leads to more demand, increasing prices.
Cost to Build.Thinking about building instead of buying? Take a trip to your local lumberyard. When lumber prices are high, the cost to build is also high, so even if you’re in a buyers’ market, if your plan is to build a home, you may end up spending significantly more on building your home.
Before diving into the housing market, make sure you take the time to consider whether you’re ready for it. Take into consideration whether buying or renting is right for you, make sure you know how much house you can afford, know your credit score, and get to know the current housing market.