Living from one paycheck to the next may be the norm for many people. But homebuyers need a better strategy.
“If buying a home is your goal, then it needs to be your priority,” says Tim Kirchner, vice president of MetLife Bank in Irving, Texas. “Most people need to sacrifice a little and stick to a budget in order to save for a home.”
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A good budget plan begins one or two years before the buyer makes an offer. Here are four tips for renters who plan to become homeowners:
Build strong credit
When it comes to securing a loan at the best mortgage rate, credit is king.
“The most important focus for all potential buyers should be improving their credit score,” says Jean Badciong, chief operating officer of Inlanta Mortgage in Waukesha, Wis. “A low score can prevent someone from buying a home or at least from qualifying for an affordable mortgage rate.”
Greg Holmes is national director of sales and marketing for Credit Plus, a company in Salisbury, Md., that provides credit reports to mortgage lenders. He says potential buyers should request their free credit report at AnnualCreditReport.com.
“Some people who think they have good credit don’t, while people who think their credit is bad may be surprised that it is actually OK,” Holmes says. “Everyone should check their report for accuracy and fix any mistakes. It can take months to correct errors.”
To improve their credit scores, Holmes says buyers should pay off past-due bills, pay every bill on time and reduce their balances to less than 30 percent of the credit limit on every account. Also, it is best to have three to five credit accounts, such as a car loan, student loan or credit card, for one year or longer.
Holmes recommends against frequently switching credit cards to get the best rate, though.
“Lenders do not want to see a lot of credit inquiries or too many new accounts because this could indicate someone who is about to take on a lot of extra debt,” Holmes says.
Kirchner says people often do not realize the consequences of paying bills late or missing a payment, which can stay on your credit report for a long time.
Some young people assume they can improve their credit scores as an authorized user on a parent’s card. But Badciong says this will have no impact on their score.
“Every consumer should establish three lines of credit such as an installment loan and a credit card or two, keeping the balance low and paying them on time, in order to generate a strong credit report,” says Christine Howard, a senior loan officer with Inlanta Mortgage.
Howard urges future homebuyers to make “virtual” mortgage payments today as a way to build up savings and learn to budget for actual mortgage payments down the road.
“Renters can estimate a mortgage payment and set aside the difference between that payment and their rent each month,” Howard says. “If they are paying $800 in rent and estimate their mortgage will be $1,100, they can put $300 per month in a special savings account.
“Not only does this help them save for a down payment, but it demonstrates to a lender their ability to afford that higher housing payment.”
Kirchner recommends future buyers create a simple budget and set a savings goal.
“If they find they can save $300 a month, then they will have $3,600 at the end of the year,” Kirchner says. “Lenders want to see that pattern of savings, and buyers will need at least 3.5 percent for a down payment on an FHA loan or at least 10 percent for a conventional loan.”
Kirchner recommends setting up an automatic transfer of funds into saving through your employer or your bank.
While buyers increase their savings, they should also reduce their debt.
“Paying off debt tops saving in terms of priorities because of the interest payments on the debt, which exceeds the amount of interest they can earn on their savings,” Kirchner says. “Lenders want to see that you are managing your debt and keeping your credit card balances low.”
Howard says debt-to-income ratios are an important element in a loan approval. This ratio compares minimum monthly payments on all debt to gross monthly income.
“If your debt-to-income ratio is over 50 percent, you need to pay off your debt before even thinking of buying a home,” Howard says. “Some companies will relax their standards for borrowers with a strong credit score or substantial cash reserves, but in general, FHA will only go up to 43 percent and conventional lenders will only go to 41 percent for the overall debt-to-income ratio.”
While it might be premature to visit a lender two years before a home purchase, it can be valuable for consumers to know if they qualify for a mortgage, Kirchner says. He also recommends visiting open houses.
“A lot of people have no idea what $100,000 or $200,000 will buy, so the more they look at places and neighborhoods, the better understanding they will have of the value in a home,” Kirchner says.