Home finance involves more than just figuring out how to get the down payment to buy a house and make the monthly mortgage payments. It’s about being able to buy and afford a house within the constraints of your household income and still have money left to enjoy a comfortable lifestyle.
The objective is to pay for your house and improve your general financial well-being at the same time. Let's look at the issues of home finance.
Which Type of Mortgage Is Best for You?
The first step in home buying is to find out which type of mortgage works best for your particular financial situation as first-time home buyers. The type of mortgage that's best for you depends on your credit score and the amount of your down payment and any closing costs. Some mortgage lenders accept a lower credit score and as low as a zero down payment.
Conventional mortgages must conform to the regulations set by Fannie Mae and Freddie Mac. You need a credit score of at least 640 and a debt-to-income ratio less than 43 percent of your monthly gross income. The minimum down payment is 3 percent. However, if you put down less than 20 percent, you have to pay private mortgage insurance on your home loan, which can add $100 or more to your monthly payment.
Conventional mortgages that conform to Freddie Mac and Fannie Mae requirements are currently limited to a maximum loan amount of $510,400. Loans above this amount are considered jumbo loans and are subject to stricter approval requirements by loan officers.
FHA Loans require a minimum down payment of 3.5 percent, but they accept FICO credit scores as low as 580. If you have a credit score less than 580, the down payment requirement jumps to 10 percent. Like conventional loans, FHA allows a debt-to-income ratio up to 43 percent, but lets your mortgage payment percentage go up to 31 percent of the homeowners' monthly gross income.
United States Department of Agriculture Mortgages
USDA loans are guaranteed by the US government and are intended to encourage homeownership in rural areas. This loan program is designed for borrowers with low-to-moderate incomes and low or zero down payments. Income cannot exceed 115 percent of the median salary for the area. USDA loans don’t have a minimum credit score qualification, but they do limit the debt-to-income ratio to 41 percent or less.
Veterans Administration Loans
Eligibility for VA loans is intended for members of the military or the surviving spouses of servicemembers. Qualifications for VA loans are much more flexible than typical mortgages. While the VA does not have a minimum credit score requirement, some lenders require a FICO score of 620 and above. No down payment is required.
Read More: The Pros & Cons of Mortgages
How Much Home Can You Afford?
Homeownership is a major financial commitment, and in the long term it's a good investment. However, owning a house shouldn’t wreck your household budget and put you in risk of foreclosure. You don't want to overspend on your house and become house-poor, not having any money left to meet your other financial goals and obligations.
Start by taking a look at your financial situation. Do you have stable sources of income? Do you have funds set aside for emergencies? How much debt do you already owe?
The first issue to determine when looking for a home is your price range. How much home can you afford to buy? You'll also need to consider the pros and cons of a fixed rate vs. an adjustable-rate mortgage and any funds you'll need to have for escrow.
As a general rule, you don't want your mortgage payment, including taxes and insurance, to exceed 28 percent of your monthly gross income and your total debt payments to go over 36 percent of your monthly gross income. For example, suppose you have a monthly gross income of $5,000, other monthly debt payments of $250, like a car payment and credit card, and you’re able to make a down payment of $25,000.
According to this mortgage affordability calculator, you’d be able to purchase a house up to a price of $271,000. Your mortgage payment would be $1,534 a month at 3 percent interest for 30 years.
After making on-time payments for several years, you may be able to refinance your mortgage at a lower rate if refinancing makes sense given your plans to stay in the home or use the increase in home equity to purchase a larger home.
How to Save for a Down Payment
For most people, saving enough for a down payment is the major obstacle to buying a house. In most cases, you're looking at saving up at least $10,000 or more for a down payment. So how can you accumulate enough money for a down payment in just a few years?
Set a goal for the amount of down payment you want to reach and start analyzing your household budget, looking for expenses to cut back or eliminate. Here are a few examples with estimated savings per month:
- Buy generic groceries - $160
- Save eating out for special occasions - $200
- Cut back on cable cost by using Netflix and Hulu - $110
- Pause gym memberships - $60
- Take lunch to work one day per week - $40
- Trim clothing budget - $100
- Carpool with coworker - $60
- Change to lower-cost cell phone plan with less data usage - $20
- Bring your own coffee to work instead of stopping by Starbucks every day - $50
These savings add up to $800 per month, or $9,600 a year. In two years, you would save $19,200, and in three years, you would have $28,800.
Here's the point. You won’t have all these expenses you can cut. But, if you look hard at your budget, you'll certainly find a number of ways to reduce expenses that can add up to a large sum in just one year. You don't need to wait 10 years to save enough money for a down payment.
Read More: What Does It Mean if Freddie Mac Owns My Mortgage?
How to Improve Your Credit Score
Your credit score has a major effect on the interest rate and terms a lender offers for your mortgage loan. Higher credit scores get lower interest rates and better terms. Even if you have a low credit score, you can still get a mortgage, but you'll pay more in interest costs.
Lowering your credit score takes a consistent, long-term strategy. Here are the steps that will increase your credit score.
- Get copies of your reports - Request copies of your credit reports from the three major reporting agencies. Look for any mistakes or discrepancies, and if you find any, get in touch with the reporting agency and have them corrected.
- Reduce your credit utilization - Your goal is to keep your utilization percentage less than 30 percent. For example, if you have $10,000 in lines for credit cards, you want to keep the balances owed to the less $3,000.
- Pay all bills on time - An established history of paying your bills on time brings your credit score up. A single late payment will result in a major drop in your score, so it's important to make your payments promptly.
- Don't close old accounts - If you have old credit cards you're not using, leave them open. The length of time or age for credit history is a positive for your credit score.
- Don't open new accounts - Each application for a new account creates a hard inquiry on your credit report, which has a negative effect on your score. In addition, opening new accounts decreases your average length of credit history, which has a further negative impact on your score.
A higher credit score also helps you get reduced premiums on car insurance, lower rates and higher limits on credit cards, higher loan limits on personal loans and waiver of deposit requirements on utility services.
After you have purchased your new house and moved in, you can continue the cost-cutting steps you took to accumulate your down payment. The funds can be used to set up your emergency account, which should be three to six months of your monthly budget. In the meantime, you can continue to work on improving your credit score.
All of these steps taken together will improve your financial health for years to come.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.