Financial Preparations for Homeownership

No one else can tell you that you’re ready to be a homeowner. This is one of the largest purchases many consumers will ever make. It’s something most of us do just a handful of times in our lives.

For many people, the right time is when they feel financially and emotionally ready for the responsibility. That’s not always easy to discern, especially for first-time homebuyers.

It’s essential that prospective homebuyers take steps to prepare for the financial responsibilities of homeownership.

Let’s take a look at a few key things you can do to better prepare yourself.

A budget will help you create and save for financial goals and determine if a mortgage is manageable. It’s important to get a clear picture of how much money is coming in and going out each month. Look for patterns and potential ways to save money. It’s tough to know what kind of mortgage payment you can afford if you don’t have a budget in place.

There are countless strategies, tools and best practices when it comes to budgeting. The goal is to figure out what works best for you while still giving you a clear, realistic picture of your finances.

Some consumers stick with the tried-and-true spreadsheet method, tracking all of their monthly expenditures in an editable document. Others prefer online tools and apps to track expenses and budget.

Mint.com and You Need a Budget are among the most popular, but there’s a host of options out there. You can log expenses as they happen, and some products will even link all of your financial accounts into a single profile. This form of real-time budgeting has become increasingly powerful for many would-be homebuyers.

Whatever your budgeting method, what’s vital is knowing where your money goes each month. Log all of your expenses over the last month or more -- and be sure to include all of them, like ATM fees and other easy-to-miss costs.

You can start by lumping them under broad headings or categories, along the lines of:

• Housing
• Installment loans (student loans, car payments, etc.)
• Credit cards
• Food
• Transportation
• Clothing
• Entertainment
• Utilities
• Infrequent expenses (auto insurance, holidays, vacations, etc.)
• Unexpected expenses (car repairs, medical bills, etc.)

You may have different expense categories, or more, or fewer. You want your budget to accurately reflect your specific financial situation and your savings goals. There’s no other way to get a handle on how to trim expenses and maximize savings.

Once you see all of your monthly expenses in black and white, you can start to set new spending goals. Let’s say you want to trim your overall spending by 10 percent, build an emergency fund and start saving for a home purchase. Run through your expense categories and look for simple ways to cut costs and start saving.

Some ways you might be able to curb spending include:

• Buy groceries in bulk and plan meals ahead of time rather than eat out
• Try to negotiate better deals for current services, such as cable TV or Internet; or downgrade your current plans; or drop them entirely and get a library card
• Carpool or use public transportation
• Evaluate memberships and subscriptions
• Repair clothes or hit a thrift shop rather than buy new

Some consumers will earmark every dollar that comes in each month for a specific category or need, whether it’s paying the cable bill, covering the month’s groceries or putting money in a “new house fund.” Automatic withdrawals and bill pay can help make it easier to dedicate those dollars every month.

Other people use an envelope system to pay for some of their monthly expenses in cash. Once the “groceries” envelope is empty, for example, that’s it until the next paycheck.

No matter your approach, it’s important to be realistic and committed yet flexible.

Put a little money in a “Fun stuff” category every month. Giving yourself some room to breathe will help you fight the urge to abandon what might feel like an overly restrictive new lifestyle. Common-sense budgeting is really meant to help you gain more financial freedom, not less.

It’s also a critical step before you begin the homebuying journey.

You don’t need to be debt-free to land a home loan. But lenders will calculate a debt-to-income (DTI) ratio based on your gross monthly income and major debts, including your new projected mortgage payment. For example, if your gross monthly income is $4,000 and your major monthly debts are $1,800, that’s a 45 percent DTI ratio (1,800/4,000).

Broadly, the VA likes to see a DTI ratio of 41 percent or less. You can have a higher ratio and still get a loan, but you’ll often need to meet additional financial requirements. Different lenders can have different caps for DTI ratio, but the higher your ratio, the tougher it can be to secure financing.

In addition, some types of debt can be more troublesome than others. Lenders may have an in-house cap on how much “derogatory credit” borrowers can have. This catch-all term can include things like collections, charge offs, judgments and liens.

Whether it’s $5,000 or $15,000 or more, these derogatory credit caps can vary by lender. And some of these issues, like judgments and liens, need to be satisfactorily addressed before a loan can close. That often means either paying the sum in full or establishing a repayment plan and a history of on-time payments.

The bottom line is: Your major monthly debts will play a big role when lenders look at what you can afford and how much home you can buy.

As with budgeting, there are multiple approaches and strategies out there for how best to pay down debt. Some common approaches include:

• Target the debt with the highest interest rate (it’s often a credit card). Work on paying that down first before moving on to the account with the next-highest rate.
• Transfer high-interest balances to a lower-rate credit line. Be mindful of transfer fees.
• Pay more than the minimum on your accounts. This can speed your repayment plan considerably and cut down on how much interest you pay. By paying only the minimum, all you’re doing is drawing out the repayment period.
• Start by paying off the accounts with the smallest balances and work your way up to the largest. Use the “little victories” method to build momentum.
• Stop taking on any new debt. Stick to your budget and live within your monthly means. Build an emergency fund to avoid racking up credit card debt if there’s an unexpected expense.
• Have a garage sale or unload little-used household items online. Put the money toward debt repayment.
• Avoid short-term lending options like payday loans. These tend to have exorbitant interest rates that can lead to a debt spiral. Don’t co-sign on loans for people, either.
• Avoid short-term lending options like payday loans. These tend to have exorbitant interest rates that can lead to a debt spiral. Don’t co-sign on loans for people, either.

Establishing a realistic budget is a key early step before you decide how best to tackle your debts. Set monthly savings goals that include funds earmarked for debt repayment. Finding the right strategy is important, but you also need the available cash to make those payments every month. You can’t do that effectively without a good budget in place.

Then you can settle on a debt repayment approach that best fits your specific situation.

A mortgage “test run” can help you understand how much of a mortgage payment you can handle. You can use our VA Home Loan Calculator to determine your estimated monthly payment.

Let’s say you’re paying $800 a month in rent, and the kind of home you’d like to buy will have a mortgage payment of roughly $1,200. That’s a $400 difference. Over the course of the next few months, pay your rent, and then take an additional $400 and put it in a separate account.

See what it’s like to live without that $400 you’d normally have on hand. If you can manage just fine without it, you may be ready for a mortgage payment. Otherwise, you might want to revisit your budget or set your sights a little lower in terms of how much house you should buy.

What if you don’t have housing expenses right now? If you’re living with a family member or friend rent-free, lenders may be concerned about “payment shock” with a new mortgage. Ideally, prospective buyers who haven’t been burdened with a rent payment should have been able to build up a nice nest egg.

Those who haven’t socked away money thanks to their rent-free arrangement may come under closer scrutiny. Lenders may wonder: If you haven’t been paying rent for 12 months, why don’t you have 12 months of rent saved up? How will you able to afford your new $1,000 a month mortgage payment when you weren’t saving $1,000 a month in rent?

This is where assets and reserve funds can play a key role in showing mortgage lenders you’re ready for the financial responsibility of a home loan.

We’ve already talked about some of the upfront costs associated with home loans. In most cases, there’s no set amount of assets you’ll need in the bank to begin this journey, but lenders will want to make sure getting a loan doesn’t leave you penniless.

Before buying a home, consider stockpiling at least three months’ worth of living expenses in a separate account. This emergency housing fund is also known as “reserves,” and it needs to be readily accessible in case of joblessness, illness or injury. An added bonus is that those reserves will make you look really strong in the eyes of lenders.

There can also be situations when lenders will require you to have a certain number of months' worth of reserves in the bank. Larger loan amounts and buyers who aim to count rental income toward qualifying for a new mortgage are a couple common examples.

With the right financial preparation, mortgage payments will slip comfortably into your monthly routine. You’ll have the diligence, experience and funds necessary to make that payment without a second thought.

As prepared as you might be, a lender still has to decide if you’re ready to handle a mortgage. A big part of the evaluation hinges on your credit profile.

We’ll cover credit in detail in Course 2.