Smart Financial Planning Must Come Before Homeownership

Jo-Carolyn Goode | 5/6/2015, 9:30 a.m.
Whether you’ve got house envy about your best friend’s new place or just want to start building equity instead of ...

By: Michele Lerner

Whether you’ve got house envy about your best friend’s new place or just want to start building equity instead of renting, the first time you think about becoming a homeowner is the moment you should start financial planning.

While it may be tempting to begin looking at homes for sale, you need to be financially prepared so you don’t fall into the trap of identifying your perfect home—and then realizing you can’t afford to buy it.

Casual visits to open houses or random Internet searches are fine to see what homes cost where you want to live, but you will need to start working on your finances, too.

The most important elements of the financial planning you need to put in place before buying a home are developing a budget and starting to save.

Financial Planning for Homeownership

When you are ready to consult a lender to find out if you can be approved for a loan, the lender will base a decision on your credit profile, income, assets, job history and debt-to-income ratio.

Your debt-to-income ratio for the lender’s purposes is based on the minimum monthly payment for all of your credit card debt, student loans, car loans and personal loans—compared to your gross monthly income. In many cases the amount a lender will say you can borrow is higher than you may feel comfortable borrowing.

It’s crucial you decide what you think you can afford for your monthly payment and work with that number when you begin searching for a home.

Your comfort level should take into consideration other financial goals you have—saving for child-raising expenses, college tuition, retirement and even things like vacations, skiing or golf. Most of those expenses won’t be part of your lender’s calculation of what you can afford to spend on a housing payment.

Most lenders allow a maximum overall debt-to-income ratio of 43%, and some allow only a 41% ratio. The housing payment portion of your income should be a maximum of 31%, so if your annual income is $60,000 and your monthly gross income is $5,000, then your housing payment should be $1,550 or less.

Housing Payment

Homeowners have extra expenses renters don’t, such as property taxes and homeowners insurance. Your mortgage payment will include those costs as well as the principal and interest on your loan. You may also pay mortgage insurance if you make a down payment of less than 20%.

If you live in a condo or a community with a homeowners association (HOA), you will pay condo or HOA fees separately.

You should also budget for maintenance and repairs on your home, at least 1% of the home value.

Before you become a homeowner, you should create a budget based on your current finances and consider how you can adjust that budget to accommodate extra savings to allow you to buy a home and to afford potentially higher housing payments.

Saving Strategies

There are countless resources for living frugally and finding ways to save on everyday expenses such as your cable bill and groceries, but in order to save for a home you will need discipline to set aside money for the future.

Here are some ways to do that:

§ Create a special savings account for your home purchase and have part of every paycheck automatically transferred to that account. Start with as little as $100 if you can afford it so you get used to living on less and then gradually increase the amount.

§ Consider saving the difference between your rent and anticipated housing payment. This increase your savings, and you’ll also show a lender an established savings pattern and the ability to afford the housing payment.

§ Work extra hours or take on a second job temporarily to increase your income. Even something simple like walking dogs each evening or babysitting can help your savings accumulate more quickly.

§ If you get a bonus, a tax refund or a cash gift, deposit it into your home-buying account.

The simple process of creating a financial plan should be the beginning of a long-term plan to buy a house—and to keep it.

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