4 Financial Factors That Determine If You're Ready to Buy a House
There will likely be a time in your life where you’ll ask yourself, “Should I Buy A House?” You may have a baby on the way, or you may just need more space for your family. Many Americans have the dream of owning a home, and it may be the right choice for your lifestyle.
Before you decide to buy a house though, you should take a look at your financial situation. There are four primary variables that will determine whether you can buy a house, and they are often more daunting to first time home buyers than they should be. These variables are income, debt, downpayment,
and credit score.
Written by Matt Lavinder, President of New Again Houses®
As a rule, your mortgage or rental payment should not exceed 30% of your gross income
. The housing payment (mortgage or rental) includes the monthly payment, property taxes, and insurance. This is often referred to as PITI, meaning Principle, Interest, Taxes, and Insurance. The gross income is your monthly gross wages BEFORE taxes are taken out of your paycheck. It’s typically the top line “Gross Wages” on your W2.
Self-employed or 1099 income?
Well, lenders don’t like either. But don’t give up on the American Dream. Lenders will typically want to see two years of 1099 or self-employed income in the same line of work. They’ll average those years to determine your gross monthly income. Once you have your gross monthly income, multiply it by 30% to find the maximum amount lenders will be comfortable allowing for your monthly housing payment, property taxes, and insurance (PITI). $3,000 per month of gross income?
Lenders will assume you can afford $900/month for payments, property tax, and insurance (3,000 x .3 = $900). Lenders might allow more than 30%, but you will need to show some offsetting factors like a high credit score, additional down payment or cash reserves.
What if you have a spouse or partner who will be buying the house with you?
You can put anyone on the deed with you. If you include them on the mortgage and count their income, you’ll also need to count their debts and credit score. If the two of you have combined gross income of $6,000 per month, your maximum PITI will be $1,800 ($6,000 x .30 = $1,800). If your partner has a disastrous credit score, you probably won’t be able to count their income for purposes of the mortgage.
Lenders calculate your debt by a calculation called Debt to Income Ratio
, commonly referred to as DTI. DTI is the percentage of your income that is used to make debt payments. Debt payments include payments for a car, student loans, mortgages (PITI), minimum credit card payments, personal loans, and any other debt payment. This does not include utilities, taxes, personal insurance, or other similar expenses.
Debt payments are only payments owed to others as opposed to living expenses. Here is the calculation:
Total Monthly Debt Payments / Monthly Gross Income = DTI
For example, let’s assume you have the following situation:
W2 Year Income = $48,000 ($4,000 per month)
Car payment = $400/month
Minimum Credit Card payments = $100/month
Student Loan payment = $300/month
Personal Loan payment = $200/month
Total Monthly Gross Income = $4,000/month
Total Debt Payments = $1,000
DTI = 1,000/4,000 = 25%
Now, let’s see how much house payment (PITI) you can afford. Lenders differ, but most lenders are comfortable with a DTI up to 41%, meaning 41% of your income can go toward debt payments. This includes your mortgage payment. Here is the calculation:
Income x .41 - Existing Debt Payments = Allowable Mortgage Payment
4,000 x .41 - 1,000 = $640
A $640 house payment might not get you the house of your dreams, so let’s add your partner’s $3,000 income and $500 of debt.
7,000 x .41 - 1,500 = $1,370
Better, right? If you use your partner’s income, you must also use their debt and credit score. If your partner has a low credit score, you might not be able to add their income to the calculation. If you use an individual’s income for the mortgage qualification, they will also have to sign on the loan and bear equal responsibility if it defaults.
Some lenders will allow you to have a cosigner, such as a parent. If they co-sign and add their income to the equation, they will be personally responsible for the mortgage if you default. The PITI payment will also be included in your co-signer DTI as well as the mortgage. That means their ability to borrow money for their own house could be severely limited because they have co-signed for your mortgage.
Some mortgage products will allow your DTI to go as high as 50%+, but most lenders will only be comfortable up to 41-43%. If you need a higher DTI, your best option might be an FHA loan that can go up to 50% or higher. These federally backed mortgages typically allow for the highest DTI.
Your grandparents likely needed to save up 20% before they could get a mortgage. 20% down is still the ideal, but it is not required to buy a house today. There are many options that require as little as 0% down to buy a house.
Here is a list of federally backed available mortgages and the required minimum downpayment:
FHA Mortgage - 3.5%
VA (Veterans Administration) Mortgage - 0% (Must be a qualifying veteran. Check this link.)
USDA Mortgage - 0% (House must be located in a rural area. Check this link for eligibility.)
95% Conventional - 5%
State Funded Mortgages - These are state funded second mortgages that cover the down payment required by the first mortgage.
In addition to these widely available options, individual banks and credit unions offer their own “in house” portfolio mortgages. Since the local lenders typically hold these mortgages long term, they have some discretion in the qualification requirements.
It’s not unusual for local banks and credit unions to offer 0% down mortgages for applicants with strong credit scores, typically over 660. These products are unique to each local lender so it’s okay to shop around to local banks and credit unions to understand the options. The interest rates are often a bit higher, but they usually don’t require mortgage insurance.
Mortgage insurance is often required on mortgages with less than 20% down payments. The mortgage insurance can equate to an additional 1-1.5% interest increase. USDA and VA mortgages are especially valuable because they are 100% options with minimal mortgage insurance.
Explore 1st time home buyer grants
In addition to low down payment mortgages, there are a lot of first time home buyer grants available. Such grants are usually federally funded through Economic Development Districts
throughout the country and are between $3,000 - 15,000 toward a down payment or principal reduction. These grants typically have income caps that are around 80% of the median household income in the county.
If your income is below the median in your county, these are certainly worth looking into. They often require a half or full day of homebuyer education class. These funds are often funded by the federal government on July 1 and often run out by winter. Late summer and fall are the best times to secure these first time home buyer grants. Other grants, referred to as the Hardest Hit Fund, are available for specific zip codes in 18 different states. These grants go up to $15,000 and can be added to other grants.
The FHLB (Federal Home Loan Bank) is mandated by law to fund homebuyer assistant grants in each of its regions. It does so through various agencies, lenders, and nonprofits. The Welcome Home
grant funds $5,000-7,500 toward purchases. These grants are funded in March by various approved lenders and credit unions. The funds are typically exhausted within 30-60 days and aren’t available again until the following year.
Every lender has access to different grants, so do your research and don’t depend on one lender to educate on all the options available.
Credit scores are one of the most important variables involved in getting a mortgage and they are shrouded in mystery. Your credit score is a measurement of your likelihood to pay your debts. It’s based on your payment history, the number of accounts, and utilization rates of credit cards. Credit scores range between 300 and 850. Any credit score over 660 is good and over 700 is an excellent score that will get you the best options for mortgages. Credit scores over 630 should be eligible for some, but not all, mortgages. Many first time home buyers have minimal to no credit history, which results in a low credit score.
There are ways to build on a shallow credit score. The most important thing is to get a credit card and keep a low utilization rate. If your credit card limit is 1000, pay down the balance to under $100 each month. This will tell the credit bureaus you have access to funds and don’t need them. If your scores are low, it may be because your utilization rate is high. The easiest way to move a credit score is by adjusting the credit card balances to under 10% of the limit.
Another shortcut is to have someone with a low utilization credit card add you as an authorized user. Oftentimes, you’ll piggyback on the history of strength of that account immediately. If you don’t have enough history to get approved for a credit card, you can get a secured credit card. This is a prepaid card offered online and through many local banks and credit unions. You can get one with no credit history and it will report to the credit bureaus like a credit card. Over the course of several months, a secured card can significantly raise your score.
Once you determine your house payment budget and qualification status, shop around for a quality lender with multiple mortgage options. If you are denied by your own bank, don’t panic. You may need to build your credit, pay down some debt, or simply find a different lender with different requirements.
Should I Buy A House?
These 4 financial factors will help you determine if you should buy a house. Buying a home is a key part of the American Dream that can help you build wealth, but there are many hurdles to jump through before you can own a home. However, it’s definitely not impossible.