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THE PATH TO HOMEOWNERSHIP

Proper preparation now can help to make the most of your resources.

PREPARE FOR YOUR PURCHASE

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Preparing yourself and your finances before you start looking for a home can help you afford the home you want to buy.  Putting in some time and financial discipline up front will give you an opportunity to improve your credit, pay down debt, save money, organize your finances, or possibly increase your income.  All of these factors can directly improve your ability to qualify for and purchase your new home.​  

ROADMAP

SAVE MONEY

BUILD AND STRENGTHEN CREDIT

MINIMIZE DEBT & LOWER YOUR DTI

ASSESS YOUR INCOME

ORGANIZE YOUR FINANCES

UNDERSTAND THE NUMBERS

Save Money

SAVE MONEY

This may be the most obvious preparation, but also most difficult for many borrowers.  There are so many things that demand and desire our money, that it can be a challenge to keep any in our saving account!  But, for those looking to buy a home, saving is a must.  Cash reserves are needed for several things when buying a home:  the deposit, the down payment, closing costs and, last but not least, the unexpected - repairs, improvements, furnishings and emergencies.  

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  • Earnest Money Deposit - This deposit is an actual cash deposit that is required to be paid to the title company when your offer to purchase a home is accepted.  It gives the seller confidence you are serious about the purchase and "holds" the contract between you and the seller until closing.  If you decide to walk away, other than for a few specific reasons, you will not receive this money back.  The amount of the deposit is 1% to 2% of the purchase price and must be provided within 3 days of the signed bi-lateral contract (aka both seller and borrow signed contract).   For a $180,000 home purchase this deposit could be between $500-$3000.  In competitive purchase situations, a slightly larger deposit could be advantageous, depending on the specific scenario. 

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  • Down Payment - Most loans require at least 3.5 -5% to be put down at closing.  If you put down less than 20% or have less than 20% equity in the home, you will be required to pay private mortgage insurance (PMI) until you reach 20% equity.  PMI can cost about 0.5%-1% of the loan amount annually.  On a $180,000 loan PMI could cost between $75-$150/month.  Thus putting 20% down - if you have the funds available - can translate to monthly savings.  VA loans have a 0% down payment option and do not require PMI, however they do have a one time funding fee (1.5 to 3..3% of the loan amount) that is slightly higher if you put 0% down.  When considering saving for a down payment, another factor to look at is how much you will pay in interest over the life of the loan.  The more you put down, the smaller the loan and the less you will have to pay in interest.  You can check out a mortgage amortization calculator like this one to check the total interest over the life of the loan, but here are some examples.

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    • 180,000 with 0% down @ 4.5% over 30 years = $148,332 in interest ​

    • 180,000 with 5% down @ 4.5% over 30 years = $140,915 in interest ​

    • 180,000 with 20% down @ 4.5% over 30 years = $118,665 in interest

            (This saves $183/month and about 30K in interest savings over the life of the loan)

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  • Closing Costs - The final step in the buying process is to "close" on the home.  This is where you sign all of the legal documents and the money and keys exchange hands.  There are costs involved in finalizing the deal that must be paid, in most cases, by the buyer.  In addition to closing fees, there are items (referred to as "pre-paids", such as insurance and taxes) that must be paid to the lender at closing.  All of these costs are referred to as closing cost and can be about 3-5% of the purchase price.  The buyer will need to have this money (known as "cash to close") wired to the title company in order to close.  Some loans allow the seller to pay all or a portion of the closing costs, but this must be written into the original purchase contract (and can hinder your negotiating power).  The closing costs can also be rolled into certain loan types.  It is important to consider that whenever you increase loan amount, you also increase the amount of interest you pay over the life of the loan.  

  • Repairs, Improvements, Furnishings and the Unexpected -  There are a lot of quantifiable costs during the buying process, but don't forget to plan for necessary and or unfortunate situations that could lead to unexpected expenses.  You don't want one of life's curve balls to plunge you into a bad financial situation once you've just moved into your new home.  In addition, moving can cost money - so does furniture, appliances, painting or small updates you want to make once you move in.  Plan ahead so you don't exhaust all of your cash reserves on the purchase.  

BUILD & STRENGTHEN YOUR CREDIT

Your credit score plays an important role in what loans and interest rates you will be eligible for.  Excellent credit allows you to take advantage of some of the best mortgage options and lowest interest rates available.  A lower interest rate essentially means the loan "costs" less.  There will be less money going to interest each month, so your monthly payment will be lower.  To demonstrate the impact the interest rate can have on your monthly payment, we will look at a $180,000 loan amount with a 4.5% rate vs a 5.5% rate.  The monthly payments for these rates would be $912 or $1022  (payment only includes principal and interest).  The interest rate only differs by 1% which may sound insignificant, but an extra $110 a month  can quickly add up.  For the higher rate, you would spend an extra $1320 per year or over the life of the loan (typically 360 months) you would end up paying about $40,000 more for the same home.  Understanding the impact of small variances in interest rates can help you to appreciate the impact that good credit can have on the cost of your home.

 

Unfortunately, the world of credit scores can be a confusing place.  Most people know a good score is important but aren't sure how to increase their score.  Some things that increase your score are obvious, but others can be counter intuitive.  Here are a few tips as you are trying to build and strengthen your credit.  It may also be helpful to consult with a reputable credit repair company to review and make recommendations for your specific situation.

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  • KNOW YOUR SCORE.  What is your credit score?  There are ways to find out your credit score without impacting your credit.  A "soft pull" may not be as accurate as a full credit report, but it can provide you an idea of where you stand. â€‹ 

  • DON'T close credit accounts that are in good standing or paid off; a long positive history helps your credit score!  Closing lines of credit you have had for awhile could shorten your credit history and result in a lower score. 

  • COLLEGE LOANS can be considered long lines of credit.  If you have had them longer than your other lines of credit, paying them off in preparation for a home purchase could also shorten your length of credit history, resulting in a lower score.  

  • DO keep your credit card balances under 25% of your overall limits.  This is called your utilization ratio.  Your credit score can negatively be affected if your balance is higher than 25% of your overall limit. 

  • DO have rotating balances that you pay ON TIME.  These can be helpful if you pay them off on time and keep the amount under 25% of your overall limit.  

  • PROCEED CAUTIOUSLY with PAST DUE credit accounts.  Overdue accounts can be outside of the credit report window and may not show up on your credit.  When you pay them off it could re-open the debt and lower your credit score.  In other situations the debt is sold to a new debt collection agency which causes it to show back up on your credit report.  It may be helpful to consult a credit professional to find out the best option for your situation.

  • CREDIT PULLS FOR A HOME PURCHASE WON'T HURT YOUR SCORE.  Shopping around for a mortgage won't hurt your credit!  There is a 45 day window allowed for credit inquiries from mortgage lenders.  These inquiries are recorded on your credit report as a single inquiry.   

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Build Credit

MINIMIZE DEBT & DECREASE YOUR DTI

On top of having money saved up to make the initial home purchase, the lenders want to determine if there is enough money in your monthly budget to be able to make your mortgage payment.   To calculate where you stand, the lender will add up all your monthly debts (credit cards, car loans, school loans, child support, other debts you owe) and compare that amount to your monthly income.  This is called your debt to income ratio or DTI.  Lenders utilize a borrower's DTI to classify the risk of a borrower defaulting.  When too much of your monthly income is devoted to paying debts, there is not as much available for your mortgage payment and you are more likely to default.  Lenders like to see no more than 36% of your gross monthly income (gross = before taxes) going toward your monthly debts, which includes your proposed mortgage payment.  There are exceptions, but generally a DTI of 43% is about the highest DTI a borrower can have and still get a qualified mortgage.  The only ways to lower your DTI (and make room for a higher mortgage payment) is to either pay down your debt or increase your income.  The maximum loan amount you will be approved for is directly impacted by your outstanding debt. 

 

How to calculate your DTI:

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Minimize Debt
DTI Calculation
DTI Table-Income
DTI Calculation and Explanation
DTI Table-Liabilities

The following expenses/debts are considered liabilities when calculating DTI:

  • Minimum credit card payments

  • Car loan payments

  • Child Support payments

  • Alimony payments

  • Co-Signed Loans.  These loans count as though they are solely your debt unless you have 12 months of proof the other party has paid the bill.

  • Deferred student loans.  A monthly "payment" of 1% of the outstanding balance will be included in your DTI.  This can be significant to your DTI if you have a large loan, 1% of 50K is $500.  

  • Back Taxes.  These can and will stop a deal if they are not discussed and taken into account.  You must be on or eligible for a payment plan.  If you suspect you may owe back taxes, DO NOT wait or keep it to yourself during the application/approval process.  These taxes will be discovered prior to closing and can have serious, and potentially terminating, implications for your home purchase. 

  • Active litigation or other professional debts require either proof of payment or proof of a payment plan.  Some loans (FHA) will include 5% of the total amount as a monthly payment in the DTI calculation. 

Assess Income

ASSESS YOUR INCOME

​Income plays a relatively obvious role in how much house you can afford.  For loan purposes, your income is the amount of money you consistently bring in each month thru your employment, or other means - rental property, pension, social security, child support, adoption, etc.  To be considered income and included in the lenders calculations, your income must meet two requirements: it must be consistent and it must be reasonably expected to continue for the next 36 months. 

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  • Consistent Monthly Income- The history and consistency of your income is important.  The underwriters looks at your current pay stubs to see what you are earning now, as well as your tax returns to see what you have been earning over the past 18-24 months.  This helps to identify what your monthly income has been and what income can be expected in the future.  If you have overtime or other income that can be variable, potentially 2 years of paystubs/earning history could be needed.  

  • Continued Income - The underwriters want to evaluate if your income is reasonably expected to continue for the next  3 years and into the future.  They look thru your file to ensure there are no red flags or indications your income has an end date.  Work contracts expiring, children aging out of child support, alimony terminating etc could all disqualify an income source from the calculation.  

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The larger your income, the more likely it is for you to be approved for a larger loan, but there are still limitations.  The percent of your monthly income that banks will allow to be devoted to housing related expenses is called the mortgage to income ratio.  

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  • Mortgage to Income Ratio - Even if you are debt free, lenders only allow so much of your income to be allocated to your mortgage payment.  Each loan type has a slightly different maximum mortgage to income ratio but most are below 50%.  FHA loans cap housing related expenses (principal, interest, insurance and taxes) at about 30% of your income.   The mortgage to income ratio can be a limiting factor for those who do not have any additional debt and could potentially put more of their income toward their home.  It can also restrict buyers who are on a path to higher earnings, but don't have the history of a higher monthly income. 

  • How to Calculate your Mortgage to Income Ratio (Sometimes referred to as "Top"):

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There is a different process and requirements for calculating income for Self Employed borrowers (and other non W-2 borrowers) looking to purchase a home.  The experts at Simplicity Mortgage have a great deal of experience and expertise in securing home mortgages for self employed borrowers.

Mortgage Income Calculation
Organize Finances

ORGANIZE YOUR FINANCES & DOCUMENTATION

Lenders and underwriters don't take your word about your financial readiness, they require proof and documentation.  In order to be approved for a mortgage, you have to have both the cash available for the initial purchase and regular, consistent income to make the on-going monthly mortgage payments.  They will look over your file, verify what you have stated and determine your eligibility and risk.  Their assessment will determine how much they are willing to lend and your interest rate.  Being organized and prepared will help this process to go smoothly.  You must be able to justify your financial readiness by providing documentation such as bank statements, tax returns, W2's, paycheck stubs, legal paperwork for child support/adoption/alimony, etc. .    

  • Paycheck Stubs: show your current income, place of employment and year to date earnings.

  • Bank Statements: will provide the money for your deposit, down payment and closing costs.  Several months of history may be required to show that you have a sufficient amount available for the transaction.  If there is a large deposit, the underwriter will need to track back several months to determine where the money came from.   It can be easier to track (and less researching & uploading for you) if you begin to consolidate the cash to be used for the purchase earlier on in the process.  This way you will have several months of history and you won't have to scramble at the last minute to provide sets of statements from various banks, stocks, bonds, retirement etc that shows the source of the funds.​

  • Tax returns, W2's and 1099's: are used by the underwriters to find out additional information about your financial history and readiness to repay a mortgage.  The tax return confirms your income history, history of any property or rentals owned, as well as if you any outstanding debts to the IRS.   

  • Legal/Court Documents: are used to provide proof income from alimony, child support, adoption or other settlements.  

  • Gifted Funds:  - Gift funds can be used for the down payment but have to be from an eligible source.  Eligible sources include relatives, close friend (who has a clearly defined and documented interest in the borrower), charitable organization, government agency, or a public entity that assists low-income or first-time home buyers.  A relative is defined as the spouse, child, dependent, fiance, domestic partner, or any other individual who is related to the borrower by blood, marriage, adoption or legal guardianship.  A gift donor may NOT be a person with an interest in the sale of the property, such as the seller, agent, broker, or builder.  

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