17 Critical Financial Steps You Should Take When Buying a House
So you’re ready to take the leap and buy a home. Congrats, you’re about to enter a long financial process that has more hoops to jump through and potential tricks than a three-ring circus.
Done the right way, though, buying your home can be a smooth process that’s a relative breeze for everyone involved. What follows are 17 financial steps you can take, from getting a credit health check to selecting a lender, that will make buying a home a better experience.
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1. Check Your Credit
Your credit score and history are the first things all lenders will look at to decide whether or not to consider offering you a mortgage, so you need to check your credit to make sure you’re in good standing with all your debts. Numerous sites offer free credit reports and free estimated credit scores.
When you pull your report, first check out your score, which will be a three-digit number that generally ranges from 300 to 850. Most lenders look for a score of at least 600 to 640 to offer you financing, but some will make exceptions for buyers in the high 500s. This estimated score will give you a good idea of where you stand, but keep in mind that lenders have their own scoring models, so your official score will vary.
After checking your score, you’ll want to dig deep into your credit report to find any old unpaid debts that could affect you. Forgot to pay that old electric bill six years ago? That's probably on your report as an old collections account and will impact lenders’ willingness to approve you.
You also want to check for accounts you don’t recognize and dispute them if you believe they are fraudulent.
2. Fix Any Outstanding Issues on Your Credit Report
If you found any outstanding debts, even ancient ones, it is worthwhile to track down the creditors and call them. It may sound strange to call a debt collector yourself, but hear me out.
Once you get the collector on the horn, find out what the debt is for, how much you owe and if there is a discounted settlement to pay it off in full. If the collector offers you a settlement to pay it off in full and leave it as a $0 balance, take it. If the creditor offers a payment plan only, you will want to pass, as this could renew the debt on your credit and make it look more recent than it actually is. The collection account will remain on your credit after paying it, but lenders are more likely to forgive an older collection account with a $0 balance than one you still owe money on.
You will also want to type up quick explanations of any collection accounts, even those with a $0 balance. Remember, the mortgage underwriting process involves a human element, and these explanations go a long way in easing an underwriter’s mind.
3. How Much Home Can You Realistically Afford?
You have wants and needs in mind for your new home, but can you really afford to pay for a home that ticks all the boxes? This is often the most difficult part of the home buying process.
Many so-called “rules” govern much you should spend on a home, but financial guru Dave Ramsey recommends a conservative approach that’ll keep you from getting too deep in debt. Ramsey suggests limiting your mortgage payment to 25 percent of your take-home pay or less. Sure, your realtor and bank will likely base everything off your pretax pay, but you must pay that mortgage from the cash that hits your bank account after taxes.
Using this approach, if your household take-home income is $4,000 per month, you should limit your monthly mortgage payment to $1,000. There are numerous mortgage calculators on the internet, but Dave Ramsey’s calculator is one of the easier ones to use, plus it helps you estimate taxes and insurance, which you need to include in your 25-percent budget.
Based on your $1,000-per-month budget, you can afford up to a $161,500 home on a 30-year mortgage. If you go the 15-year route, which lowers your interest rate but increases payment amounts, you can afford a $119,000 home.
Keep in mind, with this strict budget you may run into the unfortunate reality that it doesn’t align with your wants and needs. This means there are sacrifices you must make like mothballing that man cave or scraping the she shed to stay within your budget.
4. Calculate the Down Payment You’ll Need
Now that you know what home price you can afford, you can anticipate what down payment you will need. This varies greatly by the lender and type of loan. Some loans, including FHA, require as little as 3.5 percent down, while traditional lenders often want 10 to 20 percent.
Since you don’t want to apply for loans and ding your credit score yet, you need to look at a worse-case scenario. Let’s say you cannot qualify for one of the low-down-payment government-backed options and must go with a conventional loan and take a cheaper home on a 15-year plan to pay it off quicker. Based on the 10-percent minimum a conventional loan would require, you would need at least $11,900 for a down payment.
5. Set a Household Budget
You should already have a household budget — even a loose one. If not, there’s no better time than the present to get your finances in check. List all your expenses and subtract them from estimated income. If your bottom line ends up a negative, then you have larger issues that require significant cuts before you can even consider buying a home.
If you fall in the positive, you’re off to a good start. Adjust your budget to include your savings toward a down payment by multiplying your monthly surplus by the number of months you have until you want to buy your new home. For example, if you have a $1,000 surplus each month and plan to buy a home in 12 months, you would have $12,000 saved for a down payment and closing costs.
Now, compare that savings to the down payment you need on the price of home you plan to purchase. If it is equal to or more than that, you are in good shape and can proceed with confidence. If it is less than that, you need to divide the difference by the number of months you have until you make you home purchase to find out how much in expenses you need to cut.
For example, if you plan to buy a home that requires a $15,000 down payment and your current budget adds up to only $12,000 in savings, you would have a $3,000 shortfall, which means you would have to cut another $250 per month in expenses on a 12-month purchase plan or push back your purchase date.
6. Collect All Your Savings and Gifts in One Account
If you already started saving for your new home, received a financial gift from a friend or relative to help you buy your home, or plan to cash out your 401(k) to get your new home, it’s best to get all that funneled into one account as soon as possible. Lenders don’t take last-minute big shifts in money lightly and may ask for time-consuming and tedious explanations if you move money around late in the process. Handling this months in advance keeps it off the lender’s radar and eases the process.
7. Collect Your Tax Returns
Unless you’re an avid collector of past pay stubs or customer invoices, there’s a good chance you have no way to prove you made as much money in the last few years as you told your lender. This is where tax returns come in.
If you are a regular employee, lenders might request your last three or four years of tax returns so they can analyze your income and determine your average yearly salary and bonuses. If you own a business or are a contract employee, the lender will almost certainly ask for these to verify you produce as much profit as you claimed on your application. The lender will typically use your last three returns to create an average salary for your application.
If you don’t have your last three years of tax returns, you can navigate to IRS.gov and order tax transcripts.
8. Create a Year-to-Date Profit-and-Loss Statement
A what and what statement? If you own a business, or are a sole proprietor or contractor, most lenders will want to make sure you are profitable every year, including the current year. You can prove your profitability in past years with tax returns, but the only way to prove it in the current year is a running year-to-date profit-and-loss report.
This may put you in an immediate state of shock because you’re not an accountant and have no idea how to make a YTD P&L report. Take a deep breath and just search “profit and loss report” online to find countless templates. Plus, there’s nothing overly complex to filling in your numbers — as long as you file all your receipts and invoices where you can access them easily.
With all your receipts and invoices handy, this is a quick and painless math problem: YTD revenue - YTD expenses = YTD profit or loss. Done!
9. Print Out Bank Statements and Explain Any Irregularities
Mortgage companies get a little picky when handing over a few hundred grand for a home, so be prepared to jump through hoops. One such hoop will be the six or so months of bank statements the lender will want to see. When you are getting ready to apply for a mortgage, it’s best to have at least some of this legwork done ahead of time because it can get tedious and muddy up the process.
Why is printing out a few bank statements so tedious? It’s not the printing. Instead, it’s all the analysis these statements will go through. The underwriter will tear through every page of your bank statements looking for red flags and asking for written explanations.
That $10 your Aunt May gave you for your birthday last month won’t raise any suspicions, but that $3,000 check you deposited from selling your car sure will. After printing out your statements, just do a quick scan to see if there are any irregular large deposits or withdrawals and type out quick explainers ahead of time. Your lender will appreciate your initiative.
10. Find What Loans You May Qualify For and Get Prequalified
When you are about 60 to 90 days from buying your home, it's time to take the first big leap and get prequalified for a mortgage. But first you have to find out what kinds of mortgages you can qualify for. There are more types of mortgages than anyone cares to count, but the most common ones are conventional, adjustable rate, Veterans Affairs, United State Department of Agriculture and Fair Housing Administration.
You can do a little light reading to see what you may qualify for, but you will want to speak with a mortgage professional to highlight your best options. Many people qualify for low-rate FHA mortgages, but its mortgage insurance requirements and other regulations offset lower down payment and interest rates they offer. A mortgage professional will quickly identify these details and steer you in the right direction for your financial situation.
To get prequalified, simply apply online through one of the countless mortgage lenders online or call a few local lenders. They will pull your credit and do a quick check of your finances to see if you qualify. If you qualify, the lender will tell you your spending cap, which will likely be way above the 25 percent budget you set earlier. Don’t let the amount you are approved for dictate your budget — future you will appreciate if you stick to the 25 percent rule.
One thing to keep in mind about a prequalification: It does not guarantee approval.
11. Meet All Your Conditions
Sometimes, you get what’s called a “conditional prequalification,” which means you qualify but only if you meet certain requirements. In some cases, this is paying off an old cable bill from your first apartment or lowering your debt-to-income ratio — the amount you pay on debts relative to your monthly salary. Without meeting these conditions, it’s unlikely you’ll get the final approval to buy the home.
12. Save, Save and Save Some More
With your down payment and closing costs all estimated, continue your savings journey with a more precise destination. By this point, you should already have a large chunk of money saved, but the exact dollar amount will give you a clearer picture as to how much you really need.
Depending on the amount you need to save and your estimated home-purchase timeline, you may need to tweak your budget. So revisit the budget you set a while back and make any additional cuts where needed. While these cuts may hurt now, they are only temporary.
13. Time for Free Money and Loans
With a prequalification in hand, it is time to see what kind of homebuying assistance you qualify for. Many local and state governments will hand over cash for special homebuying situations. In Florida, for example, many counties participate in neighborhood improvement projects that offer buyers up to a few thousand dollars in interest-free loans to buy homes in select areas. I used one of these loans to buy my first home and got an interest-free $5,000 loan.
If you’re having a hard time finding these programs, speak with your realtor, as they generally know all the local homebuying programs.
14. Choose a Lender and Get Approved
When you are about 30 days from officially buying a home, pick a lender. Sure, you may have gotten a prequalification letter from one or more lenders, but that doesn’t marry you to them. Feel free to shop around for the best rates.
You may be scared to shop for rates because each lender must pull your credit when giving you a rate, and inquiries generally hurt your credit score. According to MyFico, you can shop for rates for 14 to 45 days, depending on the scoring model, and all the inquiries in that span will count as just one inquiry. So feel free to shop around.
Keep in mind, you are shopping for more than just the lowest payment. You also want to consider the interest rate, closing costs and many other variables. One way to keep this all in check is to ask the lender for a quote that includes the total cost to finance the home. This will add the price of the home, closing costs, interest and all other fees to give you the complete cost of the house over the course of the mortgage.
Once you find a lender with the best overall deal for your financial situation, apply and get your preapproval letter. This is the official approval that basically means as long as nothing changes in your financial situation, you are good to go.
15. No New Debts
When house shopping, it's common to get a nasty case of the I-want-its and rack up debt buying furniture and other items for your new digs. Make sure you pump the brakes on that desire, as one of the key terms to your preapproval is no new debts that cause significant change your financials.
No, a $200 couch on an existing credit card will not raise any red flags to the lender, but a $10,000 bedroom suite on a brand-new credit account may be enough to kill the deal. Even worse, a new $60,000 Bimmer to put in that fancy three-car garage you plan to have — that will certainly raise a stink.
So, keep your shopping to the window variety and make tons of lists of what to buy after you close on the house.
16. Get Your Insurance in Order
The mortgage company sees your house as collateral on the big loan it’s about to give you, so it expects you to insure that collateral against damages. Before you close, shop around for homeowners insurance. In most states you have virtually limitless options, so call a handful of them and find out which offers the best total package at a fair price. Sadly, in some states prone to natural disasters, like Florida, you may have few options.
Compare apples to apples, though, so make sure you have standardized deductibles and other coverages for the insurers to quote you on. Also, get every quote in writing so you have a record of it and to keep the insurer from changing anything at the last minute.
Once you choose your insurer, you can opt to pay the premium yourself up front or have the mortgage company pay it via escrow.
17. Collect Your Cash to Close
Just days before your scheduled closing date, you will receive the update you’ve waited months to hear: “You are clear to close.” This means you have jumped through every hoop, wiggled every left elbow, twinkled your nose just right and kept your credit clean enough to buy your new house. But there is one last step: cash to close.
Cash to close is the amount of money you must bring to the closing table to pay all your prepaid items to get the house. These can include your down payment, initial escrow funding, unpaid taxes, closing costs and much more. When you get the clear to close, the mortgage or closing company will give you the final amount of cash you need to close, and it will give you several options to pay it. These options generally include a cashier’s check, certified check or a wire transfer.
Regardless of which option you choose, have that cash ready to go well before closing. So, if your savings are in several areas, pull the cash needed to close into one account so you’re not bouncing around various accounts and making multiple checks or transfers. Only transfer the exact amount needed to close, as this makes it easier to explain to the bank if it suddenly requests an updated bank statement at the closing table.
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Ready to take an initial step? Start by getting a quick health check on your credit rating. Know your starting point and make progress from there.