What to know before buying a home
In fact, we've been getting quite a few questions from people looking to buy a home, especially with the pandemic coming to an end. Here are some steps you can take to make sure you're financially well-positioned to go get your slice of the American Dream.
1. Decide if you're really ready to be a homeowner
Contrary to much popular wisdom, owning a home doesn't always make sense for everyone. I'm not just talking about owning a home you can't afford (which is always a bad idea). Even if you can, there are some reasons you may be better off renting at least for now.
In some areas of the country, it's still a lot cheaper to rent than to own, especially after factoring in property taxes, utilities (some of which are often included in the rent), and the cost of maintenance and repairs. In that case, you could be better off paying the lower rent and investing the difference. This could be even more true if you're fortunate enough to live in a rent-controlled area. Not sure if it's cheaper for you to buy or rent?
But the main reason to rent is the flexibility it provides. You don't want to have to turn down a lucrative job offer just because you can't sell your home and move, especially when you're just starting in your career. If you do sell, closing costs usually eat up any advantages you gain from owning within the first 3-5 years.
On the other hand, there are very real financial advantages in being a homeowner. You can deduct the interest and at least some of the property taxes from your income taxes plus you’re locking in most of your housing costs from growing with inflation. Perhaps most significantly, you're building equity in an asset that generally appreciates over time and will eventually not have a mortgage payment at all. For a lot of people, this can be the most effective way for them to build wealth because it's a form of forced savings into an investment that they aren't tempted to sell every time the price takes a dip (just the opposite, in fact).
2. Improve and protect your credit
Once you've decided to buy, you'll want to do what you can to improve your credit. That's because it's one of the biggest factors in determining your future mortgage interest rate that you have some control over. You can start by ordering a free copy of your credit report from each of the three major credit bureaus at www.annualcreditreport.com and checking to see if there are any errors on them that could be hurting your score. About 70% of credit reports have mistakes, so there's a good chance one of yours does too. If you find anything, ask the creditor to remove it or dispute it with the bureau directly.
Try to get caught up on any payments you're behind on before they become delinquent and pay down any consumer debt you have as much as possible. You might be tempted to close a credit card once you pay it off, but that can be a huge mistake for a couple of reasons. If it's a card you've had for a while, closing it can shorten your credit history, which hurts your credit score.
Second, creditors look at how much debt you have relative to your total credit available. Paying off the credit card helps by reducing your debt, but closing the card can hurt by reducing your total credit available. If your card is costing you a big annual fee, you can always wait until after you close on your home to close the card too.
That all being said, if you have a lot of available credit, you might actually benefit from closing some of those lines of credit so creditors don't worry about your potential to run up a lot of debt in the future. One way to find out is to use a site like Credit Karma. In addition to providing a free copy of your credit score (which you don't get with your free credit report), you can use the site to see how actions like closing a card could impact your score. Best of all, these features are free to use. (Note that your Credit Karma score might be higher than the FICO score used by a mortgage lender so don’t rely on it entirely before applying for a mortgage.
Paying down debt is generally a good thing, but be careful of making payments on old debts or even contacting the lenders or collection agencies. That's because you don't want your actions to turn an old debt into a "new" debt since the latter hurts your credit score a lot more. That doesn't mean you should necessarily forget them. If you can get them paid off in full and reported as such on your credit report, it will generally help your score after about 2-6 months. Just don't do so immediately before applying for a mortgage.
Finally, you’ll want to take steps to protect your credit. Placing a security freeze can help protect you from identity theft. You can also get free credit monitoring through Credit Karma (for Equifax and TransUnion) and Experian to alert you in case anything does happen to your credit. This can include things other than identity theft like a missed payment so they’re not redundant.
3. Save for the down payment and closing costs
You've probably heard that 20% of the home value is ideal as a down payment. There are also closing costs and you'll want to have some emergency funds left over so you don't run into trouble making your new mortgage payments. Not everyone can realistically save enough for the full 20% down payment though.
If you're considering dipping into your IRA or taking a loan from your retirement plan to help fund the down payment, make sure you understand all the pros and cons. They don’t require credit checks, but you will lose whatever earnings you would have made by keeping the money invested. IRA distributions can't be put back after 60 days so you're permanently reducing your retirement nest egg.
Retirement plan loans have the opposite problem. They need to be paid back so check to see that you can afford that extra loan payment in addition to the mortgage. You also may face the risk of having to pay a tax and possibly a 10% penalty on any remaining balance of the loan that you can't pay back after leaving your job.
4. Figure out how much you can afford to pay in housing costs each month
When examining your budget, don't just estimate your expenses. Go through at least the last 3 months of your bank and credit card statements to see where your money is actually going. For most people, this can be a real eye-opener.
Also, notice that I said "housing costs" rather than "mortgage payment." Don't forget to include utility bills, property taxes, homeowner's insurance, and an estimate of maintenance costs. Those costs can really add up.
Remember, the point of this is to avoid biting off more of a mortgage than you can chew. While the mortgage companies have tightened their lending standards, that won't necessarily stop them from offering you a bigger mortgage than your budget can handle. They may know your income, but only you know where that income is going.
5. Get pre-approved for a mortgage before you shop
Before the fun of house hunting begins, it would be a good idea to visit a mortgage broker or lender and get pre-approved for a mortgage with a monthly payment that fits in your budget (see the previous step). This will let you know what price range to shop in before you get carried away by some amazing but not quite affordable piece of property. When this happens, all reason can get thrown out the window and you can get stuck with a big house and an even bigger mortgage payment to make each month. The other reason to get pre-approved is that it can give you an edge when competing for a home with other prospective buyers. The key here is to be "pre-approved," which is much stronger than being merely "pre-qualified."
If you've followed all these steps, you should now be ready to start looking for your next home. Just find a good real estate agent with experience in the neighborhood(s) you’re looking in and make a checklist of what you want in a home. Then have fun!
Neither Voya nor its representatives offer tax or legal advice. Please consult your tax or legal advisor before making a tax-related decisions. Products and services are offered through the Voya® family of companies.