The Homebuyer's Guide | Part 1: Evaluate Your Finances
Updated: Aug 24
"Real Estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world." " - Franklin D. Roosevelt
Welcome to The Homebuyer's Guide, Part 1: Evaluate Your Finances - The Crucial First Step in the Home Buying Process.
Whether you’re buying your first home, downsizing, or expanding your investment portfolio, purchasing a property is a monumental and life-altering event. Along with that comes a host of financial considerations and commitments that can dramatically improve or impair your future. A home purchase includes not just a down payment, but also a long-term commitment to mortgage payments, property taxes, insurance, maintenance costs, utilities, repairs, renovations, and more. If you start your journey prepared and are equipped to make well-informed decisions, your home purchase can be the key to unlocking financial freedom.
Understanding your financial standing is the foundation for a successful home buying experience that will set you up to build generations of prosperity.
In this article, we will guide you through the process of taking a look at your financial landscape to help you make well-informed decisions that balance your financial reality with your aspirations. Here are the basic steps, which we will walk you through in detail below:
Gather your financial documents
Determine your "Purchasing Power"
Consider your up-front cash needs
Identify areas for improvement
Call us!
Evaluating your financial landscape is just as critical to the veteran real estate purchaser as it is to the First Time Home Buyer. For tips specifically tailored for people Buying and Selling at the same time, we recommend checking out this article which contains tips on financing a second (or third, fourth, etc.) home purchase.
So... grab a cup of coffee, your laptop, a pad of paper, and let's get to work Evaluating Your Finances!
KEY POINTS
→ Evaluating and understanding your financial standing is the foundation for a successful Home Buying experience.
→ Taking time to gather documents before beginning the home search process is crucial because you will have necessary information at your fingertips, and will set yourself up to avoid delays down the road due to missing documentation.
→ Your "Purchasing Power" is an important concept that will guide your home buying process. This is a measure of how much you can spend on a home purchase, and is determined by how much cash you have to pay, or a mix of your down payment, credit score, debt-to-income ratio, work history, and other factors.
→ A down payment is not the only cash you will need on hand to buy a house. Don't forget to factor in closing costs (3%-6% of the purchase price), moving costs, home repairs and renovations, and an emergency savings cushion.
→ A low debt-to-income ratio, high credit score, and generous down payment* will set you up for the best loan terms and highest purchase price (*First-Time Home Buyers can often qualify for little-to-no down payment). If you're not happy with where you stand in any of those factors, it may benefit you to take some time to improve them before making an offer.
→ After you have an understanding of your financial situation, make us your first call to get the ball rolling on beginning your home buying journey!
KEY TERMS
→ Budget: The purchase price of a house you can comfortably afford and are pre-approved for (if using a mortgage).
→ Closing Costs: Closing costs are expenses paid to transfer title and secure financing, over and above the purchase price; they are usually 3% - 6% of the purchase price and can include fees for the appraisal, title search, attorney, underwriting, recording, and more.
→ Debt-To-Income Ratio (DTI): All of your monthly debt payments divided by your gross monthly income. Used by lenders to help determine how much to lend a Buyer.
→ Down Payment: The amount a Buyer pays up front towards a real estate purchase; usually 3% - 20%, but many First Time Home Buyers can purchase with a much smaller Down Payment, or use programs that cover it entirely.
→ Purchasing Power: The measure of a Buyer's ability to purchase a home (usually determined by the amount of cash the Buyer has to spend and/or the amount a lender will loan).
Step 1: Gather Your Financial Documents
The first step to a thorough financial evaluation is to gather your documents. This is important for a few reasons; (1) it will help you get a clear picture of your financial situation, (2) you will use the information gathered to help in the next steps, and (3) you will probably be asked for a lot of this information at one point or another during the home buying process. Even if you are buying in cash, you will be asked to provide financial information such as proof of funds.
The following is a checklist of documents you will want to gather and keep on hand, particularly if you are financing with a mortgage:
☐ Proof of Income
☐ Pay stubs (past two months)
☐ W2 forms (past two years)
☐ Tax returns (past two years, especially with 1099 income)
☐ Proof of Assets
☐ Bank statements (past 2-3 months)
☐ Credit Score Report
(Your lender will do a hard credit inquiry, but see if you can obtain a recent score from your credit card statement or a personal credit check program)
☐ Debt-Related Documents
☐ Debt Account Statements (student loans, auto loans, credit card balances, etc.)
☐ List of monthly debt payment obligations
☐ Employment Verification
☐ Proof of Employment (W2 forms are enough for now if you have been at the same W2 job for at least 2 years; if you just started a new job recently, get a letter from your employer stating your job title, salary, and employment status).
☐ Proof of 1099 or Additional Income
☐ Other (if applicable)
☐ Gift letters (if applicable; if someone is giving you a monetary gift to help with a down payment, have them write a letter stating that the amount is a gift, not a loan)
☐ Divorce decree (if applicable, to show financial obligations)
☐ Bankruptcy or Foreclosure documents (if applicable)
☐ Alimony or child support documents (if applicable)
After you’ve gathered all of your documents, you may feel ready to start an initial conversation with a lender. If that’s where you’re at, reach out to us today and we will connect you with our network of trusted lenders who can offer you no-obligation pre-qualifications to get you on your way to your home purchase. With that said, there are a few more steps to take before you have finished evaluating your financial picture. Keep reading to find out more!
Step 2: Determine Your "Purchasing Power"
Now that you have all of your documents gathered, you can start nailing down a key factor that will guide your home-buying journey - your Purchasing Power. This is the measure of your ability to purchase a home, usually determined by the amount of cash you can pay and/or the amount a lender will loan you.
If you're buying in Cash, your Purchasing Power = the amount of Cash you have to spend on a property.
If you're buying with a Mortgage, your Purchasing Power will be determined by a mix of your credit score, your debt-to-income ratio, your down payment, your work history, and other factors determined by the lender. Although a conversation with a lender is necessary to really finalize this figure, you can begin to get an idea with all the information you have at your fingertips now. Here are some key factors that will affect your Purchasing Power:
DEBT-TO-INCOME RATIO
Your Debt-To-Income Ratio (DTI) is all of your monthly debt payments divided by your gross monthly income. This is a key figure used by lenders to determine how much to lend you. Now that you have all of your income statements and outstanding debt inform in front of you from Step 1, figuring out your DTI will be a breeze! Here's what to do:
Make a list of all of your monthly income sources (before taxes) and add them up to one figure.
Make a list of all of your monthly debt obligations and add them up to one figure.
Divide your monthly debts by your monthly income. That percentage is your DTI.
Typically, lenders will look for a DTI no higher than 36% - 43%. A higher DTI means that lenders may view you as a financial risk, and therefore may hesitate to work with you. If you find your DTI is too high, it may benefit you long-term to take some time to focus on paying off some of your outstanding debt to lower this ratio.
CREDIT SCORE
Your Credit Score is simply a measure of how likely you are to pay a loan back on time, based on your past credit history. This will be a key factor in determining the type of loans you qualify for and the amount of interest you pay. A higher credit score typically equals lower interest rates, which can potentially save you thousands of dollars a year.
Some banks and credit card companies offer you a free credit score every month, along with an interpretation of whether your score is "excellent," "good," "fair," or "poor." If your card company doesn't offer this, try doing a "soft" credit inquiry through a personal credit check program.
If your credit score is "fair" or "poor," it may benefit you to take some time to build it back before applying for a mortgage. Focus a few months on making on-time payments, paying off outstanding personal debts, and avoiding any hard credit inquiries. You’ll be set up for a much more successful home purchase and will likely save yourself a ton of money in interest payments!
DOWN PAYMENT
A Down Payment is cash that a Buyer pays up front during a real estate transaction which goes towards the equity in the property. Depending on the lender, typically you will need 20% or more of the purchase price for a down payment. If you are a First-Time Home Buyer, you'll typically need 3% - 20% of the down payment - although there are many First-Time Home Buyer programs to may help you by with little-to-nothing down.
Whenever possible, a larger down payment is usually preferable. Here are a few reason:
Decreased monthly mortgage payments
Decreased amount of interest paid over the life of the loan
Decreased overall amount owed the lender
Increased Seller confidence in your Offer and your ability to close the deal
Increased likelihood of not needing to pay Private Mortgage Insurance (PMI; an insurance required by lenders of Buyers putting less than 20% down, usually between $30 and $70 per month for every $100,000 you borrow).
With that said - for First-Time Home Buyers, a larger down payment is understandably not always possible. That's why there are so many programs to help you achieve your goals of homeownership with less up front, and that positive may very well outweigh all the drawbacks of a smaller downpayment!
We will talk more about figuring out up-front cash needs in Step 3 below.
BUDGET
Your lender may pre-approve you for something higher or lower than what you expected - but how much are you truly comfortable spending up front and committing to on a month-to-month basis? That's where your budget comes in. A budget is simply the purchase price of a house that you can comfortably afford (and are pre-approved for).
You already did most of the legwork when you factored your DTI above. Here's how to estimate your budget:
List out all of your monthly income sources.
List out all of your current monthly expenses, debt payments, and savings goals, besides your current housing costs.
Subtract your monthly expenses/payments/savings from your monthly income. This number is how much leeway you have for your potential monthly housing costs (keep in mind - you'll need a cushion for utilities, maintenance, insurance, and taxes).
Head over to NerdWallet's “How Much House Can I Afford?” Calculator. Here, you can plug in your down payment, monthly payment, credit score, and location, to determine what purchase price of a house is in your budget. We love this calculator because it lets you factor in often-forgotten costs such as property taxes, insurance costs, etc.
How much you'll be able to spend will be determined by a conversation with a lender; nevertheless, it will be good to get an idea with what you're comfortable beforehand.
If you’ve made it this far - congratulations! You’ve done most of the upfront legwork, and you should now have a pretty good idea of your Purchasing Power – how much house you can afford. You’ve laid the crucial foundation to making an informed decision that can set you up for a smooth homebuying process and a future of financial peace and prosperity. Just a few more steps to go and then you’re ready to get the ball rolling on buying a home!
Step 3: Consider Your Up-Front Cash Needs
Today there are so many options (particularly for First-Time Homebuyers) to purchase a home with little-to-no down payment. This may make you think you don’t have to have anything in savings to buy a house. Home purchasing and ownership includes many costs besides the down payment. The following are the major up-front costs you will need to think about – although there may be more, depending on your circumstances:
DOWN PAYMENT: Typically 3% - 20%+ of the purchase price
See Step 2 above for more on this. Plan to spend 20%+ if you are not a First Time Home Buyer - if you are, plan for 3% - 20%. There are many programs that may be available to you that offer little-to-no down payment - get in touch with us to learn more today.
CLOSING COSTS: Typically 3% - 6% of the purchase price
Closing costs are the various expenses over and above the purchase price that are paid to secure financing. These costs typically run between 3% - 6% of the purchase price, and can cover services involved in the home purchasing process, such as appraisal fees, title search, attorney costs, underwriting, municipality recording fees, upfront escrow costs, and more. You do not need to pay your Real Estate Agent for their Buyer’s Agent service – their compensation comes from the Seller’s commission fee.
MOVING COSTS: Situation-dependent
Be sure to budget for truck rentals, professional movers, packing supplies, transportation, or other related applicable costs. If you're in a rental and will need to break your lease, make sure to speak with your landlord and factor in any lease-breaking penalties or fees.
HOME REPAIRS & RENOVATIONS: Situation-dependent
When you purchase a home, there will certainly be maintenance and improvements you will want to make – whether it’s as small as installing some towel hooks or getting the chimney cleaned; or as large as building an addition or completely renovating the kitchen. You may not be able to get an exact quote at this point in the home buying process, but there are many resources online to help you estimate, such as HomeGuide.com or HomeAdvisor.com. Your Agent can also connect you with local pros to get estimates.
EMERGENCY FUND: 3 - 6 months' worth of living expenses recommended
A good rule of thumb is to have 3 – 6 months’ worth of living expenses in an emergency fund before you purchase a home. This will help cover unforeseen expenses such as emergency repairs or a temporary income loss, and will give you peace of mind as you move ahead in your journey to becoming a homeowner.
Step 4: Identify Areas for Improvement
The last step in your financial evaluation is to identify areas for improvement. Did you come across any factors that, if improved upon, could set you up for lower monthly payments, less interest, or a higher budget? Try listing out 2 – 3 areas you can improve, along with 2 – 3 actions steps you could take to improve it. You may realize that you can get to a great position earlier than you think!
Here's an example:
Example: You found during this process that your credit score is "Fair," but you want it to be "Good" or "Excellent" before buying to help save money in interest.
Improvement Area: Increase credit score by 100 points.
Action Step 1: Make all payments on time for the next 3 months.
Action Step 2: Set aside my discretionary spending budget for the next 3 months to put that money towards paying off a personal credit card.
Action Step 3: Call my credit company to see if they will increase my line of credit to help lower my debt utilization ratio.
After listing out those areas for improvement, you should start to have a good idea of how ready you are to buy in the price range you'd like to be in. Of course, if you're not already talking with a Realtor® and a lender, this is a great time to start a conversation - run the information you've gathered in this article by them and they can help guide you in how to set yourself up for success.
Step 5: Call Us!
Now that you've gathered all your documents, determined your "Purchasing Power," figured out your up-front cash needs, and identified (and worked on) areas for improvement - we hope you are feeling more confident and equipped to start your journey towards homeownership. As you've learned, it's an intricate and complex process... but it is so worth it. And, with the right Real Estate Agent, you will be guided through each step above so that the whole process is not only easy, but fun and exciting too! Get in touch today and let us be your first call to help you find a place to call home. We'll connect you with a lender, identify homes for sale in your budget, make you a personalized home buyer's plan, and walk you through each step in the process. It's time to get going on your journey to homeownership!