For a lot of people, the American dream means owning a home. In fact, in a Bank of America study, 72% of millennials pointed to homeownership as a top goal, prioritizing it above travel, marriage, and children.
But because a house is probably the most significant purchase you’ll ever make, you need to shore up your finances ahead of time. Here’s how.
You can get a mortgage with as little as 3%, but there are advantages to putting down more. With less than 20% down, you’re typically considered a high-risk buyer and need to make private mortgage insurance (PMI) payments. Designed to protect the lender in the event you default, PMI fees tend to run from 0.5% to 1% of the loan amount—the more you borrow, the more you pay. A bigger down payment can also result in a better mortgage rate.
Use a site like Zillow to price the kinds of homes you’d like, and do some basic math: Set a date for when you’d like to buy, and divide the amount you need to put aside by the number of months left. Arrange for an automatic, recurring cash transfer from your paycheck into a high-interest online savings account dedicated to your house fund.
When you’re figuring out your housing budget and needs, envision your life in the upcoming years instead of just focusing on what will work right now. “Will you experience any big transitions that could impact your overall financial picture?” says Bill Nelson, founder of Pacesetter Planning in Natick, Massachusetts. “If you lock yourself into a mortgage based on your current budget, and then a few years later have children or go to grad school, it may be a problem.”
Also, if there’s a good possibility you might move in under five years, hold off on buying. “The transaction costs [of buying and selling], which could be 10% of the home’s value, will likely outweigh any fiscal benefits,” Nelson says.
You may be familiar with the term “house poor.” “You have a big, beautiful home but can’t afford to have fun or save because all your money is going into the mortgage payment,” says Ian Bloom, a certified financial planner and owner of Open World Financial Life Planning in Raleigh, North Carolina. That’s no way to live.
Many people make the mistake of taking on a mortgage payment that equals what they paid in rent. “But owning a house comes with a lot of extra costs—homeowners insurance, property taxes, utilities, and upkeep,” Nelson says.
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Ask your realtor to help you work through annual projections for taxes and utilities. When it comes to repairs and maintenance, “Plan to spend 1% of the home’s value in annual upkeep,” Nelson says. “As you evaluate properties, ask how long ago the roof was done, and take note of expensive problems like termite damage or a flood-prone basement.” The home inspection checklist should also detail needed fixes.
All told, Nelson suggests aiming for a mortgage payment that’s 15% to 20% lower than your current rent to account for the added costs of ownership.
The better your credit score, the lower the mortgage rate you can qualify for. A few months before you start house-hunting, review your credit report to catch any missed bills or errors that could hurt your score. Then be on your best credit behavior, paying bills on time and keeping credit card balances low.
Weigh your loan options to find the right type for you. “If you intend to live in the house long term, a fixed-rate mortgage is the way to go,” Nelson says. “If you only plan to be there for 5 to 7 years, then an adjustable-rate mortgage might be favorable—they tend to start with lower rates, but can increase quickly over time.”
One more thing to keep in mind: “The more expensive the home you buy, the more the lender gets paid,” Nelson says. “There is an incentive to preapprove you for a higher number than is realistic for your budget.” Don’t be swayed from those numbers you calculated earlier.
If you’re coupled up, think about beefing up your life insurance coverage. You want to make sure that in case of death, the surviving partner can afford to stay in the house. “Take out a policy that at least covers the mortgage balance,” Bloom says.