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If you’ve been thinking about buying your first home, this could be the year to finally pull the trigger.
But with all the information out there about the real estate market, it can be difficult to determine what it all means for a first-time homebuyer like yourself.
Before plunging headfirst into the homebuying process, take a step back and make sure you—and your finances—are ready. Here are three factors for you to consider:
1. Your total amount of debt
When creditors determine how big of a mortgage you can afford, they look at your debt-to-income ratio. Your debt-to-income ratio is just what it sounds like: it’s the amount of debt you have compared to your gross (before taxes) income.
Not surprisingly, creditors like to work with homebuyers who have a low debt-to-income ratio, since these individuals are more likely to make on-time mortgage payments. So the lower your debt-to-income ratio, the more likely you’ll qualify for a mortgage with competitive terms.
Experts generally agree that you can spend between 25 and 33 percent of your gross monthly income on just housing expenses—including your monthly mortgage payment, real estate taxes, and homeowner’s insurance—and between 28 percent and 36 percent of your gross income in total debt service, or your housing expenses plus any other debt payments.
The good news is if you don’t have any other debts, lenders will allow you to spend up to 36 percent on your housing expenses, and as much as 42 or even 43 percent of your gross monthly income if you get an FHA or other government-backed loan—help many first-time home buyers need.
If you need help calculating your debt-to-income ratio, there are online calculators that can crunch the numbers for you.
2. The cost of buying versus renting
To gauge whether buying a home or renting an apartment makes most financial sense for you, check out the home prices and rents in your target markets and consider their trajectory. Compare the list price of the homes in which you’re interested to the annual rental costs of comparable rental units in the same area. Divide the list price by the annual rent you’d pay to determine the price-rent ratio.
Housing experts and economists agree that a ratio below 20 is an indicator that it’s a good time to buy. If it’s higher than that, you may want to rent.
But determining whether buying or renting is the best move you can make isn’t only about home prices. Remember to factor in the cost of property taxes, utilities, and home maintenance.
You’ll also want to think about your long-term housing needs—if you plan to stay in the same home for several years, for example, you’ll typically save money over the long haul if you buy. This is because the longer you stay in a home, the more equity you generally build.
On the other hand, renting gives you the flexibility to move frequently and try out new neighborhoods, cities, and even countries.
3. Interest rates
Interest is the amount you pay to borrow money, and it is generally expressed as a percentage. When it comes to your mortgage, the interest rate for which you qualify will determine how much money you’ll pay the lender over the life of your loan. A difference of just one percentage point, or even less, can actually make a significant difference in how much you’re spending.
If you’re offered a 4.2 percent interest rate on a $400,000 mortgage, for example, your monthly payment will be $1,961, and you’ll pay more than $300,000 in interest over the loan’s 30-year term.
If your interest rate were 4.9 percent, your monthly payment would jump to $2,115, and the total interest paid over the life of the loan would exceed $360,000. (To find out how much an interest rate can cost you, check out the Amortization Schedule Calculator on ThinkGlink.com.)
When it’s time to apply for a mortgage, lenders will use a number of factors to determine your interest rate. Your credit score is one of the biggest factors considered, but the type, length, and amount of the loan, as well as whether the loan is conventional or government-backed, could also affect the rate you’re offered.
Market conditions also come into play. Interest rates bottomed during the Great Recession, for example, and have been slowly climbing back ever since. As the Fed eases its stimulus program, which has kept rates artificially low, interest rates will continue to go up.
By understanding your financial situation and how buying a home will impact it, you’ll be more prepared to answer the question: Is now the time to buy?