6 financial steps to take before buying your next home
CATHERINE ALFORD • March 2, 2020 • 6 min read
What we'll cover
Financial steps to take before buying a home
How to calculate your debt-to-income ratio
How to get pre-approved
If you’re already a homeowner, you know buying a home can be a long process. There’s the fun part, which is touring homes and dreaming of your new place. But there are the practical parts too, like getting pre-approved for a mortgage, saving for closing costs, and more.
If you’ve outgrown your current home or simply want to move to a better school district or a new state, there are a few financial steps to take before buying your next house. Completing them will help you to become financially ready to enter this exciting next phase in your life.
Step 1: Check your credit report.
Thanks to federal law, you’re entitled to three free credit reports every year, one from each of the main credit bureaus — TransUnion, Equifax, and Experian. If you’ve never seen your credit report before, you can access it by going to AnnualCreditReport.com. When you get there, they’ll ask you a few questions to verify your identity. Once verified, you can download your credit report.
Look for any errors or adverse accounts on it — things that could prevent you from being approved for the mortgage on your next home. And, even if you think your report is squeaky clean, it’s always good to check. For example, the library once sent me to collections for not returning a book, and I had no idea until I checked my credit report. #TrueStory.
Step 2: Check your credit score.
In addition to accessing your credit report, it’s good to know your credit score too. Typically, the better your credit score is, the better your interest rate will be. Consumers with excellent credit scores (750 and above) usually qualify for the lowest interest rates. This is important when buying a house because even a 1% difference in interest rate could mean a savings of thousands of dollars over the course of your loan.
You can get a general idea of what your credit score might be by visiting Credit Sesame or Credit Karma. They won’t show you your exact FICO score; they use something called the Vantage Score. But it will still give you a ballpark idea of what your FICO credit score might be. Sometimes, certain credit cards give you your FICO score for free every month as a perk, so check and see if one of yours offers that as a feature.
There’s no reason to pay to access your credit score. Just use one of the services mentioned above to get an idea of where you stand today. Then, decide if you want to spend a few months improving your score before applying for a new mortgage or if you’re ready to go to the next step now.
Step 3: Calculate your DTI ratio.
Next, calculate your DTI, also known as a debt to income ratio. This is a percentage you find by dividing all your monthly debt payments by your gross monthly income.
The debts typically included in a DTI calculation include:
Student loan bills
Personal loan payments
Check with your lender to see which debts they include in a DTI calculation, as these may vary from lender to lender. In order to qualify for a mortgage, the max DTI you can have is typically 43%, but the lower the better to show lenders you’re not too overextended with debt payments.
Step 4: Know your savings balance.
Ideally, you have equity in your current home, which will enable you to sell your house and use that money as a down payment on your next home.
However, there will still be costs associated with buying your next home, like closing costs and appraisals. Also, it’s not always possible to time the sale of your current house perfectly to line up with the purchase of your next house. This means you might need to use money from your personal savings to cover you while you wait for your current house to sell.
So, as part of getting financially ready to buy your next place, know exactly how much you have in savings as well as how much equity you have in your current home. That will help you with the next step, which is calculating how much house you can afford.
Step 5: Use an affordability calculator.
You know your savings balance, you’ve checked your credit score, and you know your DTI. Now, you have all the information you need to use Ally Home Loans’s affordability calculator. When you use this calculator, you enter your income, credit score, and the state where you want to buy a house. Then, you can add in your itemized monthly expenses like student loan payments and child support payments.
When you submit this information, the calculator will show you how much house you can afford and the down payment you’ll need based on the information you provided. Remember to leave room in your budget to save for future goals. You don’t want all of your available monthly income to go towards a house payment. Save some room for unexpected expenses, savings, and future goals to help ensure you choose a next home you can pay for without it becoming a financial burden.
Step 6: Get pre-approved.
Lastly, the final step is to get pre-approved. You might remember this from your first homebuying experience, but in case you don’t, becoming pre-approved for a mortgage simply means you’ve gone to a mortgage lender like Ally Home Loans to seriously discuss buying a home.
During this process, an Ally Home Loan Expert will check your credit and verify your information. You’ll share proof of your income, bank statements, past income tax returns, and more. When they receive all that information, they’re able to determine how much home you can actually afford. And, to make it super easy, you can do this completely online with Ally Home’s Innovative Digital Experience, where you can update your application and any personal information 24/7. Once completed, you can get pre-approved for a mortgage in as little as three minutes. After that, it’s on to house shopping — the fun part!
Buying a home is a major financial decision. Even though you’ve already done it once, it’s possible your financial situation has changed since the last time you went through the process. That’s why it’s always good to complete the steps above ahead of time, so you can get your financial ducks in a row before you start searching for your next place.
This will help the process of buying your next house go smoothly, and it will likely increase the chance of you being pre-approved for the next place you decide to call home.
Catherine Alford is a nationally recognized financial educator who partners with top brands to encourage, educate, and inspire people to take on a more active financial role in their families. She is also the founder of CatherineAlford.com, an award winning personal finance blog that she created in 2010.