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How to's and money-saving tips from resident homeowner and mortgage professional, Cathy West

Deciding if you're financially prepared to buy a home means looking at your current debts, earnings and savings.

How to know if you’re financially ready to buy a home

Current renters might be wondering if it's time to buy their first homes. Going from monthly rent payments to paying off a home is a big step, but it can be an excellent investment for people looking to settle down. Down-payments and mortgage costs might scare prospective buyers from taking the leap, especially if they still have debt from car or student loans.

Some of the most significant benefits of buying a home include:

  • Tax-deductible interest payments.
  • Flexible mortgage options.
  • Freedom to make the house into a home without needing the landlord's permission.

However, some costs homeowners make that renters do not worry about include:

  • Paying for home repairs and renovations.
  • Homeowner's insurance.
  • Property taxes.
  • Real estate broker expenses, if moving.

If individuals have enough finances to pay for a house in cash, they can afford to buy the home. However, if they don't the means to do this, as is the case with many Americans, they should consider taking out a mortgage. If households have the funds to get a mortgage, they should be financially ready to buy a house. What kind of income and savings can qualify individuals for mortgages?

Back-end debt-to-income ratio
The Federal Housing Administration typically uses this standard when approving mortgages. A back-end DTI of 43 percent typically suggests that homebuyers can afford to make their mortgage payments every month. The types of debt that make up this number include (but are not limited to):

  • Mortgages
  • Mortgage insurance
  • Property taxes
  • Homeowner's insurance
  • Student loans
  • Credit card fees
  • Car loan payments

According to this FHA guideline, these regular debt payments and housing-related costs should not be more than 43 percent of the household's monthly gross income.

Front-end debt-to-income ratio
Some mortgage lenders might take this number into consideration. This ratio is similar to the back-end DTI, but only considers debt regarding housing costs. According to Bankrate, lenders consider an ideal front-end DTI to be no higher than 28 percent.

How to calculate front- and back-end DTI
To demonstrate how to calculate both types of debt-to-income ratios, it might be helpful to provide an example. Using the following monthly expenses, what is this household's back-end DTI?

  • Gross earnings: $5,000
  • Student loans: $250
  • Credit card fees: $100
  • Car loan payments: $372

To figure out the target back-end and front-end DTI, multiple the gross income by 0.43. This means these homebuyers should have a back-end DTI below $2,150. Since the sum of the amount given is $722, this means the housing-related expenses should be below $1,428.

Calculating the front-end DTI means multiplying the gross income by 0.28. When searching for homes, this household should try to maintain a front-end DTI of approximately $1,400. This means the sum of their mortgage, mortgage insurance, property taxes and homeowner's insurance should be around this cost on a monthly basis.

Making sacrifices
If potential homeowners enjoy going to expensive restaurants, traveling to exotic locations working out at high-class gyms or doing costly activities on the weekends, they might need to give some of these expenses up when saving for a house and affording mortgage payments. If they are not willing to forfeit these pricey hobbies, they might not be ready to make the investment commitment of purchasing a house.

Saving for retirement
Before buying a house, individuals should have started saving up for retirement. Perhaps they have a workplace 401k plan or an IRA, in which a percentage of their earnings go directly into their retirement funds. The Balance recommended individuals have 10 to 15 percent of their income in their retirement plan.

Preparing for the worst
If something unexpected happens, like losing a job, getting a divorce, experiencing a costly health problem or making a poor investment, homeowners should always have a cushion to fall back on. Without a backup plan in mind, people can lose their homes to short-sale or foreclosure, which can be extremely damaging to their finances and credit scores.

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