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Are you ready to buy a home? Many renters have no idea.
Millions of renter households could have been able to buy a home in 2022, according to a new analysis from Zillow based on estimates from the U.S. Census Bureau's American Community Survey.
According to census data, in 2022, 39% of the 134 million families living in the U.S. did not own the home they lived in. Among those who did not own a home, about 7.9 million families were considered “income ready for mortgage,” meaning the share of their total income spent on a mortgage payment on the typical home in their area would have been 30% or less, Zillow found.
Some people simply choose to rent rather than buy. On the other hand, households may not be aware that they can afford a mortgage, says Orphe Divounguy, senior economist at Zillow.
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If your current lease is up, it might be wise to consider whether you can afford to buy, advises Melissa Cohn, regional vice president at William Raveis Mortgage.
“If rents are rising, it might be a good time to think about [buying instead],” She said.
A verbal pre-approval from a lender can be helpful, Cohn said. “The first step is to figure out if it's worth gathering all the paperwork,” she said.
However, remember that before you begin this important conversation, you need to have a basic understanding of crucial facts such as your annual income and debt levels.
A good place to start is to learn about your credit status and your debt-to-income ratio.
1. It can't hurt to check your credit score
To know if you're ready to buy a home, it's important to know your purchasing power, says Brian Nevins, director of sales at Bay Equity, a mortgage lender owned by Redfin.
Some potential homebuyers may be unaware of their credit score or “reluctant to even check it” because they mistakenly fear it will affect their credit score, he said.
In fact, experts say it's important to keep an eye on your credit score months before you buy a home so you have time to make improvements if needed.
“This has changed a lot in our industry. We now do soft credit checks up front that have no impact on a person's credit score,” Nevins said. “A check really can't hurt.”
Your credit score is important because it helps lenders decide whether to offer you a loan at all—and if so, at a higher or lower interest rate, depending on their score. And usually, the higher your credit score, the lower the interest rate offered.
That's why being “credit invisible” and having little or no credit history can complicate your ability to buy a home. But as you build your credit score, you need to find balance by keeping your debt-to-income ratio in check. Your outstanding debts, like your student loans or credit card debt, can also complicate your ability to get a mortgage.
2. Debt to income ratio
A debt-to-income ratio that is too high is the “main reason” applicants are denied a mortgage loan, Divounguy said. Essentially, a lender assumes that the ratio will make the applicant have difficulty making a mortgage payment on top of their existing debt.
To set a realistic budget when buying a home, you need to know your debt-to-income ratio.
“Your debt-to-income ratio is simply the amount of monthly debt you pay according to your credit report,” Nevins said. “Think car payments, student loan payments, minimum credit card payments … all the debt you're paying and the estimated monthly mortgage payment.”
A rule of thumb for calculating your hypothetical budget is the so-called 28/36 rule. This rule states that you should spend no more than 28% of your gross monthly income on housing costs and no more than 36% of that amount on all debt.
Sometimes lenders are more flexible, says Nevins, and will approve applications with a debt-to-income ratio of 45 percent or even more.
For example, if someone has a gross monthly income of $6,000 and has $500 in debt to pay off each month, they could afford a monthly mortgage payment of $1,660 if they follow the 36% rule. If the lender accepts up to 50% DTI, the borrower may be able to afford a monthly mortgage payment of $2,500.
“That’s actually the maximum amount someone can be approved for under most loan programs,” Nevins said.
Affordability and financial readiness also depend on factors such as the average home sale price in your area, the amount of your down payment, property taxes in the area, homeowner's insurance, possible homeowner's association fees and more.
Talking to a mortgage professional can help “lay out” all the factors to consider, Cohn says: “They give people goals, something like: This is what you need to achieve to be able to buy.”