Saving money for a down payment on a house takes time and effort. More importantly, it requires smart financial decision-making in the years leading up to the payment. For better or worse, the actions you take now – or lack thereof – will affect your long-term homeownership goals.
First-time homebuyers may want to take the following steps toward saving for a down payment on their future house:
Pay down credit card debt and other loans
Debt plays a significant role in mortgage approval, and directly affects the size of your required down payment as well as your interest rates. In particular, lenders focus on two crucial factors related to debt:
- FICO® credit score: Credit score is a significant factor that lenders review as an indicator of your credibility when it comes to obtaining a loan. The minimum requirement for a Federal Housing Administration® (FHA) loan is 580. Note that utility bills, student loans and other forms of debt also impact your credit score.
- Debt-to-income ratio: Debt-to-income ratio is a measure of your amount of monthly debt against your income. Any form of monthly payment weighs into this, including bills and loans, but also minimum credit card payments. Some lenders will allow a maximum debt ratio of up to 43%, but the ideal for anyone seeking a home loan is 36% or lower, according to SmartAsset®.
Credit reports typically reflect payment history from the prior 24 months, according to The Balance®. A prospective homeowner will ideally have a clean slate for the two years leading up to a home loan application. Either way, your ability to pay bills on time will reflect in your credit score and, in turn, the percentage of your down payment and interest rates.
Credit reports also provide a glance at your credit utilization, which is the ratio of your credit card balances to credit limits. Paying off your credit card debt brings down your credit utilization rate, which improves a credit score while ultimately bringing down your debt-to-income ratio.
Have a realistic timeline
Money that goes toward debts is technically money saved since it improves your net worth. This is presuming you pay off debt faster than you amass it.
A down payment requires an upfront cash commitment, however. It's rare, and highly inadvisable according to NerdWallet®, to use a credit card toward a down payment on a house.
Accordingly, a realistic timeline for your future home will need to factor in your ability to pay off debt while also putting money aside for the down payment. If it's a choice between one or the other, paying off existing debts tends be seen as the priority. If you're currently in debt or don't have much in savings, then it may be in your best interest to push back your timeline a few years to save money for a larger down payment with better rates.
Assess existing mortgage options
The specific amount of money you need to set aside will depend on the price of the home you're looking for, but also the type of mortgage. Two of the most common mortgages for first-time homebuyers include:
- FHA mortgage: With a 3.5% down payment and a minimum required credit score of 580, this option appeals to first-time homebuyers that lack substantial savings for a conventional mortgage.
- Conventional mortgage: These non-government loans typically have down payments ranging anywhere between 5% and 20%.
Most mortgages with a down payment of less than 20% require private mortgage insurance (PMI). On average, this costs borrowers 0.5% to 1% of the full loan amount on an annual basis, according to Investopedia®. Home loans with smaller down payments may also come with higher interest rates. You may be able to refinance a mortgage down the line for better rates, but it's worth remembering that paying less now may mean paying more later.
For more information about down payments, or first-time home buying in general, contact the experts at Comerica Bank.
