So you want to buy a house next year. It’s going to take more than wishful thinking to convince a lender to fork out hundreds of thousands of dollars to you so you can make your dream of home ownership a reality. You’re going to have to show lenders that you are a financially responsible person and that you deserve the loan amount that you want with a good interest rate to boot.
In Part 1 of this two-part series, we focused on how to improve your credit score. Now, let’s look at how to wow lenders with a low debt-to-income ratio so you can get the loan amount you want to buy a castle instead of a hovel.
4. Save, Save, Save
In the previous article, we encouraged you to work on paying down debt, but you’ll also need save as much as you can for your down payment. Since your down payment will go directly toward paying for your home, the higher your down payment, the more house you’ll be able to afford. Also, most lenders want to see at least a 10% down payment saved up before they’ll offer a loan. (Certain loans, like VA loans, may require a much smaller down payment or no down payment at all.)
Ideally, you’ll want to save up a 20% down payment. Anything lower, and your lender will likely require you to pay for private mortgage insurance (PMI), which protects the bank if you default on your loan. PMI is basically money you throw away each month. It protects the bank, not you! If you can save a little more over the next 12 months and hit that 20% down payment when you’re ready to shop for homes, you’ll save hundreds or even thousands each year.
5. Ask for a Raise or Increase Hours
There are two sides to the debt-to-income ratio equation. At the same time you’re working to lower your debt, you also want to show as much income as possible. If you work a traditional, salaried job the best way to do this is to ask for a raise (or bonus). Make sure the timing is right and that you have a good justification for asking. Your boss probably won’t be sympathetic to the fact that you want to buy a house next year. Instead, explain why you deserve to earn more.
Bonus – The extra income from your raise will improve your debt-to-income ratio, AND you can use that money to pay down your debt more quickly and/or save more for a down payment.
If you are an hourly worker, see what you can do to increase your hours. Let your co-workers know that you can take on extra shifts. If you really need to boost your savings or pay down a lot of debt, you may want to consider taking on a second job or trying a side gig to earn a few extra bucks on the weekend.
6. Take Fewer Deductions
If you are a contractor, self-employed, or a business owner, you have some control over what income you report on your tax return. Not only should you consider ramping up your business to earn more income if you can (easier said than done), but also work with your accountant to lower your deductions this year.
Wait, what? Doesn’t that mean you’ll have to pay higher taxes?
Yes, but you’re going to need to bite this bullet, at least for the next year until the house buying process is over.
Savvy business owners and contractors know how to deduct as much as is legally possible. Often, business deductions can take away tens of thousands or even hundreds of thousands of dollars from taxable income. This is great for your tax bill, but lenders only look at your net income (income after deductions), not your gross income.
That means if you earn $80,000 a year but only report $50,000 of taxable income, you’ll likely get approved for a loan far smaller than what you can really afford.
Take the hit this tax season. Lower your deductions and show a higher income so you can get the loan amount you need. You can always go back to your deducting ways the year after your loan is approved and you get your house.
The Time is Now
The time to start preparing to be a homeowner is now. If you don’t bother checking your credit report, paying your bills on time, lowering your debt, or increasing your income now, you could be blindsided when you submit your request for a pre-approved mortgage. You could be approved for a much lower loan than you need, given a high interest rate that will add hundreds or thousands to your mortgage payments each year, or denied a loan altogether. At that point, you may need to delay your house buying dream for months or even a year or more.
Start making changes now. Work hard this year, and it will pay off next year when you find your dream home and already have your pre-approval in place to make an offer.
Need help getting your financial life in order so you can buy a home next year (or later down the road)? One great way to get the support you need is to start a Money Club with your favorite friends and family members.