How to figure out if you're prepared to become a homeowner
By Paula Pant
Updated January 06, 2016
Are you thinking of buying a new home?
Are you unsure of whether or not you can afford it?
Don't worry. Here's an outline.
The first step in the process is to look at your current expenses.
Are You in Debt?
Do you hold any high-interest debt, such as credit card debt?
(By "high-interest," I'm referring to debt with an interest rate that's above 8 percent.)
If so, you're not ready to buy a home yet. Focus on repaying your credit cards before you start shopping for a home.
Why? Your mortgage isn't the only bill that you'll pay. When you own a home, you're responsible for paying maintenance and repair costs.
You're also highly likely to want to decorate and furnish your home, which will add to your costs. You'll need to pay for inspections and closing costs, some of which will come out of pocket.
Unless you get a Veteran's Affairs (VA) loan, you'll need to make a down payment on a house as well.
In short, buying a house is expensive. If you're in debt, you don't have the capacity to make all of these payments.
Think of rent as the price of patience, to paraphrase bestselling author Dave Ramsey. Focus on conquering your credit card debt before you add more financial responsibility to your plate.
Do You Have Emergency Savings?
Here's the next question: do you have an emergency fund?
Keep three to six months of your basic living expenses set aside in a savings account that you don't touch, unless you face a true emergency (such as losing your job).
This isn't money that you use for holiday gifts. This is money you tap into when your car breaks down in the same week that a large hospital bill is due.
If you don't have an emergency fund, you're one pink slip away from total financial disaster.
Are You Saving for Retirement?
Next, ask yourself if you're adequately saving for retirement.
If you have a workplace retirement plan, like a 401k, you should at least contribute enough to get the full employer match.
If you don't have a workplace plan, open an IRA at a brokerage like Vanguard and contribute at least 10 to 15 percent of your paycheck.
You don't need an employer benefit package in order to open an IRA, which is why plenty of self-employed people, as well as people who work at jobs without benefits, choose to open one.
Before you buy a house, make sure you're saving at least 10 percent – or ideally 15 percent – for retirement.
Look at Your Budget
Finally, once you've passed these steps, it's time to look at your budget.
Can you afford the cost of buying a home (or trading up from your current home)?
As a rule of thumb, your home-related expenses (including utilities) should come to no more than 35 percent of your overall pay, according to Jean Chatzky's 5-category budget.
In other words, if you earn $2,000 per month, your home-related expenses should come to no more than $700. If you earn $4,000 per month, your home expenses should come to no more than $1,400.
Remember that you won't just pay for the cost of a mortgage (or rent). As a homeowner, you'll pay additional costs like repairs, maintenance, and renovations.
Make sure you have enough wiggle room in your budget for this. The sum total of all of these home-related expenses should come to no more than $1 out of every $3 that you earn.
You'll need the rest of your money for other purchases, like groceries, as well as savings.
All your necessary purchases – including your rent or mortgage, utilities, gasoline, groceries, car payments, and insurance premiums – should come to no more than 50 percent of your income, according to Elizabeth Warren's 50-30-20 budget.
This plan also says that you should save at least 20 percent of your income. I recommend putting aside at least 10 to 15 percent in retirement accounts, and the other 5 to 10 percent in a savings account until you have an adequate emergency fund.
After that, put the remaining 5 to 10 percent into a college savings fund, home repair fund, create savings for big-ticket items, or invest the money in a simple, low-fee index fund.