Check Your Finances Before You Buy: Credit, Debt and Cash Reserves

Before you look at listings or research an auction, take stock of what a lender will see and what you can afford to spend. Your credit, existing debts and savings decide whether you can get a mortgage, which loan programs fit and how much cash you need on hand. Checking them first gives you time to correct errors, pay down balances or save more before a deadline forces the issue.

This step matters even more for distressed properties. Foreclosures, short sales and bank-owned homes often need repairs and move on timelines set by a bank or an auction. A buyer who already knows their numbers can act quickly and avoid offers they cannot complete.

The aim is a clear picture of four things: your credit, your debt-to-income ratio, the cash you need to close and the reserves you will keep afterward. With those in hand you are ready for the next step, getting a pre-approval or documenting your funds.

Your credit reports are the records lenders use to judge how you have handled debt. You can get free reports from each of the three nationwide credit bureaus, Equifax, Experian and TransUnion, through AnnualCreditReport.com, the site authorized under federal law. Check all three, because each may hold slightly different information.

When you review them, look for:

• Accounts you do not recognize, which can be errors or a sign of identity theft.
• Late payments, collections or public records that are wrong or out of date.
• Balances and credit limits that do not match your own records.
• Duplicate debts, such as the same balance listed by both the original lender and a collection agency.

You can dispute inaccurate information with the credit bureau and with the company that reported it. Investigations and corrections can take a month or more, so start well before you apply.

Credit scores are calculated from your reports using several different models, and the score a mortgage lender uses may differ from the one in your banking app. Payment history, how much of your available credit you use and the age of your accounts generally carry the most weight. Minimum scores vary by loan program and lender, and a higher score usually means a better rate.

In the months before you apply, avoid opening new credit accounts or making large purchases on credit. Each can change your score or your debts at an awkward time.

Your debt-to-income ratio (DTI) compares your monthly debt payments with your gross monthly income. Lenders use it to judge whether you can take on a housing payment.

To estimate it, add the minimum monthly payments on your debts, such as car loans, student loans, credit cards and personal loans, to the expected housing payment. Divide the total by your gross monthly income before taxes. For example, $2,000 of monthly debts, including the new housing payment, on $6,000 of gross monthly income gives a DTI of about 33%.

Lenders typically look at two versions:

• Front-end ratio: the housing payment alone, including principal, interest, taxes and insurance (PITI) and any HOA dues.
• Back-end ratio: the housing payment plus all other monthly debts. This is the figure most programs focus on.

Maximum ratios depend on the loan program, the lender and other factors such as your credit and savings, so ask a lender rather than relying on a rule of thumb. The debt-to-income calculator shows where you stand, and the guide to how much house you can afford turns that into a price range.

If your ratio is high, the main options are paying down debts, increasing documented income, adding a co-borrower or aiming for a lower price. Self-employed buyers should expect lenders to rely on tax returns, so income that is not reported may not count.

A financed purchase needs cash for more than the down payment. Plan for each of these:

• Earnest money, the deposit you make when your offer is accepted, which is usually credited toward your purchase at closing.
• The down payment, which depends on your loan program and price. On a conventional loan, putting less than 20% down usually means paying private mortgage insurance.
• Closing costs, including lender, title and government charges and prepaid items. The guide to closing costs explains each category.
• Inspection and appraisal fees, which are often paid before closing.
• Moving and setup costs, such as utility deposits, new locks and basic furnishings.

Lenders verify where your down payment and closing funds come from. Expect to provide recent bank and investment statements and to explain large deposits that are not from your paycheck. Many programs allow gift funds from relatives, usually with a signed gift letter and a record of the transfer. Money that appears shortly before you apply, without a clear source, can delay approval.

If you plan to sell investments or draw on retirement savings, ask a lender and a tax professional about timing, taxes and penalties first. Ways to reduce the closing cost share of the total, including seller credits and assistance programs, are covered in the closing costs guide linked above.

Reserves are the money you still have after closing. Lenders often count them when deciding whether to approve a loan, especially for investment properties, and some programs require a set number of months of housing payments in savings. They are also your own protection against surprises.

Distressed properties raise the stakes. A home sold as-is after a foreclosure may have sat vacant for months, with problems that only appear once you own it: plumbing that leaks when the water is turned on, a failing roof, missing fixtures or mold. Bank sellers rarely make repairs, and at a foreclosure auction you may not see inside at all.

When you set your budget, split the money into three buckets:

1. Cash to close, as described above.
2. Repair and holding funds, based on an inspection or contractor estimate where you can get one, plus insurance, utilities, taxes and loan payments while work is under way.
3. An emergency reserve that you do not plan to spend, for job loss, medical bills or repairs that run over budget.

Many buyers add a contingency to the repair estimate for unknowns. How large it should be depends on the property's age and condition and on how much you were able to inspect. If repairs would wipe out your emergency reserve, consider a lower price, a home in better condition or a renovation loan that finances part of the work. The guide to financing a distressed property compares those options.

The same checks apply if you are buying an investment property or paying cash, with a different emphasis.

• Investment property loans usually require larger down payments, stronger credit and more reserves than loans for a home you will live in. Some lenders count projected rent toward your income under their own rules.
• Short-term lenders, such as hard money lenders, focus more on the property and your plan, but still check your experience, your cash for the down payment and repairs, and sometimes your credit.
• Cash buyers need to show the money is available and keep enough back for repairs and holding costs. Spending everything on the purchase leaves no room for surprises.

Finally, write down your limits: the most you will spend in total, the cash you will keep in reserve and the monthly payment you are comfortable with, which may be lower than what a lender will approve. The affordability calculator helps you test those limits before you start making offers.