How to Prepare Your Finances to Buy a Home in Five Years

What to Know About Buying a Home

First, it's useful to understand what you're getting into when you're considering buying a house. There's the down payment, plus your monthly mortgage payment; and beyond the mortgage, your expenses will include closing costs, property taxes, homeowners insurance, furniture, appliances, ongoing maintenance and utilities.

When deciding how much house you can afford, start by determining how much cash you'll be able to save for a down payment in five years. Mortgage lenders have historically liked to see a down payment of 20% of the home's purchase price, which shows you have the financial strength to handle the ongoing monthly payments. But a full 20% down payment can be a huge amount, and may not be necessary, since there are plenty of mortgage options with down payment requirements as low as low as 3%. But for the privilege of putting down less than 20% down on a conventional loan, you'll typically pay private mortgage insurance, which increases your monthly mortgage payment.

Use a mortgage calculator to get an idea of how much you'll pay altogether for homes you're considering now. But know that your credit will influence the size of the mortgage and the interest rate you qualify for. Five years is a long time to increase your credit score if it's not already in the good-to-excellent range, so make it your goal to boost your credit over time and access the lowest rates possible. Prequalifying with a lender can tell you more about the mortgage amount you could secure with your current credit and income.

Prepare Your Budget for Buying a House

Once you know how much you'll need to save for a down payment and a robust savings cushion to cover ongoing home costs, it's time to put a plan in place. Take these steps to start budgeting for home ownership:

• List the sources of income and savings you already have. Include your current after-tax income, cash savings, investments, gifts from family and inheritances. Tally those up—remembering that it's important to leave retirement accounts alone rather than cashing them out—and see how much more you have to save to reach your goal.
• Consider ways to increase your income in the next five years. That could include planning to ask for raises at your company, moving into a new role or picking up side gigs or consulting jobs.
• Reduce big-ticket expenses. Avoid the temptation to buy a new car if yours is almost paid off, or replace it with a used one rather than a new one.
• Make a plan to pay off existing debts. This includes credit cards and student loans, which can increase your debt-to-income ratio (DTI). DTI measures the amount you earn compared with the amount you owe to creditors each month. Mortgage lenders generally prefer a DTI of 43% or less, but it depends on the type of mortgage you seek.
• Automate savings, and keep them safe. Once you identify how much you can regularly save per month for a house, transfer that amount automatically to a dedicated account. A high-yield savings account is a good choice. While investing the money in stocks may be tempting, five years is not a long time horizon to bounce back from potential losses. It's safer to invest your down payment money if you have around 10 years before you plan to buy a house.

Get Your Credit Ready for Homebuying

In the next five years, improving and protecting your credit will become a top priority. Now is the time to commit to making all your bill payments on time, reducing debt balances and preventing major issues like vehicle repossession and bankruptcy. Don't panic if you already have negative marks, like late payments, in your credit file. Generally, they'll disappear after seven years, so check your credit report to see whether you'll be in the clear by the time you apply for a mortgage.

If you don't yet have a solid credit file, build credit by applying for a secured credit card or credit-builder loan, or getting added to another person's credit card as an authorized user. Over the next five years, pay close attention to your credit by tracking your score. In the year before you apply for a mortgage, avoid taking on new lines of credit and making big purchases so that your score stays strong.

Know When You're Ready to Buy

You may find while preparing to buy a home that you're ready sooner than anticipated, or that you need more time. Periodically take a look at average interest rates and home prices in the areas you're interested in. Once you think you're ready, you could apply for preapproval and compare offers from a few different lenders to see how large a mortgage you'd currently be able to take on. That information may help you decide if you need to keep saving or continue to work on improving your credit, for example.

While saving up and searching for a house can seem like a marathon, the payoff is sweet: A place to call your own. Far in the future, you'll likely look back and find that five years of preparation was worthwhile for decades of comfort and pride in your home.