Purchasing a new home ranks among the most stressful life experiences a person can have. From the paperwork involved to the actual moving process, buying a home can leave you feeling tense. I speak from personal experience.
My husband and I are in the process of purchasing a new house right now, and the entire ordeal has left me with a few extra gray hairs.
While nothing can truly take away the hassle involved with a new home purchase, you can be prepared to face the process. Understanding the minimum requirements, the types of loans, and your lender’s expectations can give you a leg up when it comes to obtaining a new mortgage.
Whether this is your first home or your fifth, there are a few facts you should keep in mind before heading to the bank. Here are the top eight things that every prospective homeowner needs to know about getting a mortgage.
Make Sure Your Credit Qualifies
One of the very first things any qualified lender is going to do is pull your credit score to see if you qualify. Your credit score helps lenders to determine whether you are a trustworthy borrower who can reliably pay your bills on time.
Scores generally range from 300 to 850 with higher numbers being more favorable.
Credit scores look at a number of variables including:
- Payment history
- Amount of current debt
- Length of your credit history
Do you know what your current FICO credit score is? If not, this is a great time to start doing a little research into your own financial history. Many credit cards and banks offer you access to your credit score for free as a complimentary service for using their institution.
It might be located on your monthly account statement or somewhere on your online portal. If it isn’t, you can still access your score through websites like myFICO.com for a nominal fee.
It should be noted that not everyone has a credit score. When we tried to purchase our first home in our early twenties, our lender told us that we didn’t have bad credit.
Instead, we had no credit at all. We had yet to open up a credit card account that we reliably used to demonstrate that we had a good payment history.
This made it nearly impossible for us to get the home that we wanted, because our lenders had no way of knowing whether or not we’d be responsible borrowers.
They viewed us as a risk, simply because we had no credit. We eventually did get a home, but only after we buffed up our credit score, which took us a few years time, and delayed our life plans.
Depending on the type of loan you want to use, your minimum required credit score can vary. Here are a few of the most popular loan types and their minimum required credit scores:
- Conventional loan: 620
- FHA loan: 500 – 580
- VA loan: No minimum credit score (each lender sets their own requirements)
Your lender wants to be reassured that you bring in enough income to cover the cost of your bills from month to month. Before you start looking at homes and filling out mortgage applications, it is crucial to know how much house you can really afford.
Your housing costs should not be greater than 25 to 30 percent of your gross income. Most lenders will not allow you to borrow above and beyond this amount because it decreases the likelihood that you will be able to afford the property long-term.
Keep in mind that there is more to your mortgage payment than just your principal. Other items are factored into your housing costs, including:
- Mortgage interest
- Private mortgage insurance
- Homeowners insurance
- Homeowner’s association dues
- Flood insurance
- Property taxes
This is also a good time to assess how much money you can afford to put down on a home. Why is this relevant? It can dramatically change your house payments.
When we first started working with our lender, we were unsure whether we were going to go with an FHA loan that required a 3.5 percent down payment or a conventional loan that required a 20 percent down payment.
Our lender ran the numbers for us and going with the conventional loan saved us $400 per month on our estimated monthly payments!
That’s because the FHA loan would have forced us to pay extra due to the low down payment and added insurance on the loan.
In the end, those added amounts, on top of our actual mortgage payment, would’ve blown our budget and made buying an affordable home financially difficult.
Your down payment can make a huge difference when it comes to how much house you can afford on an ongoing basis.
Be sure to discuss with your lender what the overall cost of your mortgage might be as early on in the process as you can, so that you can form a realistic expectation of what you can afford, which will help you to create a solid budget.
Lower Your Debt-to-Income Ratio
Break out that budget and start taking a look at how much your bills total each month. Your debt-to-income ratio is another critical factor when it comes to getting a mortgage. Not sure how to calculate this ratio?
It’s simple: take all of your monthly debt payments and divide by your gross monthly income. Multiply this number by 100 and you should get your debt-to-income ratio.
Monthly debt payments can include your auto loans, credit card payment, and student loan debts — just to name a few.
Here’s an example for you. Let’s say that your credit card debt totals $400 per month and your car loan payment is $600 per month. You bring in $3,000 in gross income (the amount you are paid before taxes are taken out).
This gives you an excellent debt-to-income ratio of 33.3 percent.
When it comes to qualifying for a mortgage, you want this number to be as low as possible. Most lenders prefer to see a debt-to-income ratio of 36 to 43 percent or lower. When your ratio is low, it ensures that you will have enough money each month to cover the cost of your living expenses.
It gives the bank some security that you have the means to pay back that massive loan they are giving you.
I strive to keep our debt-to-income ratio as low as possible while we are in the process of buying our home.
We have paid off all our debt except for my car loan, giving us plenty of flexibility to afford the modest house of our dreams. Until we are firmly rooted in our new place, we’ve placed our credit cards on a spending freeze.
Remember that spending with your credit cards while you are in this process can increase your debt-to-income ratio and affect your loan.
Figure Out the Right Loan Option
When it comes to financing your home, there is more than one option. It’s important for you to explore all of the potential scenarios, that way you know you’re making the best decision for your finances.
For starters, you should really consider the loan repayment term. Most people traditionally opt for a thirty-year mortgage, but you could shorten that term to twenty or even fifteen years.
This typically gives you a lower interest payment and substantially cuts back on the amount of interest you will pay over the course of the loan.
Apart from the loan repayment term, there are different types of loans that you might qualify for. Here is breakdown of the most popular types and the down payments they require:
- FHA loan: 3.5 percent down payment with a credit score 580, 10 percent down payment with a credit score of 500
- VA loan: available only for veterans and active duty military, finances up to 100 percent of the home’s value with no standard minimum credit score
- Conventional loan: typically requires a 5 to 20 percent down payment and a minimum credit score of 620
If you don’t plan to live in the house for more than a couple of years, you may even want to consider an adjustable-rate mortgage. This type of loan guarantees a set interest rate for a fixed period of time, usually anywhere from five to ten years.
The rates are often lower than you will see with fixed-rate loans like those listed above.
However, you take the risk that your interest rates could rise substantially once this initial introductory period is over.
We considered an adjustable-rate mortgage for our home but ultimately decided against it. Rates are currently at an all-time low and we believe that we will be in this house for the foreseeable future.
It seemed definite that the rates would increase before we were looking to sell the property in the future. For us, a fixed-rate conventional loan spread out over thirty years was the way to go, though we have plans to pay it off early.
Will You Be Paying PMI?
When determining how much house you can afford, you should consider whether you will be required to pay private mortgage insurance or PMI. This fee is designed to protect the lender in the event that you default on the loan.
It offers you no protection for missing a few payments and provides no real value to you as a homeowner. However, it is a necessary evil for many prospective buyers.
PMI is typically included on loans where you will be financing more than eighty percent of the loan’s value. Whether you opt for a conventional loan with a five percent down payment or an FHA loan, PMI could be a given for you.
The only exception to this rule is VA loans which do not require any private mortgage insurance as one of their benefits.
These payments can range anywhere from 0.25 percent to two percent of your annual loan amount, adding up to a significant fee each year. For us, this meant that we were going to be paying almost $200 each month if we chose to go with the FHA loan.
Worse yet, the payments were going to be a permanent fixture on our loan. Over the course of our loan, we would be paying $72,000 in PMI with no significant benefit to us as the homeowners.
On new FHA loans, PMI payments will be there for the duration of the loan. The only way to get rid of these payments is to refinance it and convert the loan into a conventional loan with a twenty percent down payment.
On conventional loans, you can often get this fee taken off after you build up equity in your home. Once your mortgage dips below the eighty percent mark, you can write a letter to your mortgage company and ask that the charges be removed.
Some lenders will do this automatically, so be sure to check the terms of your loan.
Gather Up Your Financial Documents
Get ready to apply for your new mortgage starting now. The biggest headache can be collecting all of the necessary financial documents that prove that you are going to be good to pay for your new loan.
You will need to provide your most current tax return, two months of paystubs, and two months of bank statements just to get started.
It can take days to gather up all of these financial documents, but it’s worth it in the end. By taking a deep-dive into your current finances, lenders can help you determine how much house you can actually afford.
This prevents you from borrowing more than you can afford to repay and sets you up for greater success in paying off your mortgage on time.
Make sure to get organized as much as possible before you start contacting lenders.
Round up all of these documents and put them in one place. I like to keep all of my financial documents in file folders that are neatly labeled and placed into a plastic container.
I have separate folders for tax documents (including our most recent returns and our W-2s), most recent pay stubs, and bank statements.
As we receive new pay stubs and bank statements, we continue to update the folders to give us a comprehensive look at our financial health and to keep us organized for our loan.
Shop Around for the Best Rates
Many would-be home buyers automatically assume that their primary financial institution will give them the most favorable interest rates. They are wary of lenders who advertise online and offer competitive rates that could save them thousands of dollars over the course of a loan.
Before you sign on the dotted line with any one lender, make sure that you have taken the time to shop for the best rates.
When we applied for our home loan, we started with our primary bank to see what they could offer us. But we also went a few steps further. We compared four or five different lenders until we found the one that offered the best deal.
One lender even offered to give us $5,000 in credit to use toward our closing costs. Competition for your business can be fierce, so be sure to do your homework diligently.
You can actually shop for a new loan within a specific window, typically fourteen days. This window allows you to apply for numerous mortgages without negatively impacting your credit score.
All of the applications are viewed the same as if you were applying just for one loan. The credit bureaus reward your financial prowess by not penalizing you for finding the best deal.
When a lender pulls your credit for a new loan, they are typically doing what is known as a hard credit pull. These pulls are designed to see all of the details of your credit history with your permission.
They can see what lines of credit you have open, how long you’ve had them, and if you have faithfully made payments on them.
Unfortunately, a hard credit pull can damage your credit by a few points. This is why it is so great that you can shop around for the best rates within a given window of time without negatively impacting your credit score.
Mortgage companies typically cannot do what is known as a soft credit pull for a loan of this magnitude. A soft pull is typically done when you want to be pre-approved for a special offer or credit card.
You might also experience this type of pull when checking your own credit score or submitting to a background check with your employer. These soft pulls do not impact your credit score like hard pulls do.
Keep in mind that your interest rate can have a significant impact on your monthly payment. This can factor into your decision about how much house you can reasonably afford.
Check for Prepayment Penalties
Have you ever considered the fact that you may want to pay off your home early? You might come into an inheritance. You might receive a few substantial raises at your current position, allowing you to put more money toward your mortgage each month.
No matter what may happen with any future financial windfalls, paying off your mortgage can be a smart investment of those funds. After all, shortening your loan period with extra payments can save you thousands of dollars in interest.
Before you decide on a loan, make sure that you won’t be hit with any prepayment penalties if you decide to pay off your loan early.
You might be focused on simply purchasing the home right now, but you might want the option to pay it off early years down the road. It’s better to be safe than sorry in this case.
One of our financial goals is to pay off our house before our thirty-year mortgage ends. We know that we want to do this, so we made sure that our loan wasn’t going to penalize us for paying it off early.
Every time we get a raise or come into unexpected cash, we plan to apply these extra funds to our mortgage. We aren’t sure exactly how soon we will be able to pay off this massive loan, but we are determined!
Getting a New Mortgage Requires Work
At the end of the day, there is simply no denying it: getting a new mortgage requires work on your part – and lots of it!
From gathering up financial documents to shopping around for the best rates, you have your work cut out for you. Before you pick up the phone to start calling lenders in your area, you may want to consider:
- What you can afford
- Your budget
- If your credit score is high enough
- If there’s PMI on the loan
- Penalties associated with an early payoff
Knowing your loan inside and out could save you thousands of dollars in interest and countless hours of headaches down the road, so make sure you shop around for the best loan, get your finances in order, and do all of the hard work now.
That way you can sit back and relax knowing you made the best financial decision you could while getting your mortgage!