Unless you have a fairy godmother or a cool half million sitting around, you're probably going to need a mortgage if you want to buy a home. Here's how to qualify for and choose a mortgage, and what to expect throughout the process.
Let's face it: You can go to as many open houses as you want, but you're not going to be able to buy one without a mortgage. So get the ball rolling early and get pre-approved before you even start house hunting.
"My recommendation would be to always get pre-approved before searching for your dream home," says Nick Beser, director of housing and community development at nonprofit Guidewell Financial Solutions. "It's never good to fall in love with a property only to find out that you can't qualify for it at that particular price point." Beser says the pre-approval process "shouldn't take more than a day or two with a reputable lending professional." A preapproval is generally valid for 90 days, at which point you can repeat the process if necessary.
(Note that you can also get "prequalified" by a lender. This is a loose estimate of what you could afford based on financial information that you provide and a soft credit check. Prequalification is a simpler, quicker process, because you don't need to submit documentation of your finances. But for that same reason, it's also largely meaningless, and doesn't mean you've been approved for financing. It's simply a good way to estimate how big a mortgage you might qualify for.)
Are You Ready?
But before you apply for a mortgage, make sure you've got your financial act together: You want to put your best foot forward to qualify for the best rates - or at all.
"Pay attention to how you're managing your credit," says Tom Gleason, former executive director of MassHousing, the nonprofit housing finance authority for Massachusetts. "If you're delinquent on store credit or student loans or car credit, you've got to take care of those issues." Otherwise, he says, "you're just going to get rejected."
"You need to get to a point where you've had consistent income three years in a row," says Marie Presti, owner/broker at the Presti Group in Newton, Mass. Banks also want to see some cash reserves when you apply for a mortgage. "Lenders like to know that you not only have money for a down payment, but also enough money to pay the mortgage in case you lose your job after you buy the house. They like to see three to six months of expenses." This doesn't have to be a giant wad of cash in your savings account - it can include balances in retirement accounts you hopefully won't have to touch, such as a 401(k) or IRA.
Meanwhile, you'll qualify for better mortgage rates if your credit is excellent and you're not carrying a ton of debt. "In order to receive the lowest rate, credit scores should be in the 700s, and the borrower's debt-to-income ratio should be around 36%," Beser says. That means your total monthly debt obligations — including student loan payments, car loans, credit card minimums, and the mortgage you're trying to get — shouldn't exceed 36% of your pre-tax monthly income.
"However, many lenders have mortgage financing that will allow for scores down to the low 600s," Beser adds, "and Fannie Mae and Freddie Mac have recently made changes to allow for a debt ratio of up to 50%."
In general, the worse your credit score, the higher the interest rate, Beser says — and the higher the interest rate, the higher the mortgage payment. "This is important, because the size of your monthly payment can limit the size of home you're able to buy. It may even help decide the community where your family can afford to live," he says.
If you need a quick credit-score jolt, paying down credit card balances is one of the most immediate credit-boosters around. That's because roughly a third of of your credit score is determined by credit utilization, or how much of your available credit limits you've used up. Paying down balances can also get your debt-to-income ratio down to an acceptable level.
Find a Lender (and Look for First-Time Homebuyer Programs)
There are many types of mortgage lenders out there, from your neighborhood bank or credit union to online banks to nonbank lenders. While your own bank may offer mortgages, make sure to compare rates and terms at other lenders, too, since consumer banks may not be as competitive - especially for first-time buyers. In particular, check out the first-time homebuyer programs backed by your state's housing finance authority or those at local credit unions.
"We used a first-time homebuyer program offered through a credit union I have access to at work," says Sarah Korval, who bought a townhouse with her husband Scott in Boston in 2016. "We examined a bunch of different options, including three different credit unions and financing options through a loan officer. In the end, the credit unions all offered really strong programs with great rates, so we went with one of those."
For a first-time home buyer, it can often be a struggle to come up with a conventional 20% down payment: You don't have an existing house to cash in, and maybe you've been too busy battling student loans or paying sky-high rents to save up $40,000 or more in cash. However, you can take advantage of a number of loan programs designed for people in your situation.
"Mortgage products that include down payments as low as 3% are now being offered to help low- and middle-income communities and young adults attain homeownership," Beser says. "Federal loan programs such as FHA, VA, and Fannie Mae's Homeready Mortgage make it easier to lock into a mortgage without a sizable down payment." Indeed, loans backed by the Federal Housing Administration (FHA) are open to buyers with credit scores as low as 580, while VA loans allow active-duty military members and veterans to finance a home with no down payment at all.
Beser says to check out lenders in your area that offer these programs or their own first-time buyer programs. "Also ask about state and local incentive programs that may reduce your down payment or interest rate," he adds. Some states or cities offer residents even more generous first-time buyer perks, such as down payment assistance, as long as they stay in the house for a certain number of years.
In order to qualify for these programs, you'll generally need to complete a first-time home buyer class at a HUD-certified nonprofit organization, either in person or online. "Coming out of the recent recession, loan providers understand that offering a lower down payment involves risk; however, they see homeownership education as a powerful deterrent to default," Beser says.
It's true: Borrowers who take a home buying class are less likely to face foreclosure later on. "The best thing that a consumer can do for themselves is to get better educated," Gleason says. "And going through these classes, we've seen over time, makes a big, big difference."
The Paperwork Harvest
Once you're ready to apply for a mortgage (including a pre-approval), you'll need to gather an ungodly amount of financial paperwork. Depending on your organizational skills (or lack thereof), this might be the most onerous part of the home buying process. In addition to filling out the loan application, you'll usually need to locate and provide:
- Your last two tax returns and W-2 forms
- Recent pay stubs (or other proof of income)
- Balances and monthly payments owed on student loans, auto loans, and other debts
- Credit card balances and minimum payments
- Current bank account statements (checking and savings)
- Investment account balances (401k, IRA, etc.)
- Canceled rent checks (proof of current rent payments)
Fixed Rate vs. Adjustable Rate Mortgage (ARM)
Most first-time homebuyer loans involve a standard, 30-year, fixed-rate mortgage. This is where you lock in a certain interest rate for 30 years - it's the lowest-risk option because your monthly payment won't change. However, that's not the only mortgage product out there - far from it.
An adjustable rate mortgage, on the other hand, is just what it sounds like — the interest rate can change. You'll see these advertised as a 5/1 or 7/1 ARM - that means the rate is fixed for the first five (or seven) years, and then it can change based on market conditions once a year after.
An ARM is a bit riskier, but it does have an advantage — namely, the initial rate will be lower than a fixed-rate mortgage. For example, let's say a 30-year, fixed-rate mortgage is advertised at 4%; a 5/1 ARM at the same lender may start out at 3.5%. That can mean considerable savings over the first five years, and allow you to qualify for a bigger mortgage. But given that interest rates have been hovering near all-time lows since the Great Recession, it's fair to assume you'll be paying more - maybe quite a bit more - six years from now if you don't sell or refinance your mortgage before then. That's why most first-time homebuyer resources will steer you toward (or even require) a fixed-rate mortgage.
The reason any lender wants you to make a down payment - whether it's for a car or a house - is that, until you pay off a good chunk of the loan, they're the ones bearing much of the financial risk. A 20% down payment ensures that, even if the housing market collapses and home values plunge 10% to 15%, the home is still worth more than the lender has invested in it.
That's why, if you don't put down 20% or more, most lenders will require you to purchase private mortgage insurance, or PMI (which protects the lender in the above scenario, not you).
There are different ways you'll pay for PMI, depending on the loan program — some will wrap it up into the mortgage so it's financed over 30 years at a slightly higher interest rate, and other times you might just pay an extra $100 or so a month on your mortgage (until you reach 20% to 30% equity in the home). But even if you don't see it, you'll be paying for it one way or another.
"Prospective homebuyers who utilize low down payment mortgage products for financing will likely pay PMI and/or receive a slightly higher interest rate if they choose a 'Lender Paid Mortgage Insurance' option," Beser says. "That being said, many first-time homebuyers find that when all is said and done, the mortgage payment is lower than what they currently pay in rent."
Maybe you've heard of mortgage points, in which case you probably then thought to yourself, "What the hell do points have to do with anything?" Fair question! Basically, you can pay more money upfront to lower your long-term interest rate.
One point is generally 1% of the mortgage. So, for example, on a $200,000 mortgage, you might be able to pay an extra $2,000 (one point) at closing to lower your interest rate from 4% to 3.5% over the life of the loan. That extra bit will add up over the course of 30 years - saving you tens of thousands of dollars in interest, and lowering your payment every month. If you've got the cash, it can certainly be worth it — but first-time buyers are often pretty cash-strapped.
Speaking of cash: A down payment isn't the only upfront money you'll need to get a mortgage. Make sure you factor in closing costs, which vary by state but tend to average about $3,700, and can include origination fees (the bank's fee for writing the loan), surveyor fees, points, title insurance, appraiser and attorney fees, and other random charges. Your loan officer should be able to provide you with a "good faith" estimate of these charges ahead of time. In some cases it's possible to get the seller to "pay" your closing costs: Basically, they pay the fees, and then charge you that much more for the house, so the pain gets spread out over the course of your 30-year mortgage.
You may also need to prepay a year's worth of homeowners insurance and property taxes in order to close, which will go into an escrow account (meaning the bank holds the money and pays those bills on your behalf throughout the year).
What You're Approved For and What You Can Afford May Be Two Different Numbers
Finally, remember that just because you qualify for a $400,000 mortgage doesn't mean you should buy a $400,000 house. Base your target price range around the monthly payment that's comfortable for you - and, if that's lower than what you qualify for, just remember you have that extra wiggle room if you really need it.
"I usually say for first time buyers, try to go as high as you can on your limit, but still feel comfortable making that monthly housing payment," says Presti. But remember that you home ownership comes with costs beyond just the mortgage: Insurance, property taxes, utilities, and maintenance can add up to thousands of dollars a year.
"Consumers who have always rented often aren't aware of the costs of owning," Beser says. "They need to understand that financing a mortgage is just the first step. Once they move in, they will also have taxes, insurance, and maintenance costs as well."
At the same time, Presti says, some of that money will come back to you in the form of the mortgage interest tax deduction. And if you're confident as a young buyer that you'll be moving up in your career over the next few years, you might feel more comfortable stretching yourself.
Just remember: A mortgage is relentless, and selling a house isn't like breaking a lease. "You have to be realistic about the price of the home you can buy," Gleason says. "Nothing creates more stress in a family than being over-extended on your home and not being sure whether you can make the mortgage payments. So live within your budget and really stick to that."