As the U.S. economy begins to recover from the downturn that was almost ten years ago, most people are looking to buy homes after years of renting and living in a former house. As a result, the real estate market is tough in many parts of the country, forcing buyers to put in aggressive deals and contend with deep-pocketed investors paying cash in some cases.
What this means is that you need to qualify for a mortgage before you search for real estate, now more than ever.
Knowing the mortgage market of today
Before the 2008–09 housing crisis, it seemed that a mortgage (or more) could be received by anyone with a pulse. Lenders offered “sub-prime” loans to people with poor credit ranking. They knew all the time that the borrowers couldn’t afford the payments and will ultimately fail to pay.
Clearly, these borrowing practices are unsustainable. The banks got bailouts as millions of homeowners either lost their homes or get trapped underwater, owing much more to loan obligations than the value of their home.
Although the real estate market is beginning to recover, it’s mark has been left by the mortgage crisis. Mortgage underwriting— the guidelines used by banks to determine whether a loan should be made — is more strict. That’s not to say it’s going to be hard for young couples or other first-time homebuyers to get a mortgage. But it means that it is more necessary than ever to prove to the bank that you are financially prepared for a loan.
What does it take to get a mortgage approved?
You’ll want to know these things before you complete a mortgage application or even step through an open house:
- Your monthly income
- The amount of your total monthly debt payments (auto loans, student loans, and average credit card payments)
- Your credit score and any credit issues over the past couple of years
- How much cash in hand you have?
- Calculate your monthly income and debt obligations
The first step to prepare for a mortgage application is to document your monthly income and debt payments. You will need to provide your lender with at least two weeks of pay stubs, so starting to collect those doesn’t hurt. If you are self-employed or have variable income, expect a little more participation in the underwriting process. For example, you may need to send copies of your past tax returns for one or two. The borrower can then calculate the median or the lower of the two numbers of your last two years ‘ earnings.
Being accepted for the loan you need is all about keeping within the usage of those lenders ratios to decide how much you can afford to pay a mortgage. High debt payments (such as a car loan or high student loans) can restrict the amount of the authorization you will obtain. If possible, pay these loans off or, at the very least, avoid taking any new loan payments.
2. Give a checkup to your credit health
Get both your credit score and your credit history report before applying for a mortgage.
You will want to check that there are no errors or recent derogatory items such as late payments in the report. Since you may spend months shopping for homes, you may want to consider subscribing to a service that provides regular monitoring of credit reports for about $20 a month. You can cancel this after you close on your home.
As for your credit score, at least 680 and ideally above 700 should be your projected FICO credit score. Anything less than the ideal will need to find a highly qualified co-signer or could take time to improve credit score to get an approval of your mortgage. The lower your credit score, the higher you are going to pay the mortgage rate.
If your loan is just below 680, you may also consider a loan from the FHA. These government-insured loans allow lower credit scores and lower down payments, but additional costs are significant.
Ultimately, in the few months leading up to your mortgage application, do not apply for new credit. Banks are suspicious if the new credit seems like you’re piling up. My mortgage broker once told me that even getting a credit check for a new cell phone plan could require a letter of explanation to your mortgage lender.
3. Determine the plan for mortgages
You’ll want to decide how much house you can afford and how much you are comfortable to pay (two different things!) before you ever speak to a mortgage officer.
A good rule is that no more than 35% of your net income(pre-tax) should be your overall housing allowance this includes charges, taxes and insurance.
For example, if you and a co-buyer make $80,000 a year together, your average joint housing payment would be $2,333 a month. I recommend that you stick with a total payment of 25% of gross income for rent. Many readers who are even more liberal will be found here.
It can be hard to match this monthly payment to a fixed home price because the monthly home payment is subject to factors such as mortgage interest rate, property taxes, home insurance or private mortgage insurance (PMI) premiums, and any condo or association fees.
4. Figure out how much you can save for a down payment
Next, decide how much you can save to bring your first home down payment. Expect the mortgage lender to require at least a 10 percent down payment in today’s market if you seek FHA loan or other special program loans.
If you do, consider putting down 20 percent to avoid private mortgage insurance (PMI)—costly insurance that protects your mortgage lender should you foreclose your property before building up enough equity.
Once you begin the mortgage approval process, agree to the maximum amount you want to pay. Real estate agents, some unscrupulous mortgage lenders that seek to persuade you to buy a house that is more costly than you can afford, and your own desires may be rationalizing the decision by telling you that property is bound to appreciate. That may happen, but I’d take a smaller payment which you can handle in good and bad times over a larger one that you might lose in foreclosure.
5. Note that loans with an adjustable-rate are risky.
Payments on an adjustable-rate loan may start out small but will fluctuate with the market and could cost much more in the long run than a fixed-rate loan. Think of a loan with a fixed rate as a reliable vehicle that will take you everywhere you go. An adjustable rate is more like a used car — cheaper, but breakdowns will cost you more money and worry in the long run.
6. Be vigilant of refinancing
Much of the month’s payment goes to interest at the start of a mortgage, and you don’t necessarily pay back any of the principal (the initial sum of money borrowed to purchase the house). The further you get into a mortgage, the more the monthly payments will change from interest payments to debt payments. In other words, when you’re in your mortgage for five years, each payment will cover more than when you first got the loan. When you refinance, you basically restart the clock so that each payment, once again, isn’t making much of a dent in the principal.
So, if you’re in a 30-year mortgage for five or ten years and you want or need to refinance, consider getting a 15- or 20-year mortgage to avoid getting started with a mortgage where you mostly pay off interest.
