Buying a home is one of the biggest decisions you will ever make. Homes are only getting more expensive, so most buyers must finance their purchase. Read on to learn how to get a home loan and mistakes to avoid in the process.
1. Review Your Financial Situation
Before you start looking at houses, you must determine if you are able to get a loan. Lenders check four major areas, and it’s important to understand each to know if you will have any issues while applying. These criteria include:
The most important factor in determining whether you are a well-qualified borrower is credit score. While requirements vary by bank, you’ll usually get a better rate with a better score. VA and FHA loans have lower credit requirements because they are backed by the government.
Although government-backed loans don’t have minimum credit score requirements, lenders may set their own credit limits. You will typically need a 620 to qualify for a VA loan. FHA loans are typically available to consumers with credit scores starting at 580.
Conventional loans, on the other hand, have no government backing, so a minimum credit score of 740 is required. Other types such as USDA loans are only given to borrowed with credit scores of 640 or more.
Virtually all mortgage lenders will ask for proof of employment and income for the last two years. While they don’t require you to be at the same job for two years, hopping from company to company may raise a red flag with the underwriting department.
In cases where commission, bonus, overtime, and part-time income are considered, you must have consistent income for one to two years before it can be used for qualifying you for the loan. If you receive 1099 income or are self-employed, lenders will often require tax returns of the past two years.
In almost every loan program, you must pay a percentage of the total purchase price. This is considered a down payment (i.e. putting money down on the house). FHA loans require 3.5 percent while conventional mortgages may require up to 5% down.
Because they are backed by the government, VA and FHA loans are again less strict. In these cases, you may be able to avoid a down payment altogether.
Banks lend based on total risk, and more equity means less risk for them. For this reason, a larger down payment will typically result in a better rate.
Debt-to-Income (DTI) Ratio
The DTI ratio is a calculation used for determining how much a borrower qualifies for and the maximum mortgage payment they can afford. Depending on the mortgage program, the DTI ratio requirement may range anywhere from 41 percent to 59 percent.
2. Learn How Mortgage Payments Are Calculated
Before searching for a loan, you must understand how much house you can afford. Four important components make up a mortgage payment. These include:
Principal, interest, and loan term are the three factors that make up your loan payment. The shorter the term, the higher the payment will be. However, this means you’ll pay less in interest, as you’re paying off the loan sooner.
Each county has an assessor who determines the annual property tax amount for each parcel of real estate. Divide this amount by 12 to calculate your monthly property tax payment.
Given the bank has a vested interest in your property, they’ll require you to carry homeowners insurance. The annual premium of the insurance is broken down into monthly payments and added to your total mortgage amount.
Borrowers with less equity in their home (who made a small down payment) are a bigger risk to the bank because they have less equity to protect. If they default, the bank is more exposed because they have less of a stake in the property.
For this reason, conventional borrowers with less than 20 percent equity in the home must pay Private Mortgage Insurance (PMI). This protects the bank in case their borrower stops paying their mortgage.
3. Understand Your Home Loan Options
Unless you can buy your house in cash, you need to finance it. Although the conventional 30 year mortgage is most popular, there are many other options available. These include:
Seller Carry Back
Often utilized in rent-to-own transactions, sellers carry back loans help buyers with sub-par credit buy a house. In this transaction, a seller carries back the note on their own house. That is, they allow the buyer to take possession and pay the seller directly, and then they pay their own lender.
To facilitate this transaction, the buyer and seller sign a promissory note that obligates the buyer to pay a particular amount of money, at a specific interest rate, on a specific date.
This is essentially the same thing as a mortgage, but is done directly between buyer and seller. Title is transferred to the seller, but the lien is not released until the agreement is completed in full.
Alternatively, the buyer may be able to take over the seller’s loan. If the mortgage is assumable, payments are made to the lender. However, many of these loans will hold the original borrower responsible for any default.
Conventional mortgages are home loans that aren’t secured by any government entity like the Federal Housing Administration (FHA) or the U.S. Department of Veteran Affairs (VA).
Instead, they are guaranteed by or are available through Freddie Mac and Fannie Mae or private lenders like a bank, credit union or mortgage.
Private institutions set the guidelines for conventional loans. These loans typically offer some leniency to first time home buyers.
If it is your first time buying a home, you might be able to get a loan by putting a 3 percent down payment. However, PMI is required for any conventional loan with less than a 20 percent down payment.
Conventional loans generally require a minimum credit score of 680 and the maximum debt-to-income ratio allowed typically ranges between 40 percent and 50 percent. Qualifying for a conventional loan can be more challenging due to their stringent lending criteria.
Moreover, the interest rates of these loans are extremely credit-sensitive – meaning you’ll be charged a very high interest rate if your credit score is low. Ideally, conventional loans are suited for people who can put a 10% or more down and have good credit scores.
While most conventional loans are fixed-rate (meaning your rate is the same for the life of the loan), you can get an adjustable-rate mortgage. These loans are fixed for a set period (usually 5 years) and then “reset.” This means they’re either called due by the bank, or adjust to a floating rate that tracks an index like LIBOR.
Non-conventional mortgages are simply home loans that don’t conform to traditional loan requirements. These loans offer more flexible eligibility and qualification requirements as they are backed by a government entity like the FHA, the VA or the USDA Rural Housing Service.
Examples of non-conventional loan programs include FHA loans, VA loans and USDA loans.
FHA loans are another mortgage option for home buyers. These loans are backed by the Federal Housing Administration (FHA) and were created for home buyers with a fair to good credit scores.
FHA loans are available to consumers with a credit score as low as 580. However, if you want better interest rates, you should have a good credit score – up to 680.
The minimum down payment requirement for FHA loans is 3.5 percent and rates are competitive, sometimes even better than conventional loans. FHA allows up to 57 percent DTI which means buyers qualify more easily. Typically, an FHA loan is a good option if your credit score ranges from 580 to 680.
These loans are strictly reserved for Veterans and qualifying widows. A VA loan is a government-backed mortgage, which means it boasts more lenient requirements.
The main benefit of VA loans is that you don’t have to pay a down payment and there isn’t any monthly mortgage insurance. Instead, these loans come with a VA Funding Fee that’s rolled into the VA loan at the time of closing.
Because they are government-backed, the rate isn’t determined by credit score as with conventional loans. Typically, borrowers qualify for better rates with VA loans than with their conventional counterparts.
The VA hasn’t established any minimum credit score requirement. However, lenders who offer these loans will generally require you to have a minimum credit score of 620.
The only kicker is that you have to meet certain qualifications to be eligible for a VA loan. Also, you’ll be subject to loan limits, meaning you’ll only qualify for a set loan amount.
USDA loan is another government-backed program that is particularly for houses in rural settings. Qualifying for a USDA loan is extremely difficult, but it’s highly advantageous as there isn’t any minimum down payment requirement and monthly mortgage insurance is very affordable.
The USDA doesn’t set a minimum credit score requirement. However, most lenders will require you to have a credit score of at least 640.
There are certain income limits to qualify for a USDA loan and the property you are buying must be situated in an eligible area. The DTI ratio requirement is 43 percent.
Every mortgage option has different guidelines, pros, and cons. You should determine the option that is best suited for you depending on your credit score, the down payment you can make, and the interest you can afford to pay.
Tip: Did you know that credit unions offer home loans? Read our complete guide on credit union mortgages, and you may save big money!
4. Get Pre-Approved
Getting pre-approved is an important step before buying a new home. This not only establishes how much of a mortgage you qualify for, but also shows sellers that you’re able to make good on an offer to buy.
You must complete an application to apply for pre-approval. Technically you aren’t applying for a mortgage, but you will need to provide pretty much the same information that you would when applying for a home loan.
Many lenders will require income documentation like W2’s, pay stubs, and tax returns to verify your income. Additionally, the lender may ask for paper statements and bank statements.
It is important to understand that a pre-approval is different from a loan approval and in no way guarantees that you will be approved for a loan.
5. Find A House
The next and perhaps the most important step of the home buying process is finding the home you want to live in.
If you are financially prepared, have been pre-approved and have a good real estate agent on your side, it will be easier for you to find your dream home. Once you have found the home you want to buy, put in an offer and get ready to negotiate.
Everyone wants a good deal on their home, so it’s hard to negotiate the price with the seller. You should try your best to get the price you are comfortable with. If you can’t get the price you can afford, consider looking for another home that is within your budget.
6. Start Your Mortgage Application
The application for a loan is similar to your pre-approval, with lenders requiring essentially the same documents. They’ll verify your income, so make sure to have your recent paycheck stubs, federal tax returns, and W-2s handy.
If you are self-employed, you may have to provide your profit and loss statement or 1099’s. You will also need to provide bank statements.
If you currently own a home, you must provide documents that can verify the address. If you have taken a mortgage to buy a home before, you will need to provide paperwork showing the name and address of the lender, the loan number, your monthly payments, and the amount you owe.
The information you provide is passed along the underwriters who will assess them to determine if you qualify for the loan. They will pull credit reports, check your credit scores, and may also talk to your employers.
7. Order An Inspection And Appraisal
Once you have negotiated the price and signed a contract agreeing to buy a home, you’ll give your lender a copy of the contract along with other documents required for underwriting.
Your real estate agent should help you schedule a home inspection along with a termite inspection (which, we might ad, is very important)!
This is done to ensure that there isn’t anything wrong with the home. It isn’t a requirement for getting a mortgage, but it is something everyone should do when buying a home.
After the inspection, an appraisal of the home will be ordered by the lender to determine its value. The appraisal value should be equal to the purchase price or higher to proceed.
If the appraisal value comes in lower, you’ll likely have to renegotiate the price with the seller. Alternatively, you can make up the difference by making a larger down payment.
8. Receive Final Loan Approval
Once the title work, appraisal and any other borrowing conditions required by the underwriter are returned, your home loan is ready for the final approval. Generally, the loan closing process takes 30 to 40 days starting from the execution of the contract.
Tip: Do not buy any big purchase (car, boat, etc.) between loan application and final loan approval. Your bank may change their mind on the loan if your credit situation changes.
9. Close on Your Dream Home
Three days prior to closing, you will given a Closing Disclosure. This form lists the final loan terms, all payments, and closing costs. Once you know the cash due at closing, you’ll need to obtain a cashier’s check or schedule an electronic transfer to the title company.
On closing day, you will sign what seems like hundreds of papers, which are mostly legal disclaimers. Once you do this, the title company sends everything to the lender and waits for them to fund the loan. After that, you’re all set with keys to your new home!
Tips For Getting A Mortgage
Although we could write enough tips to make your head spin, we’ll stick to the most important ones. These things result from our industry experience, and by no means are required. However, these are good rules of thumb to ensure you’re successful obtaining a home loan.
Start Saving Money for Your Down Payment Early
To avoid PMI, you need to make a payment of 20 percent. While lenders permit much less down, the trade off is that your payment and interest rates will be much higher.
While this saves you money, 20 percent of a $250,000 home is $50,000. So make sure to start saving early.
Stick to Your Budget
Once you are pre-approved for a mortgage, start searching for houses that cost less than your approval amount.
Just because you can afford your payments doesn’t mean you can afford the extras that come with home ownership. Remember, you still have to pay insurance, taxes, utilities, and the cost of unexpected repairs.
Finally, don’t get into a bidding war and offer more than your budget just because you love the house. Stay calm and know that there are other houses out there for you. Patience is a virtue, and is especially applicable when dealing with home loans.
Buying a home is a big step, and should not be taken lightly – nor should getting a home loan. We hope our guide on how to get a mortgage helps you, and please contact us by email if we’ve happened to miss anything that would provide value to you.