So, you want to buy a house.
That’s great. You are now embarking on one of the most significant financial journeys of your life.
This will be an exciting time. You will look at many types of houses of all sizes and designs in many neighborhoods. These houses will range in age, design, location, and most importantly, price.
The house’s asking price (the price the homeowner is initially asking to sell the house) is only one of the critical factors in determining whether you can afford to buy the house.
The most important factor is whether you can afford it.
While this may be your dream home in terms of location, size, and design, if you cannot afford to buy the house, it will not happen. This makes the process of purchasing a home part fantasy and part reality.
The fantasy is because you have an idealized version of your dream house. The reality is that dollars and cents determine everything. You decide to focus on the fantasy house. The mortgage company that determines the financial details also holds all the cards.
If you are a first-time buyer, you may not appreciate all the details and history of this important financial transaction.
Mortgages were originally only granted by a king to other nobles. That change happened around 1066 AD. But by the time of the Industrial Revolution (around the mid-1800s), local banks began making home and property loans to qualified non-royal, average citizen borrowers or others who wanted to be landlords.
Since then, the real estate purchase process has evolved dramatically. An entire set of real estate laws were developed, accompanied by changes in civic taxation, registration, land use codes, and, importantly, financing.
All this means that buying a house requires extensive financial documentation. When you start the buying process, your lender will begin to examine your financial situation in detail.
The mortgage company will conduct its own in-house due diligence test to determine whether your current and future financial situation will allow you to buy the house you can afford. This involves a financial analysis of your specific situation to determine if you can meet the needed down payment, closing, utilities, taxes, closing, and other required expenses before the mortgage closing will occur. If you pass this financial test, you get the keys to your new house.
The reality is that you can choose the house of your dreams, but the mortgage company is the gatekeeper. They will determine if you can buy the home or whether you will have to adjust your dreams.
Welcome to the genuine world of the home purchasing process.
Factors to Consider When Applying for a Mortgage
The first reality check any home buyer, especially first-time home buyers, faces is affordability. Specifically, how much can you pay in a monthly mortgage, plus all related expenses?
This is not the same as looking at homes you think you can afford. It is the opposite. Instead of looking at the most expensive home price you love, take the time to calculate your budget to see what you can afford in total homeownership monthly costs.
This is an adult reality check. For many, it will be painful because to arrive at this critical number, you have to assess what you own, what you owe, and all your income and expense sources.
This reality check involves essential research on all your sources of current income (payrolls, freelancing, inheritance, rent, portfolio), minus all living expenses (food, entertainment, utilities, incidentals, auto insurance, entertainment, medical and dental, tuition repayments, credit card debt, child care, etc.), plus savings. The difference between the two determines what you should be able to comfortably afford to pay in mortgage expenses without altering your lifestyle.
The Importance of Credit Scores
Many homebuyers fail to consider the role of credit scores in the mortgage approval process.
Lenders use credit ratings to determine how you rate as a borrow. Do you pay bills on time? Do you borrow more than your income allows? What is your credit and borrowing history? Have you ever defaulted on a loan?
All this affects your borrowing credibility. This determines what you will pay in interest and fees to obtain the loan. Most lenders rely on FICO scores, supplemented by your income, expenses, assets, and property type. This means the credit score is essential, but it is also evaluated in context with other financial variables. An excellent credit score of 740 or above gets you the most favorable loan rates.
According to Quicken Loans, the credit scores needed to qualify for a loan in 2021, depend on which type of loan you are applying for.
- A conventional loan requires a minimum credit score of 620.
- An FHA loan requires a minimum score of 580 (with a 3.5% down payment), while the same FHA loan with a 10% down payment requires a score of 580 from Quicken.
- VA loans commonly require a score of 620. Borrowers with a good or excellent credit score generally obtain conventional loans.
The link between credit scores and mortgage rates is illustrated in this chart from Credible.com.
As this chart shows, based on a $200,000, 30-year loan and interest rates as of August 13, 2020., borrows would pay the following based on their credit scores:
|Credit Score||Interest Rate||Monthly Payment||Total Interest Paid|
|Note: All numbers here are for demonstrative purposes only and do not represent an advertisement for available terms. This example is based on a $200,000, 30-year loan and the interest rates as of August 13, 2020. Calculations were made using the MyFico loan savings calculator. Source: Credible.com.|
Credit scores matter. As the chart shows, the difference in interest paid over time between the top-and bottom-ranked credit scores over 30 years is $63,000.
Here are the Most Common Lending Ratios
Mortgage lenders also have their favorite financial ratios. These ratios are used to assess your purchasing power. Obtaining this data commonly involves a background check on the borrower, which includes their financial, credit, and legal histories, to determine their credit risk to the lender.
Here are some of the most common ratios:
Eligible Income and Debt-to-Income (DTI)
This ratio uses your most recent W-2s and tax returns. It is then compared to your credit report to determine your debt-to-income (DTI) ratio. This critical ratio compares a borrower’s monthly expenses to their gross monthly income. It is calculated by dividing the borrower’s monthly debt into their monthly income. (It is important to note that income that is not declared on federal or state income tax filings cannot be applied to any mortgage calculations.)
A positive ratio is when borrowers have a DTI under 40%. This ratio applies to conventional, FHA, and VA loans. Some experts say the highest DTI ratio is 43%. Above that and the borrower is denied the loan. If the ratio is higher, borrowers may still be eligible for certain types of mortgage products offered by the VA or FHA.
This critical ratio also has two essential variations that are both commonly used. The first, called the “front ratio,” includes all housing costs (such as mortgage principal, interest, mortgage insurance premiums, and property taxes). The second, the “back ratio,” covers non-mortgage debt. This includes credit card auto loans, child support, and student loan payments.
All of these expenses are divided by the borrower’s gross monthly income before taxes.
These DTI ratios are used to qualify for a loan, but they vary by lender and type of mortgage.
While this is an essential ratio for most conventional borrowers, the DTI is not used in some federal loan programs offered by the VA, FHA, Fannie Mae home loan programs.
The Housing Expense Ratio
This ratio gives a monthly or annual snapshot of all housing expenses. These expenses include future mortgage principal and interest expenses, property insurance, local real estate taxes, and housing association (HOA) fees. The total of these expenses is divided by the borrower’s pre-tax income to produce the housing expense ratio.
This ratio is an excellent indicator to lenders that the borrower will have the needed liquid cash on hand to make the monthly mortgage payments. Lenders don’t want borrowers to use all, or most, of their available monthly income to make mortgage payments.
The Loan-to-Value Ratio (LTV)
This is a basic ratio to determine the mortgage company’s lending risk for any property purchase.
The LTV ratio is derived from dividing the amount of the mortgage into the property value. One of the key inputs into this ratio is the borrower’s credit score. The higher the credit score, the more money the lender will provide. The goal here is for the borrower to have a low ratio. This means the borrower is a lower credit risk, so they would be entitled to a lower interest rate. The opposite is true of the ratio is high.
The All-Important Role of Interest Rates
When investigating how much house you can afford to buy, some factors are within your control. Others are not.
Among the most important factors that no buyer can control is interest rates.
Interest rates impact what you must repay the lender monthly. Since interest rates have been at near 0% since 2020, many buyers have taken advantage of these low rates to buy more houses at a lower monthly cost. But these rates will not remain low forever.
A slight increase in mortgage rates, even one-quarter of 1%, could translate into a decrease of $10,000 in your financial ability to buy a house.
Interest rates also raise the critical issue of how expenses increase dramatically over time. The miracle of compound interest shows that a small increase or decrease in rates over 15 or 30 years amounts to a fortune at the end of the payment period.
None other than Albert Einstein called compound interest “the greatest mathematical discovery of all time.” While the math may be complicated, the idea in the borrowing world is simple: interest owed over time adds to your principal amount owed. In most long-term loans, interest costs alone comprise about 60% of the total amount you owe at the end of the mortgage period.
Here is an example: On a $200,000 mortgage loan amount over 30 years at a 4.5% interest rate, the borrower would pay $165,000 in interest. Using the same loan amount and interest rate, the borrower would pay $75,000 in interest over the loan period. The point is that even small changes in compound interest over time produce a significant increase in expense. That is why it pays to shop and compare the best available interest rate and other non-recurring expense items (such as closing costs, appraisals, and related fees) when selecting a lender.
The mortgage loan amortization schedule, which your lender provides, provides your total closing costs. In any mortgage, the amount the borrower pays monthly primarily applies towards interest, not the principal. This changes over time as the monthly mortgage payment increase monthly. For fixed-rate loans, the amount paid toward interest declines monthly.
How Much You Borrow Depends on the Mortgage You Choose
Thanks to new advances in financial technology, accompanied by more federal agencies and private companies offering them, the mortgage industry is more flexible. It has more types of mortgages to offer than ever before.
Today, mortgages are available as conventional and non-conventional and from private sources. While not as common, these private sources can include friends, family, or a business instead of going through a traditional lender.
According to New American Funding, there are seven types and maturities of mortgages (excluding reverse mortgages) available to conventional mortgage borrowers. Selecting which mortgage is appropriate affects your monthly and down payment amounts.
For example, borrowers who want to budget ahead can choose fixed mortgages going out 15 or 30 years. Conventional loans can allow smaller down payments (sometimes as low as 3%) of the total cost and expedited loan processing compared to federal loans. The loan periods can be from 10 to 30 years, but the lender may require private mortgage insurance if the borrower puts down less than 20% as a down payment.
Loans fall into two main categories: conventional and non-conventional. Conventional mortgages are made by private lenders (banks, mortgage firms) and are not guaranteed by the government. The borrower is responsible for the mortgage insurance. Non-conventional mortgages are insured and made by federal government agencies.
Non-Conventional Mortgage Lenders
Non-conventional mortgages are available from the following facilities:
Government loans from the Veteran’s Administration (VA), Federal Housing Administration (FHA), and U.S. Department of Agriculture (USDA) are offered to borrowers who do not qualify or do not want to use conventional loans.
Each type of federal loan has special provisions, including those for applicants with lower credit scores. These loans also are often accompanied by smaller down payments. For instance, according to the FHA, the minimum down payment for an FHA loan can be 3.5% with a credit score of 580 or higher. If your credit score is between 500 to 579, your interest rate can rise to 10%. Self-employed people and those with non-consistent incomes can also apply for FHA loans.
The FHA loan is the most popular government-backed home loan in the country. These low-down-payment loans are made by qualified lenders and guaranteed by the Federal Housing Administration (FHA), according to www.fhaloan.com
FHA loans require a 3.5% down payment for borrowers with a 580 credit score or higher. For homebuyers with less-than-perfect credit, FHA loans offer significant additional benefits. The government backing means average FHA interest rates are typically lower than average rates for conventional mortgages.
Borrowers with credit scores as low as 500 can qualify for an FHA loan with a 10% down payment. Guidelines and policies will vary by lender.
VA loans are only available to soldiers on active duty or retirees, and in some cases, the spouses of military members. VA loans can offer lower interest rates, no down payments, no-prepayment penalties, and no monthly mortgage insurance premiums.
Getting the Important Pre-Approval Letter
The next step in determining what you can afford is to get a pre-approval letter from your lender, often a mortgage company, bank, or federal agency. To get this vital document, you should have copies of your W-2s, federal tax filing, credit reports, and bank statements.
To obtain this letter, lenders commonly ask about your annual income and credit score; whether you are self-employed and for how long; are you the owner of more than 25% of a business; and the amount of your liquid assets. Lenders will also want to know if you have been bankrupt, gone through a foreclosure, been involved in the short-sale of a home, and are a U.S. citizen.
With this in hand, you now have the basic financial information needed to get a pre-approval letter. This letter demonstrates to your real estate agent, the buyer’s agent, and buyer that the lender has vetted you to receive a loan up to a specific dollar amount.
Getting the Important Pre-Qualification Letter
It is important to note the difference between a “pre-qualified letter” and a “pre-approval letter.” A “pre-qualified” letter is issued by only asking the borrower basic financial questions without seeing any supporting documentation. The pre-approval letter requires the borrower to complete a mortgage application and provide supporting documentation vetted by the lender. As a result, it is a much more authoritative document. The pre-approval letter is valid for 60 to 90 days. This financial verification process is why sellers will not accept a buyer’s offer unless accompanied by a pre-approval letter.
Starting the Home Purchasing Process
Once the major decisions are made about whether to buy the house, the first financial step in purchasing a home is to write a check to the homeowner for the earnest money. Your earnest money check signifies your intent to the homeowner that you want to buy the house. It shows you are a serious buyer. This money (the amount varies depending on the purchase price and lender) is held in escrow by the title company or the real estate firm. Earnest money can be applied towards the closing costs, or it can be refunded to you later at the closing.
The earnest money deposit differs from the down payment. The down payment is a percentage of the purchase price (often 20% in conventional mortgages), but this varies depending on the type of mortgage and the lender’s requirements. The down payment is the money you pay the lender. It represents your first step in buying the property. This amount can be affected by your credit history, the lender’s requirements, type of mortgage, and the home price. Once the entire process is completed, the lender releases the balance of the funds to the home seller to complete the purchase.
The down payment triggers the start of the mortgage approval (also known as underwriting) process. Depending on the mortgage company, this process can involve up to nine distinct steps.
Close the Deal and Shop for Your Best Lender
Choosing a mortgage company or lender is a financially important decision that has lasting ramifications. While getting the best rate is essential, it is not the single most crucial factor. The other key decision-making variables are choosing the mortgage product that meets your budget, so you can comfortably make payments and not become a financial slave to homeownership. The final step is to lock in the mortgage rate.
Be Prepared to Wait
The mortgage process proceeds in sequential steps, and each step takes time. Since you are an anxious buyer, you understandably want it to be completed as quickly as possible. Unfortunately, your time frame is different from the lender’s time frame.
As a result, be prepared to wait. Be ready to sign many legal forms. Be ready for the mortgage company to ask for additional documentation or to clarify your sources of income. Despite their efforts at improving client communications, don’t be surprised if you do not hear from your mortgage company for days or weeks at a time.
However, since it is in the best interests of both the applicant and the mortgage company to approve the applications accurately and as quickly as possible, you should expect that the process is continuously moving ahead. Until the real estate closing is completed, no one gets paid for their work; the homeowner does not get the proceeds, and the buyer does not get the keys.
Know What To Expect in the Mortgage Application Process
The most important thing in the mortgage process is to be well-prepared. Know the process. Then, know your resources and limitations.
If you have all the prepared documentation, know your bottom line and how the process works, you will have a better and more profitable home purchasing experience.