Are you thinking of buying a home, or wondering what you’ll need to get organized for a mortgage? If so, you’ve come to the right place. In this article, I aim to give you, the reader, as much information as you might need before applying for a mortgage.
Before delving into the specifics of getting a mortgage, I think it’s important to preface this article by saying, don’t spend too much money on a home. You don’t want to have a mortgage that eats up all your monthly surplus and become house-poor.
Indeed, buying too much of a property, perhaps to keep up with the “joneses” is generally not the best idea.
For sure, owning a home was one of the contributing pillars to my becoming financially independent at age 35. Still, I always recommend staying within your budget and generating a monthly surplus. Unfortunately, too many millennials find themselves with little to no money left over at the end of the month, but it doesn’t have to be that way!
So, let’s dig in and see what you’ll need to get organized for a mortgage!
When should I buy a home?
As soon as you can afford to buy, I recommend it. Owning a home offers several advantages, and if you do it right, you can treat your home as an investment and have others pay your mortgage for you!
As soon as you become a homeowner, you start building equity. In contrast, renting contributes to your landlord’s investment, says Andrina Valdes, COO of Cornerstone Home Lending, Inc.
As this year’s housing market has recovered faster than expected, owning a home is about 12% cheaper than renting thanks to record-low rates. The average homeowner’s equity has also grown, with the latest estimates sitting at around $9,600, adds Valdes. It can be a good idea to buy a house when you’re financially prepared to do so since you’ll have more time to build this long-term investment.
Whatever you do, avoid worrying about trying to time the housing market. Investing is not about timing the market, but the time in the market. So, find a place where you can see yourself staying for the next 5-10 years and get the best deal you can get now, suggests Christensen from 50PlusOnFIRE LLC.
Before getting a mortgage
I can’t stress how important it is to prepare before applying for a mortgage or buying a home. Investing in real estate is a serious matter and can make or break a budget.
Check and Improve Your Credit Score
Considering a mortgage will likely be the largest loan you’ll have ever received, it generally makes sense that you’ll want the lowest interest rate (APR) possible. In general, the higher the credit score, the lower the interest rate. And this rule applies to practically any loan.
The first thing you’ll want to do before getting a mortgage is to check your credit score and report. It’s important to know that all the report’s information is accurate, error-free and that you haven’t fallen victim to identity theft.
Working on getting the highest credit score is worth it as it opens more mortgage options and leads to the lowest rates, says Jennifer Beeston. However, don’t bite off more than you can chew. Your mortgage should be a benefit, not a burden. Buying less than what you can afford will reward you in the long run, adds Beeston.
For example, someone with a credit score in the mid 700’s that applies for a $300,000 mortgage will likely be approved at the best possible rates, today around 3% for a 30-year mortgage. The cost of interest over this period alone is $155,513.21. However, if your credit score is less than perfect, say in the 600’s, you’ll be paying more. Even just 0.5% more APY means you’ll now be paying $185,005.13 in interest… that’s almost $30,000 more!
One of the ways to improve your credit score is to look at credit utilization. John Davis from ScoreSense tends to agree. I would certainly tell my younger self to get my credit utilization in order before applying for a mortgage so that I could get the best rate, says Davis. Reduce my utilization rate of revolving credit to 25% and not take any more credit before applying for the mortgage.
Little credit cleanup steps like checking your score and challenging any errors can undoubtedly help. Also, avoid large credit purchases before applying for a mortgage, pay your bills on time, and don’t closing old credit accounts can go a long way, says Andrina Valdes, COO of Cornerstone Home Lending, Inc. Indeed, when I worked as a realtor, my mortgage broker friends always said, buy the house, then the truck, not the other way around! I’d say, don’t buy the truck.
What to do about your credit cards
High-interest rate debt (bad debt) such as credit cards, lines of credit, or personal loans, should usually be paid off before even considering a mortgage.
High-interest rate debt, i.e., 19.99% credit card debt, will cost you heavily in terms of interest, impact your credit score, and the minimum payment will eat into your mortgage affordability. Not only that, bad debt hurts your ability to keep solvent.
If you’re young and buried in a credit card debt spiral, consider filing a Chapter 7 bankruptcy now, while you are still income-eligible. Five years from now, the bankruptcy will be in the rearview mirror, and your credit will be on track, given sound financial practices post-filing, says Latife Neu from Neu Law.
How to handle student loans
Having student loans or other debt does not mean homeownership is out of reach. There are two types of debt; good debt like car loans and student loans and bad debt like credit cards. If you have good debt in the form of a car payment or student loans, it’s not the end of the world, and you should not worry about trying to pay those debts off before considering homeownership. You’ll likely be better off just making the minimum payments on those debts and putting your extra cash towards saving for your down payment, says Lauren Anastasio From SoFi.
Whether you have low-interest debt, high-interest debt, or perhaps a combination of the two, it’s essential to be realistic about what you can afford to add to your debt obligations. Your goal should be to have manageable monthly payments for all of your debt, ideally less than 36% of your gross monthly income, adds Anastasio.
So what does this mean? It means that if you add up all your existing debt payments (including the student loan payments), AND any potential mortgage, it should not add up to more than 36% of your pre-tax income (Monthly). Any more than 36%, and you’ll become house poor, and you will run into challenges when it comes to financing.
However, don’t let federal student loans go into default! Manage them through income-driven repayment plans if the contractual monthly payments are too big, says Latife Neu from Neu Law. As soon as federal loans go into default, huge collections costs are applied, and these loans never go away. There is no statute of limitations for federal student loans!
Car loans and other secured loans
Just like any other loan, the loan payment eats into your affordability, dollar for dollar. For example, a $650/mo car payment might reduce your mortgage affordability by as much as $100,000 for a 30-year mortgage.
Make a budget
It’s essential to have a budget before buying a home and factor in the new mortgage payment into your budget. If you don’t have one, here’s how to make a budget. If you don’t have a lot of existing debt, banks will typically approve you for more house than you should buy, says Marie Buharin from Modernesse.
Buharin offers a different calculation when it comes to mortgages. She recommends buying a home where the mortgage payment will be about 25% of your after-tax monthly income (including property taxes). Buharin also recommends setting aside 20% of your after-tax income to pay off debts and build an emergency fund.
Don’t trust the banker to come up with the monthly payment you can afford. Figure out your budget ahead of time. Estimate your local taxes and your homeowner’s insurance. There are plenty of only calculators available to help, says Todd Christensen from 50PlusOnFIRE LLC. Just because the bank says you can afford $500,000 doesn’t mean you should spend $500,000!
For example, let’s say you and your partner start looking at homes selling for $500,000. Still, after doing the numbers, you might realize your workable budget is actually $275,000, says Michael Bogardus from Barnum Financial Group. However, those homes in your affordable price range now do not have the same “shine” or appeal compared with the first group of houses. The $500,000 house is just too hard to resist, and you become “anchored” to it.
Don’t also forget to allocate some money (in your budget) toward your emergency fund. Indeed, homes will always need a certain amount of work, and this is where your emergency fund comes in.
I recommend having six months of expenses (needs) available in your emergency fund. And don’t forget, older homes come with older home problems, such as plumbing and electrical issues, and so on. You won’t want to let these expenses accrue interest on a high-interest credit card.
Save for a downpayment on your mortgage
Your down payment is a key to buying your property, so save, save, and save some more. Every dollar you save means you can potentially save $1.50 – $2 over the life of the mortgage! Where else can you get a guaranteed return of 50-100%?
Indeed, saving for your down payment might mean that you have to find a side hustle and cut back on your wants. Wants are discretional items in your budget, such as eating out, shopping, and so on.
While your credit report tells the mortgage professional some information about your past payment history, the downpayment makes the bank feel better about approving the loan. The more you have for a down payment, the lower your loan to value (LTV). And a lower LTV means a less risky mortgage to approve. The riskier the loan, the higher your interest rate will be.
The next steps for getting a mortgage
Now that you know a little more about your credit, having a budget, and a general idea about how much savings will be required to buy a property, the following steps will help you gather the documents needed for your mortgage approval.
Documents you will need for mortgage approval
Banks and financial institutions will want to know that you can actually pay for your mortgage. For this reason, you will need to gather documents that show proof of employment (pay stubs), bank statements, and tax returns, says Marie Buharin from Modernesse. If you’re borrowing money from family to help with the downpayment, you will need to provide a signed affidavit that the money is a gift.
Lauren Anastasio from SoFi says every lender is different. However, there are some standards you can expect when it comes to document requirements. You will always need to show proof of assets and income so a mortgage lender can understand where your down payment is coming from and how you’ll be able to make your loan payments.
Typically you can expect to be asked for your last two years’ tax returns, copies of all your bank and investment account statements, as well as copies of your two most recent pay stubs.
Tip: Now, if you’ve done well in the past couple of years and your income was higher than usual, you might want to consider using it to your advantage by filing an extension with the IRS. To be sure, filing an extension will buy you an extra six months to use your previous two high-income years when applying for a mortgage.
You must close the deal before the extension is over (October 15th) because that’s when you’ll need to show the lender the current tax year’s return.
Additionally, if you’ve recently changed jobs and have less consistent income like commission, company stock, or bonuses, the lender may ask for additional documentation that goes further back in time. I keep all my bank statements, investment statements, and tax returns organized into folders by year on my computer. This way, if I need a bank statement or a tax form, it’s always easily accessed.
Once you have your documents collecting, you’ll want to consult with a mortgage professional as soon as possible. When I started investing in real estate, I used mortgage brokers, and they can work well. However, later in my career, I found myself with a closer relationship with my banker. Regardless, if you don’t know any mortgage professionals, check with your realtor!
The mortgage professional might ask you some high-level questions such as your last two years of income and total minimum payments. Also, if you’re going to buy a rental property (i.e. to rent out a portion), questions about the rents will come up. They may or may not do a soft pull of your credit report and figure out what price range you should consider. Unfortunately, this phone call is as far as some people get because of their Michigan Ave. tastes, and Wal-mart budgets, says Tomas Satas from Windy City Homebuyer.
Early loan approval is critical right now because so many housing markets are competitive. These days, many first-timers face multiple offer situations, says Andrina Valdes, COO of Cornerstone Home Lending, Inc.
Early loan approval tells a seller that your loan is capable of closing, and it could give you an advantage above other offers, especially when there aren’t any cash offers on the table.
Types of mortgages to choose from
It can seem like there are dozens of different mortgage options, and while there are many, not all are available to everyone, so we can keep things simple by focusing on mortgage types based on payment.
There are fixed loans, standard 15 and 30 years that offer fixed interest rates and fixed monthly payments for the loan’s life, says Lauren Anastasio From SoFi. Additionally, there are adjustable-rate mortgages, also known as ARMs, which have a short fixed term, like 5, 7, or 10 years, and then the rate adjusts after that time.
As a first time home buyer, Anastasio suggests trying not to get too overwhelmed by these options. Anything other than a fixed-rate loan will usually require a higher down payment, so a fixed-rate 30-year is typically the most attractive option.
The 30 year mortgage
It’s important to remember that your first home is likely not going to be your forever home.
First-time home buyers should be realistic about what they can afford and the likelihood that their priorities will change over time. As a result, we don’t need to be concerned about finding and affording our dream home right away, says Lauren Anastasio From SoFi. As such, it’s logical that a first time home buyer is usually best served by a 30-year mortgage. A 30-year fixed mortgage will give a buyer the most affordable combination of low down payment and low monthly payments. Since there’s a very high likelihood the house will get sold in a few years, you don’t need to feel stressed about trying to pay the mortgage off early, adds Anastasio.
Suppose you’re not buying a forever home, and you have a good credit score. In that case, I highly recommend looking at a 30-year mortgage because it will give you the most flexibility, especially given the incredibly low-interest rates currently available.
Additionally, considering the large-cap stocks gain, on average, 10% a year, it might make better sense to also invest in the stock market. Indeed, having a diversified portfolio of both real estate and stocks will likely prove to be a good idea when it’s time to retire.
The 15 year mortgage
If you have lots of monthly surplus funds available, and can both afford and qualify for a 15-year mortgage, then might be something to consider. 15 Year mortgages currently offer a slightly better interest rate and allow you to pay off your mortgage in fifteen years, rather than thirty years. However, the tradeoff is the higher monthly payment.
If paying off your mortgage faster is your goal, consider maying extra payments throughout the year. The additional payments go toward the principal and not interest. Therefore, you’ll pay down your mortgage far faster than just making the contracted monthly payment alone.
Over time, making extra mortgage payments will shave years off the loan and save you thousands of dollars in interest, says Nick Standlea from Test Prep Gurus.
I would tell myself to get the 15-year mortgage instead of the 30-year mortgage, says Joe Bailey From My Trading Skills. The 30-year mortgage may have a lower monthly payment due to its longer-term, but you wind up paying more money overall than the 15-year mortgage because of the additional interest, adds Baily.
Bails also would suggest waiting until he cleared any student loan debts and have an emergency fund set up before getting a mortgage. Going into a mortgage with student loan debts nearly crippled him financially. Also, an emergency fund would have come in handy when paying for the costly maintenance and repair costs the occurred.
Adjustable rate mortgages (5/1 or 7/1 ARMs)
An ARM is an adjustable-rate mortgage that offered a low, fixed-rate for the first five years (on a 5/1) or the first seven years (on a 7/1) of the mortgage.
Eric Jeanette From Dream Home Financing says the ARM’s interest rate will be lower, and the average mortgage (especially when you are young) does not last more than seven years. People move or refinance before that time. As a result, a 7/1 arm might be the way to go!
Jeanette would tell his younger self to seriously consider a 7/1 ARM vs. a 30 year fixed mortgage. Indeed, after the five or seven year period is up, you can refinance to another arm, or a fixed-rate mortgage, depending on your circumstances.
Interest only mortgage option
Less common, but also available, are interest-only ARM mortgages. Interest-only mortgages are ideal for those who have variable (lumpy) income. Also, they offer the most flexibility to the homeowner, as this mortgage will offer the lowest monthly payment. Generally, interest-only mortgages are only for an initial fixed period, such as five or seven years. Then, the mortgage goes into a typical payoff mode.
The interest-only mortgage will be the riskiest because the mortgage principal doesn’t go down for the initial period. As a result, the homeowner will hope the property appreciates over the initial period.
HELOC (Home equity line of credit)
HELOC stands for Home Equity Line of Credit. A HELOC is a variable-rate credit line based on your home’s value and allows an individual to continually borrow from and pay back the home’s value over a set period. It is a form of a second mortgage, without fixed repayment terms.
Many people use their HELOCs to refinance or consolidate existing loans or purchase big-ticket items, pay for their child’s education, etc.
According to Bankrate, HELOC rates currently range between 2.87% and 21%, depending on the borrower’s creditworthiness and other factors.
In general, HELOCs are additional debt and carry risk if you cannot pay them off, says Marie Buharin from Modernesse. Individuals taking out HELOCs were a significant factor of the 2008 crash. Buharin recommends you avoid them except in very particular scenarios.
If you make a sizeable down payment and instantly have sizable equity in your home, you can use a HELOC in several ways as an interest-free loan. For example, say your home needs a new roof or you would like to remodel the interior. And, if you do use your HELOC to repair or renovate your own home, some, if not all, the interest you pay becomes tax deductible at the end of the year.
While it’s a great financing alternative, a HELOC may not be the right choice for a first-time homebuyer in the current economic environment due to the loan terms’ variability, says Stacey Corso from Mynd Management
Also, interest rates will likely stay about as they are, since the Fed remains committed to keeping rates low as a means to stimulate the U.S. economy. Nonetheless, there’s no guarantee that interest rates will stay this low forever, says Corso. As a result, it might be better to lock in a fixed, low-interest rate and pay off the loan in 15 years amid the current economy. This option also seems like the more secure one.
An FHA loan is a mortgage insured by the Federal Housing Administration (FHA) and issued by an FHA-approved lender. FHA loans are for those who require a lower minimum down payment and lower credit score requirements. However, FHA loans will come at a slight premium.
First-time homebuyers should know that just for the sake of taking the pressure off of themselves, flawless credit is not an absolute requirement to procure a mortgage, says John Romito from Heart & Home Real Estate.
The minimum credit score a buyer would need will depend on the type of mortgage they’re applying for and the lender they’re working with, says Lauren Anastasio From SoFi. FHA loans tend to have lower minimum requirements than conventional loans, and every lender will set their credit criteria for their applicants.
Interestingly, it’s possible to get approved for a mortgage with a credit score as low as in the 500’s, adds Anastasio. However, it’s important to remember that the higher your credit score, the better the rate you will likely qualify. As a result, it’s best to work on your credit score before applying for an FHA loan.
Getting yourself organized before getting a mortgage could save you thousands of dollars over the life of your mortgage. In my own experience, the best mortgage is the one that that lets you borrow the most, for the longest period, and at the lowest rate. Indeed, those terms will give you options. If you have a tip or a question, please leave a comment below, and I’ll happily get back to you!