If you're thinking of buying your first home, there's a good chance that you're planning to obtain a mortgage to finance the purchase. While mortgages can seem intimidating and complex to inexperienced buyers, they don't have to be. As long as you know what to expect, and some basic information about how mortgages work, the mortgage process can be relatively smooth and painless.
Fixed rate vs. adjustable rate mortgages
When it comes to your mortgage's interest rate structure, you have two basic choices. You can get a fixed-rate mortgage, which has the same interest rate throughout the entire loan term, or you can choose an adjustable-rate mortgage, which has a set interest rate for a certain number of years (five is common), but the rate can then adjust periodically thereafter.
There are valid reasons in favor of both options, and the best choice depends on your situation. For example, a fixed-rate mortgage can allow you to lock in an interest rate, and maintain a predictable mortgage payment. On the other hand, an adjustable-rate mortgage generally has a lower initial rate, so if you don't plan to keep the home for more than a few years, it could be a smart option.
30-year vs. 15-year and other options
The 30-year mortgage has been the U.S. industry standard for many years, but it's not the only option. 15-year mortgages generally have lower interest rates and can allow you to pay off your home in half the time, and you may be surprised to learn that your payment won't be nearly twice as much. It may be a smart idea to ask your lender to run the numbers on a 15-year mortgage as well as any other loan lengths they offer (10-, 20-, 25-, and 40-year mortgages aren't uncommon).
Conventional, FHA, and other types of mortgages
There are several different types of mortgages you should be aware of before starting the house-hunting process.
- Conventional/conforming – This is the "standard" mortgage, and typically refers to loans that conform to Fannie Mae and Freddie Mac's lending limits and standards. Conventional mortgages are not guaranteed or insured by the federal government.
- Jumbo – A jumbo loan is a mortgage that isn't guaranteed by the government, but exceeds the Fannie Mae and Freddie Mac lending limits. A jumbo loan is a type of non-conforming conventional mortgage.
- FHA – FHA mortgages are insured by the federal government, and therefore have looser credit standards than conventional mortgages.
- VA – VA loans are mortgages that are guaranteed by the U.S. Department of Veterans Affairs. For those who qualify, VA loans have no down payment requirement and several other advantages.
- USDA – Designed to encourage rural homebuying, USDA loans have no down payment requirement, but also have some drawbacks, such as relatively high fees.
In addition to the mortgage types listed here, many lenders have their own unique mortgage products, so this isn't necessarily an exhaustive list.
How much can you borrow?
When you apply for a mortgage, your lender will approve you for a maximum monthly mortgage payment, including property taxes and hazard insurance premiums, which generally have to be paid with the mortgage. The exact dollar amount you can borrow depends on your interest rate as well as a particular property's tax and insurance cost. However, your lender will typically provide you with a pre-approval for a specific amount of money, based on certain assumptions.
Lenders generally use two debt ratios to determine your maximum mortgage payment. The front-end ratio considers your new monthly mortgage payment as a percentage of your income. Generally, lenders like this to be 28% or less. The back-end ratio includes your mortgage as well as your other monthly debt obligations, and lenders like this to be 36% of your income or less, although it's possible to get approved with a significantly higher debt-to-income (DTI) ratio.
As a final thought in this section, keep in mind that just because you can get approved for a mortgage of a certain amount doesn't necessarily mean that you should spend that much. After all, if you get a credit card with a $10,000 limit, does that mean that you should go spend $10,000?
How much money do you need to put down?
The industry standard down payment is 20% of the purchase price, but it's certainly possible to buy a home with much less. You could potentially get a conventional mortgage with as little as 3% down or an FHA loan with as little as 3.5%, but either of these options will require you to pay mortgage insurance, which is an additional ongoing expense you'll need to budget for. Certain types of loans, such as VA and USDA loans, may be available with no down payment whatsoever.
Do you need excellent credit to get a mortgage?
Not necessarily. The average American has a FICO credit score of 700 on a scale of 300-850, and anything in the upper 700s or above is generally considered to be indicative of excellent credit. However, you can buy a home with a significantly lower credit score.
As of this writing, Fannie Mae and Freddie Mac guidelines call for a minimum FICO score of 620, and you can obtain a 3.5%-down FHA mortgage with a FICO score as low as 580. With a higher down payment, your score can be even lower. VA and USDA loans also have somewhat flexible credit requirements.
Having said that, a better credit score can get you a better interest rate, especially with a conventional mortgage, which could potentially save you tens of thousands of dollars over the life of the loan.
How to start the mortgage process
Before you start shopping for a home, it's a smart idea to meet with a lender and obtain a pre-approval. Doing so will require a full mortgage application, including a credit check and employment verification, but a pre-approval can be a powerful tool to have when shopping for a home. Don't confuse this with a pre-qualification, which is based solely on unverified information you provide.
Be sure to gather the proper documentation before you start the process, as doing so will make the process much easier.
What are closing costs, and how much are they?
Closing costs refer to the various fees and taxes you'll pay (or finance) upon the finalization of your mortgage and include such things as the loan origination fee, appraisal costs, title insurance, deed recording fees, and more. Closing costs are typically between 2% and 5% of your loan amount and depend on several factors.
It's important to mention that it's quite common for buyers, especially first-timers, to ask the seller to pay for some or all of the closing costs as part of the deal.
After you've been approved
Two final words of caution. First, between the time you have an accepted offer on a home and the time when you close, expect some hassles related to the mortgage. It's quite common for a lender to realize they need additional documentation, or a letter from you explaining something on your credit report or work history.
Second, once your mortgage is approved and you're under contract on a home, leave your credit alone. Your lender will do at least two credit pulls -- one when you apply for the mortgage, and another shortly before closing. Any differences between the two (new accounts, higher debt levels, etc.) can result in serious delays, or an outright denial of the mortgage, especially if your credit score dropped significantly. It's common to finance several major purchases (such as furniture) when you buy a home but wait until after closing to buy anything big.
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