Published in: Mortgages | Sept. 21, 2018
6 Things to Do Before You Apply for a Mortgage
By: Christy Bieber
So, you're thinking of buying a house. This means you probably need to get a mortgage.
Since you'll be paying your mortgage for years to come, it's imperative you find the right loan with the most favorable terms possible. While this means you need to shop around among different lenders, it's also important to get your financial life in order so you're an attractive borrower who's ready to pay your mortgage bills.
To ensure you're fully prepared to qualify for a loan -- and to pay it off responsibly -- check these six tasks off your to-do list before applying for a mortgage.
1. Save up a down payment
When you buy a home, you can't finance the entire cost. You need a down payment. In fact, buyers are supposed to put 20% down on a home -- so if you buy a $300,000 home, you should have a down payment equal to $60,000.
Most home buyers don't have a 20% down payment. In fact, recent data from National Association of Realtors found 54% of all buyers and more than 70% of first-time buyers who financed their homes put down less than this. And, for some loans guaranteed by the government -- such as FHA loans -- you can qualify for a mortgage with a down payment as low as 3.5%.
But, just because you can do something doesn't mean you should. Saving up a 20% down payment allows you to avoid paying mortgage insurance, which costs around .5% to 1% of the borrowed amount on an annual basis. Mortgage insurance protects the bank if you default, but you pay for it.
Perhaps more importantly, having a substantial down payment means you're unlikely to end up owing more than your home is worth. If you put nothing down on your home, even a small dip in the real estate market means you wouldn't be able to sell your home for enough to pay off your mortgage.
In fact, by the time you consider the costs of selling -- including 6% commission to a realtor plus other closing costs and transfer taxes -- home prices would hardly have to fall at all before you end up in a situation where you have to bring cash to closing even if you put 10% down.
If you can't sell your house for enough to pay off your mortgage and costs of the sale, you're effectively trapped in your home or forced to borrow money to get out. You don't want this to happen, so don't buy a home until you have a substantial amount of money to put down.
2. Raise your credit score
Your mortgage interest rates are determined by your credit score. Because you're borrowing so much money, even a small difference in the rate on your loan will make a huge impact in the total cost of your mortgage over time.
According to myFico, if you live in New York and borrow $300,000, here are the mortgage rates, monthly payments, and total interest you'd pay -- depending upon your score -- as of August 2018.
FICO Score APR Monthly Payment Total Interest Paid 760-850 4.19% $1,465 $227,508 700-759 4.413% $1,505 $241,651 680-699 4.591% $1,536 $253,075 660-679 4.806% $1,575 $267,030 640-659 5.239% $1,655 $295,644 620-639 5.788% $1,758 $332,868
Bad credit can cost you more than $105,000 in interest over the life of the loan, and can raise your monthly payment close to $300 monthly. To get the best rates possible, work on building credit before you apply for a mortgage.
You can improve your credit score by paying off debt you owe, making payments on time, and avoiding opening new accounts or closing old ones. If you have a past late payment, you may be able to get it removed from your credit report -- and substantially increase your credit score -- by writing a goodwill letter to your card issuer to ask them to take the black mark off your record.
Also, check your credit report to see if there are any mistakes that are hurting your score. Do this well before applying for a mortgage because it can take time for errors to be fixed. You don't want to pay thousands of dollars more on your mortgage because of a reporting snafu.
3. Save up an emergency fund
Once you're a homeowner, a loss of income could be catastrophic if it puts you at risk of foreclosure. Homeownership also comes with big unexpected expenses for home repairs if something goes wrong.
That's why having an emergency fund is so important before getting a mortgage. Ideally, you should have a fund with three to six months of living expenses saved up so you can still pay your bills even if a serious problem occurs. This should be separate from your down payment and from any money saved to pay for a move or new furniture.
This may seem like a lot of money, but you don't want to be in a home with a roof leak or coping with a job loss and be unable to pay for fixes or make the mortgage payment. If you don't want to wait to buy a home until you've saved a full emergency fund, at least make sure you have a few thousand dollars to get you through lean times.
4. Set your budget
When you apply for a mortgage, your lender will look at your financial information and let you know how much you're approved for. If you've got good credit and a solid income, you may be approved to borrow a lot of money. But, just because you're approved for a big loan doesn't mean you have to take it.
You probably have lots of financial goals, like retiring some day or paying for college for your kids. If you tie up too much money in your house, fulfilling your other financial priorities becomes really hard. So, before you apply for a mortgage, decide how much you want to spend. That way, you won't just accept a larger amount if the bank happens to offer it.
It can even be helpful to try to living on your budget and “making your mortgage payment” for a few months. If your mortgage will be larger than the housing costs you're currently paying, put the extra money into savings and see if you can make things work on what's left over. If you find it's too hard, you'll know you need to adjust your expectations downward.
5. Pay down debt
Mortgage lenders consider not just your credit but also your debt-to-income ratio when you apply for a loan. This ratio compares total debt payments to your gross monthly income. For example, if your gross monthly income is $4,000, your mortgage will cost $1,000 monthly and all other debts add up to $500, your debt-to-income ratio is $1,500/$4,000 or 37.5%.
Typically, your debt-to-income ratio can't exceed 43% to qualify for a mortgage, although many lenders prefer a lower ratio. If you owe a lot of money, you're going to have to pay down some of it to get approved for a loan to buy a home.
Paying down debt also helps improve your credit, which allows you to qualify for a better mortgage rate and lower monthly payments and interest.
6. Get your paperwork in order
Finally, you should start getting your paperwork in order because you're going to have to produce a lot of it when you apply for a mortgage. Typically, you'll need:
- Proof of income: This can include tax returns, pay stubs, W2s from employers, and 1099s if you're an independent contractor. You'll need to show you've had steady income for two years. If your income was $50,000 annually until recently and just went up to $100,000, your lender may only “count” $50,000 in determining what you can borrow.
- Proof of assets: You'll need to show you have a down payment and money to cover closing costs. Bank and brokerage statements provide proof of assets.
You'll need many other documents after you actually find a home, including an appraisal, a survey, proof of insurance, and more. But providing basic financial documents early is important so you can be pre-approved for a loan. Pre-approval makes you a more competitive home buyer since sellers know you can actually qualify for financing.
Getting the right mortgage is crucial
Your mortgage is probably the biggest debt you'll ever owe, so be ready before you apply for a loan. If you get your financial life in order first, buying your home should be a good experience that helps improve your net worth -- rather than a financial mess that comes from getting stuck with a costly loan that's difficult to pay back.
Today's Best Mortgage Rates
Chances are, mortgage rates won't stay put at multi-decade lows for much longer. In fact, the Fed has already signaled that it expects rates to continue increasing. That's why taking action today is crucial, whether you're wanting to refinance and cut your mortgage payment or you're ready to pull the trigger on a new home purchase. Click here to get started by scanning the market for your best rate.