A Complete Guide to Getting a Home Loan
Whether you're a first-time home buyer or a seasoned house hunter, getting a mortgage can be an intimidating, complicated process. Lenders often seem to be speaking a different language with all of their financial jargon, and you're left worrying about whether or not you qualify to make one of the most important investments a person can make in their lifetime. Despite the confusion and stress they create, a mortgage is a necessary part of buying a home. Are you ready to pursue one?
To get started, you can use this comprehensive guide to better understand mortgages and what is expected of you as a buyer. First, we'll cover some basic information about mortgages and things you need to consider before getting one. Then, we'll use that foundation to explore the steps you'll take to secure a mortgage.
Two Types of Mortgages
There are two basic types of mortgages: fixed rate and adjustable rate. Both of them can offer buyers certain benefits depending on the situation. As its name suggests, a fixed rate is unchanging. Regardless of market conditions, your payment and interest rates stay the same. An adjustable rate mortgage is subject to changing interest rates depending on the market, so your payment will rise and fall accordingly.
A fixed rate loan has the clear benefit of stability. You know exactly how much you're expected to pay every month, so it's easy to budget and plan your finances. This stability makes the FRM the most popular option for US consumers. The majority of the market chooses a 30 year amortization schedule, while those who are looking to pay off their home sooner & save money on interest may choose a 15 year term. The fluctuating, uncertain nature of an adjustable loan is understandably off-putting to many buyers, but you can potentially enjoy rock-bottom payments if the market allows. However, if interest rates rise, then so do the monthly payments.
You'll be happy to know that you aren't alone in the struggle to get a mortgage. Many local, state, and federal agencies offer special programs to help buyers get a home as well as programs that assist with down payments. There are also programs available that can help you cut closing costs, but we'll touch on those later.
Your Mortgage Payment
When you think of a mortgage, you probably immediately think about the monthly payments you make to cover the cost of the loan. But do you know exactly what your payments are going towards? There are two key components that make up a loan payment: the principal and the interest.
The principal is simply the amount of money you originally borrowed, while the interest is the fee your lender charges you for borrowing in the first place. You make your mortgage payment to cover both of these costs. If you have a fixed rate mortgage, your payment will remain the same, but where the money goes will not.
For the first few years of your mortgage, most of your payment will go towards paying off your interest. So, a $1,000 mortgage might consist of a $900 interest payment with a $100 principal payment. After a while those values will shift, with the bulk of the payment going to the principal cost.
Keep in mind that many mortgages have subcomponents, such as property taxes and insurance, that can also be included in monthly payments. Choosing to opt out of those subcomponents means you'll be responsible for making those payments separately.
The Cost of a Mortgage
In addition to monthly payments, it's often very expensive to even obtain a mortgage. Closing costs, for example, include things like property taxes, which can be either recurring or non-recurring.
Property tax and homeowner's insurance are recurring costs, and a year's worth of each must be paid in advance and placed in an escrow account. Non-recurring costs include real estate fees that cover the cost of things like credit checks, title searches, and surveys.
And, of course, buyers must also consider the cost of a down payment, which ideally accounts for at least 20 percent of the total price of the house. It's possible to pay a lower percentage, but then you're forced to purchase private mortgage insurance that will significantly raise your monthly payment.
Most commonly, lenders write loans for 15 or 30 years. With 15-year loans, your interest rate will be lower and your monthly payment will be higher. The opposite is true of 30-year loans. Both timeframes are quite lengthy, and many homeowners end up selling before reaching the end of their loan. In that case, they use the money they make from the sale to pay off the remaining loan amount.
Now that you have an understanding of mortgage basics, let's cover the steps of securing your loan.
Work on Your Credit
Before you even begin looking for a lender, you should spend several months building up your credit. Your credit score is one of the first things a lender will look at to determine your eligibility for a loan, and as we know, first impressions are lasting. In addition to increasing the chances of getting a loan, a higher credit score means lower interest payments right out of the gate.
When you start thinking about buying a house, go ahead and order a copy of your complete credit report so you can identify weak points that need work. Do this well in advance of meeting with a lender so you have time to boost your score if you feel that it's lacking. Work hard to pay your loans on time, pay off or pay down credit card debt, close unused cards, and try not to open any new ones if you can help it.
Rome wasn't built in a day, and neither is your credit score. Bear in mind that lenders look favorably on longer, decent credit histories when compared to shorter outstanding ones.
Choose a Lender
While banks are the most common source of mortgage funding, they aren't the only places you can go for a loan. There are likely dozens of businesses in your town that offer mortgage services, not to mention the thousands of online vendors you could also choose from. When it comes to lenders, you want to be choosy. No source is the best for everyone, and you'll quickly see that not all lenders are created equal.
Lenders aren't forced to operate under any kind of federal regulations or standardizations. That means they're all free to set their own procedures, they aren't required to offer the same rates on mortgages, and they can charge you various fees for services like appraisals, credit checks, and title insurance. Some lenders may prefer that you think you're at their mercy, but it's important that you take control of your situation.
There are three main types of lenders you're likely to encounter:
- Banks: As we mentioned, banks are the most traditional route buyers take when seeking a lender. Banks offer the benefit of face-to-face service as well as competitive fees in order to keep up with other lenders. However, their loan program selection might be limited, resulting in higher interest rates.
- Brokers: Brokers, on the other hand, often have a variety of loans to offer, including programs for buyers with bad credit. A broker is a good place to start when looking for a lender since it can serve as a "one-stop-shop" of sorts to compare services and prices. The downside is that their fees are often higher than other lending options.
- Online Vendors: Finally, online vendors have the largest selection of loans to choose from with the added convenience of round-the-clock shopping. Online providers also make it easy to instantly compare multiple loans at once. Some buyers dislike the impersonal feel of working with an online vendor, and it's true that getting in touch with a human being is often challenging.
Given all the options and variables, no lending source is considered better than the next. It comes down to your personal situation and the lender's ability to meet your needs. It may be true that lenders are doing you a favor by financing your new home, but that doesn't mean you should be subject to unfair practices or exorbitant fees. It's critical that you shop around for the right lender, someone you trust and who you know is giving you the best deal possible. Meet with as many people as you see fit, take notes, ask questions, and compare.
Secure a Loan
After you choose a lender, it's time to secure a loan. If you're wondering how much you can afford, you can use your income as a benchmark. It determines how big your mortgage can be since lenders typically won't approve a mortgage for you if monthly payments would exceed 28 percent of your pre-tax income.
Your lender will take a look at your income and other finances to see if you pose a high risk. High-risk borrowers are those who are more likely to default, or quit paying their mortgage. Naturally, borrows who have a high credit score hovering around 720 are lower risk clients. The lower the risk, the lower the interest rate. Anything below 620 is considered subprime, so getting a loan will be difficult.
Lenders will also analyze your debt-to-income ratio, which is a measurement that compares your debt payments to your overall income. As a rule, that ratio shouldn't exceed 36 percent of your gross income.
Finally, a sizeable down payment will greatly help your case. If you're willing to pay money up front, lenders know you're less likely to walk away later. As mentioned before, the payment should be 20 percent of the cost of the house, otherwise you may have to pay for mortgage insurance.
After you've met with a lender and they've gone over your assets and liabilities, they can then pre-qualify you for a loan. Unfortunately, that doesn't guarantee you'll get a loan. It just means that your lender will let you know how big your mortgage can be. You'll be able to pinpoint your budget, but nothing is promised.
If your lender pre-approves you for a mortgage, on the other hand, you have more options. Pre-approval means you have officially qualified for a loan, which sellers find particularly attractive. You'll have more leverage when negotiating a price since the seller knows you have the funds to purchase the house.
Locking in a Mortgage Rate
While you're getting approved for a loan, it might not hurt to consider locking in a mortgage rate. It's possible to walk into a lender's office and discuss an interest rate only to find that it has changed by the end of your conversation. This isn't necessarily the lender's fault. Interest rates are affected by many things, including the secondary market, which is comprised of investors who buy loans and either keep or sell them to other investors.
A lock-in rate protects you from the ebb and flow of the secondary market. Your lender will hold a certain rate for you for a given period of time, usually while your application is being processed or you're preparing to close on a house.
There are a few situations where lock-ins are particularly beneficial, such as when you barely qualify for a loan. If you're on the cusp of being a high-risk borrower, a flux in the market could push rates just out of your reach. You may also choose to wait until you see a low rate before locking it in.
After you've locked your rate in, you can only take advantage of lower rates if you paid for float down provision in your lock-in contract or if you rewrite the contract completely. Both cost extra, but their benefits may outweigh that cost in the end.
Close the Deal
When you've found a home and the sellers accept your offer, it's time to start the closing process. As stressful as everything has been up until this point, most people consider closing to be the most taxing step since everything has the potential to fall apart at the last minute. Fortunately, there are a few things you can do to ensure things go smoothly.
We discussed how expensive closing costs can be, but it's possible to secure a loan that lets you pay slightly higher interest rates in exchange for a lower closing cost, sometimes called a "No Closing Cost Loan." Conversely, you may choose to pay a higher down payment or other fees at closing in order to lower interest rates.
Upon closing, your lender may request an update on your financial situation. Expect them to look for credit inquiries and be prepared to verify that you're still employed. Save pay stubs and financial statements between having your loan approved and closing on your home so your lender can see that you're still a reliable borrower.
You'll also need to make sure all of your closing funds are ready to go in your bank when you begin the closing process. It's not uncommon for banks to hold large sums of money following a big deposit, and your lender won't be pleased if he or she can't account for every penny of your closing costs. Also, try to secure homeowners and flood insurance coverage prior to closing so it can be accounted for in your monthly payment.
Refinancing Your Mortgage
It's possible that you may decide to refinance your mortgage someday. There are a few reasons that could prompt you to do this, including wanting to take advantage of lower interest rates or trying to lower your monthly payment by extending your mortgage term. If your credit is in good shape, refinancing is usually simple and beneficial. However, it can do more harm than good if you have poor credit or too much debt.
Before you refinance, identify your goal. Reducing interest expenses and consolidating debt are two of the most common reasons to refinance, but not the only ones. Sometimes homeowners decide they want to get out or into an adjustable-rate mortgage. Whatever the reason, make sure it's a good one since, as a general rule, you should only refinance once.
Some situations make refinancing risky. If you don't plan on staying in your home much longer, for example, you should probably keep your current mortgage.
It's a common misconception that being underwater (that is, owing more on your house than it's worth) means you can't refinance, but that's not necessarily true. Government programs, like the Home Affordable Refinance Program, make it possible for homeowners who are current on their mortgages to refinance. Whatever you do, just make sure you're refinancing for the right reasons and that it won't hurt you financially.
This mortgage guide is a good starting place as you begin the process of finding your perfect home. Now that you have a firm foundation to stand on, you can navigate these muddy waters with more ease and confidence. However, keep in mind that your specific situation drives the process in a unique way. Use what you've learned here to help you pre-plan for your mortgage application. You can start by evaluating your finances and the kinds of loans you would be comfortable with, and from there you can identify a comfortable spending amount.
Getting a mortgage will probably be stressful no matter how prepared you are, but finally securing that loan will be rewarding enough to justify all of your hard work.