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- Knowing what lenders look for in a mortgage borrower is key to understanding the process.
- Before applying for a mortgage, take steps to get your credit in order and know how much house you can afford.
- Figuring out the type of mortgage that's best for your financial circumstances is the first step.
For most people, buying a home starts with getting a mortgage. And there's quite a bit involved in that.
Whether you're a first-time buyer or a current homeowner looking to upgrade, the sheer amount information you have to wade through can feel overwhelming. Going into the process knowing what to expect and how to approach it is key to keeping the stress under control and finding the best option for you. This guide will help you do it.
Mortgage defined
A mortgage is a loan from a bank or mortgage lender that enables you to borrow money to purchase your home. The bank or lender takes a mortgage lien out on your property, meaning they can foreclose on it if you default on the debt.
What do lenders look for in a mortgage borrower?
Lenders look at various financial information of a mortgage borrower as they want to ensure you are financially viable to pay back the money borrowed. Below are the primary factors that lenders take into account when considering mortgage applications:
- Credit score
- Income and employment history
- Debt-to-income ratio
- Assets the applicant owns
- The type of property the applicant wants to buy
- Down payment amount
Things to do before you apply for a mortgage
Every homebuyer should make sure they are fully prepared before beginning the mortgage application process. If not, it can take much longer.
"When it comes to homeownership, your credit score, along with your debt-to-income ratio, is a major factor in determining what your loan terms will be," says Shelby McDaniels, channel director of corporate home lending at Chase. "That is, whether you'll be approved for a mortgage, and if so, at what rate."
Get your credit in order
Having a good credit score shows you can manage debt and will give you a competitive interest rate with a good or excellent credit. You may still be able to get a loan with a low credit score but it may be at a higher interest rate.
In the past, it was common for consumers to have to pay a fee to get access to their credit scores from one of the credit agencies. Today, there are many free options available. Most credit card companies will provide your score on your monthly statement or anytime you check your account online. There are also a number of websites, like Credit Karma and Credit Sesame, that offer credit scores when you sign up for their free services.
You can work on improving your credit score before applying for a mortgage, such as making payments on time, reducing credit card debt, and checking if there are errors on your credit report.
"Any score in the 700s or above is considered a good credit score, and will help you get a loan with lower interest rate, says McDaniels.
Lower your debt-to-income ratio
Debt-to-income (DTI) ratio is a calculated percentage of how much money you spend to payoff debt versus how much income you have.
"The higher your ratio, the riskier they consider lending to you to be, and the smaller chance you have of being approved for a home loan at a good rate," says McDaniels.
A DTI ratio of 36% or less is generally considered to be good. When it comes to mortgages, 50% is usually the highest DTI that will allow you to qualify for a loan.
Review your budget and figure out how much you can afford
"Typically, mortgage lenders look at gross income to determine what clients can afford, but homebuyers should really look at what they live on and how they manage monthly budgets," says Nicholas Lynch, senior vice president of mortgage sales at Webster Five Bank in Massachusetts.
Several factors are used to determine how much of a house you can afford, such as household income, monthly debts (car loans, student loans, credit card debt), and the amount you have in savings accounts. If you have not created a monthly budget, you should do so to determine how much house you can afford.
To determine how much house you can afford, you can use a rule of thumb where housing costs are less than 28% of your income, and other debts are less than 36%, says Michael Moskowitz, president of direct lender Equity Now.
"In the calculation, this means your housing payment: principal, interest, real estate taxes, private mortgage insurance, homeowners insurance, are less than 28% of your total gross monthly income, while the second ratio of 36% includes any payments on credit cards, car loans, installment loans, etc.," Moskowitz says.
Another key factor to determine as a homebuyer is how long you intend to to own your home.
"It can affect how you choose to structure the mortgage financing," says Kraig Spence, a home loan specialist at Churchill Mortgage. "If the time horizon is less than three years, then putting 3% down payment may leave you in a precarious position if the market took a slight down turn."
Regardless of how much you put down on a home, Spence says a good rule of thumb is to have at least three to six months of living expenses saved in a separate account. "It's not required for a home mortgage, but it's a wise measure to protect your most important investment."
Mortgage Calculator
- Paying a 25% higher down payment would save you $8,916.08 on interest charges
- Lowering the interest rate by 1% would save you $51,562.03
- Paying an additional $500 each month would reduce the loan length by 146 months
Save as much as you can for a down payment
Determining how much down payment is needed to buy a house is a big factor.
"It's a myth that you're required to put 20% down to purchase a home," McDaniels says. "Some home loans may require far less of a down payment (between 3% and 5% percent), and the industry average is typically within 6% and 8% percent."
However, if you put less than 20% down payment on a home, you'll have to pay for mortgage insurance. This insurance protects the lender in case you default on the loan.
"The cost of PMI depends on several factors, including your credit score, the size of your down payment, and the type of mortgage you have," says Cliff Auerswald, president of All Reverse Mortgage, a direct lender of reverse mortgages. "If you're putting down less than 20%, you can expect to pay a higher interest rate than someone who puts down 20% or more."
Get your documents in order
A mortgage is likely to be the largest loan you ever apply for. Be ready to face much scrutiny in the application process. Below is a list of the most common types of documents you will need to furnish to the lender. There may be more, depending on your individual circumstances:
- Tax returns
- Pay stubs, W-2s or other proof of income
- 1099 forms, or profit and loss statements if you're self-employed
- Bank statements, retirement account statements, and proof of other assets
- Credit history
- Divorce decrees, child support decisions, etc.
- Photo ID
- Renting history
- Sale of any assets before you applied, such as copy of the title transfer if you sold a car
How to get a mortgage in 6 steps
Once you've laid the groundwork, you can apply for the mortgage. These are the main steps involved in the process.
1. Choose the right type of mortgage for you
The first step in applying for a mortgage is determining the type of mortgage you need. There are two main choices: conventional or government-backed loans.
Conventional loans are mortgages not backed by the government. These loans usually have stricter eligibility requirements such as a higher credit score, lower DTI ratio, and larger down payment.
Government-backed loans are backed by a federal agency. There are three types of government loans for a home:
- FHA loan: Mortgages insured by the Federal Housing Administration have a low down payment of 3.5%, a credit score of at lease 580, and DTI of less than 43%. Mortgage insurance is required both at closing and annually with these mortgages.
- VA loan: VA mortgages are backed by the US Department of Veterans Affairs, and they are provided to active military members or veterans, or certain qualifying spouses of members who have died. They require no down payment or private mortgage insurance.
- USDA loan: US Department of Agriculture loans are for low-to-moderate income borrowers who are buying homes in rural or suburban areas. No down payment is required. Eligibility requirements are somewhat lenient, and they have competitive interest rates.
2. Shop for the best rates and choose a lender
"Not all mortgage products and programs are created equal," says McDaniels. "Some have more stringent guidelines than others. Some lenders might require a 20% down payment, while others require as little as 3% of the home's purchase price."
The loan that's best for your situation depends on which one you can qualify for and which one offers you the best rate.
"Focus on researching and identifying mortgage options such as the loan term, interest rate type, and loan type," says McDaniels.
As an example, some homebuyers may opt for a 15-year or 30-year fixed home mortgage. You will pay off the loan earlier with a 15-year term, and will have a lower interest rate than a 30-year term. However, your monthly mortgage payment will be higher.
Your financial health will determine how much monthly mortgage payment you can afford. That's why it's best to shop around for the best lender, do your research, and ask friends.
3. Get preapproved
It's a good idea to get preapproved for a mortgage before you start shopping for a house.
The lender reviews your finances and determines the amount you will likely qualify for. At this point, you will know the price range of the house you can afford to purchase.
A preapproval doesn't guarantee approval for a mortgage, but it helps with negotiations with home sellers as it shows you took the extra step to understand how much house you can afford.
4. Find a house you want and make an offer to buy it
You have been preapproved for a home mortgage. Now, you can start searching for your new home.
Since you know how much money you can borrow, you know the price range of the home you can afford. Knowing what area you want to live in is key as that will narrow your search.
You can work with a real estate agent that knows the area to help in the process. When you do find that perfect home, be ready to make an offer. In some markets, home sales go quickly.
5. Button up the details with your lender
Once you have found a home and made an offer, it's time to submit your mortgage application.
You have to submit a complete application with all the supporting documentation. The lender will verify your documents and check your credit. Getting financing will be determined by the underwriter, who evaluates the risk of the borrower, and determines the amount to be borrowed.
6. Close on your new home
Once you have been approved, you are close to the finish line.
"It's important to keep in mind that buying a home involves more money out-of-pocket than just the down payment," says McDaniels. "Closing costs are used to pay for items such as appraisals, inspections and much more."
However, there are ways that homeowners can save on closing costs. Some lenders will offer incentives such as money toward closing costs. At closing, you'll sign a lot of different documents, but it's important that you understand each one. Don't be afraid to ask questions if you come across something confusing or surprising.
Getting a mortgage frequently asked questions
Borrowers typically get started with a mortgage by applying for preapproval with a lender they're interested in. But before you get to this point, you'll need to make sure you're prepared for the process. This means saving for a down payment, preparing your credit and finances, and gathering up all the documentation you'll need for your application.
To qualify for a conventional loan, you'll need a credit score of at least 620. With an FHA loan, you'll usually need a score of at least 580, though you may qualify with a score as low as 500 if you can put 10% down. For other types of mortgages, lenders may look for a score of 620 or higher.
To increase your odds of obtaining mortgage approval, work on improving your credit score, lowering your debt-to-income ratio, and saving for a larger down payment.
FHA loans are typically considered the "easiest" mortgage to get if you're looking to buy a house. You can get an FHA loan with a 580 credit score, or 500 if you make a 10% down payment.
You'll generally need to show income for the last two years to qualify for a mortgage.
No, you won't pay your mortgage immediately after closing. Your first mortgage payment will be due one or two months after you close. You'll pay any interest you accrue during the period not covered by your first mortgage payment at closing.
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