Understanding today’s mortgage market
Before the housing crisis of 2008–09, it seemed that anybody with a pulse could get a mortgage (or two or three). Lenders pushed “sub-prime” loans on people with poor credit knowing the entire time that the applicants couldn’t afford the payments and would eventually default.
These lending habits were obviously unsustainable, and we know the rest of the story. The banks got bailouts while millions of homeowners either lost their homes or got stuck underwater, owing much more on their mortgage than their home was worth.
Mortgage underwriting—the criteria banks use to determine whether to make a loan—is more stringent. That’s not to say that young couples or other first-time home buyers will have a difficult time getting a mortgage. But it means that proving to the bank that you’re financially prepared to take on a mortgage payment is more important than ever.
What it takes to get approved for a mortgage
Before completing a mortgage application or even strolling through an open house, you’ll want to know these things:
Your monthly income
The sum of your total monthly debt payments (auto loans, student loans and credit card minimum payments)
Your credit score and any credit issues in the past few years
How much cash you can put down
How much house you can afford
1. Calculate your income and your monthly debt obligations
The first step in preparing to apply for a mortgage is to document your monthly income and debt payments. You’ll need to provide at least two weeks of pay stubs to your lender, so it doesn’t hurt to start collecting those. If you’re self-employed or have variable income, expect the underwriting process to be a bit more involved. You may, for example, have to submit copies of your past one or two tax returns. The lender may then count the average of your last two year’s income or the lower of the two numbers.
Getting approved for the mortgage you want is all about staying within certain ratios lenders use to determine how much you can afford for a mortgage payment. Large debt payments (like an auto loan or big student loans) will limit the size of the mortgage approval you can get. If possible, pay these loans off or, at the very least, avoid taking any new loan payments on prior to applying for a first mortgage. Again, this calculator can help you estimate how much home you can afford using these ratios.
2. Give your credit health a checkup
Before applying for a mortgage, obtain both your credit score and your credit history report.
You’ll want to verify there are no errors on the report or recent derogatory items like late payments. As you may shop for homes over the course of several months, this is one time you might want to consider subscribing to a service that provides regular credit report monitoring. You can cancel this after you close on your home.
If your credit is just under 680, you may consider an FHA loan. These government-insured loans allow lower credit scores and much lower down payments.
Finally, do not apply for new credit in the few months leading up to your mortgage application. Banks get suspicious if it looks like you’re piling on the new credit. My mortgage broker once told me that even getting a credit check for a new cell phone plan could require a letter of explanation to your mortgage lender.
3. Determine your mortgage budget
You’ll want to determine how much house you can afford and are comfortable paying (two different things!).
A good rule is that your total housing payment (including fees, taxes, and insurance) should be no more than 35 percent of your gross (pre-tax) income.
For example, if together you and a co-buyer earn $80,000 a year, your combined maximum housing payment would be $2,333 a month. That’s an absolute, max, however. I recommend sticking with a total housing payment of 25 percent of gross income.
It can be difficult to equate this monthly payment to a fixed home price, as your monthly housing payment is subject to variables like mortgage interest rate, property taxes, the cost of home insurance and private mortgage insurance (PMI), and any condo or association fees.
In some cases, taxes, insurances, and fees may be equal to or greater than your actual mortgage payment. So you’ll have to work backwards based on houses you like to determine what your payment will be and whether it fits your budget.
4. Figure out how much you can save for a down payment
Next, determine how much you can save for a down payment to put towards your first home. In today’s market, expect your mortgage lender to require at least a 10 percent down payment unless you’re getting an FHA loan or another special program loan (low down payment loans are available).
If you have it, consider putting 20 percent down to avoid private mortgage insurance (PMI)—costly insurance that protects your mortgage lender should you foreclose prior to building sufficient equity in the property.
Commit to the maximum you want to spend before beginning the mortgage approval process. I would take a smaller payment you can afford in good times and bad over a bigger one that you may lose in foreclosure.
When and where to apply for your mortgage
You can meet with a mortgage lender and get pre-qualified at any time. A pre-qual simply means the lender thinks that based on your credit score, income, and other factors, you should be able to get approved for a mortgage. It’s informal and totally non-binding.
As you get closer to buying a home you’ll want to seek pre-approval.
Wherever you go, this pre-approval isn’t binding, but it’s a formal(ish) indicator of your ability to get approved for a mortgage that you can send to sellers with your offer. Most sellers will want to see a pre-approval within a couple days of receiving your offer, if not included with the offer itself.
One of the first steps to take as a potential home buyer is to get pre-qualified for a loan. This step helps both you and your lender learn just how much home you can afford. And you should begin this process before you even start looking for a home.
According to the Federal Housing Administration (FHA), their pre-qualification essentials include:
- Having a steady employment history, covering at least two years.
- Consistent or increasing income over the past two years.
- Credit report reflecting a good repayment history with creditors.
- Any bankruptcy must have been discharged at least two years prior (one year for a Chapter 13), with good credit since the discharge.
- Any foreclosure must have been completed at least three years prior, with good credit since the completion of the foreclosure.
- Mortgage payment – including taxes, homeowners insurance, mortgage insurance, and HOA dues (if applicable) should be no more than approximately 30% of your total gross monthly income.
- Total monthly debt payments should not exceed approximately 45% of total gross income.
To determine pre-qualification, mortgage lenders will look at your credit report, earnings, debts, and savings in order to see how much home you really can afford.
Why is pre-qualification important?
Pre-qualification for a home loan typically costs you nothing, but gives you a goal of what homes are in your affordability range, as well as how much money you should look to have saved for a downpayment.
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