What You Need to Know
For many people, buying a home is the biggest financial move they’ll ever make. Most homes are bought with mortgage loans, which let you buy property and come with tax-deductible interest.
If you’re in the market for a new home, especially if you’re a first-time homebuyer, take some time to learn the ins and outs of mortgage financing so you know what to expect. Here’s our guide.
Do This First
Before you begin shopping for a house, do your own homework to determine your creditworthiness and prepare for a conversation with a lender, says Bob Collins, mortgage broker at Signal Hill Mortgage in Signal Hill, California.
First, gather tax returns, pay stubs, and other paperwork that documents your income for the past two years. You’ll also need documentation of liquid assets, cash in the bank, as well as credit history and current income. That may include bank and investment account statements.
If you’re not familiar with your credit rating, request a free copy of your credit report from one of the three reporting agencies. You can do this once per year without affecting your credit score — and if there’s an error on your credit report, fix it first.
As you gather information, keep in mind what lenders are looking for. According to Harrine Freeman, a financial expert and owner of H.E. Freeman Enterprises:
- A credit score of at least 700.
- An explanation of any late payments in the past two years.
- Credit card balances that are kept to 30 percent or less of the credit limit.
- A solid work history and income.
- Solid banking history, and collateral such as a bank account, investment accounts, retirement accounts, life insurance policies, and automobiles.
- “A debt-to-income ratio of 36 percent or less; 28 percent is ideal. And a down payment of at least 3 to 5 percent.” [Editor note: Way more in NYC.]
Find the Right Loan Consultant and Lender
Before talking with a real estate agent, talk to a loan consultant, says Arlene Jimenez Piazza, home loan consultant at Patelco Credit Union in Pleasanton, CA. “Why waste the real estate agent's time when you may not meet the minimum requirements for a loan?”
And not just any lender will do. Rather than using a lender just because he or she was recommended, Piazza advises to interview them. “Ask questions and then go with your instincts,” she says. “Ensure you select a loan consultant willing to take the time to educate buyers throughout the process, from start to finish. Many loan officers do not attend signings, which is like having your wedding planner miss the wedding!”
Start looking for a lender by considering your own bank, looking at mortgage rates at Bankrate.com, or use the “Find a Mortgage Professional” tool from the Association of Mortgage Professionals.
Don’t Fall for Gimmicks
Many lenders advertise deals, but it’s unlikely you’ll save a lot with such marketing ploys, says Casey Fleming, author of The Loan Guide: How to Get the Best Possible Mortgage, and mortgage advisor at C2 Financial Corporation in San Diego. “Lenders get calls by advertising, ‘We never charge points!’ or ‘We pay your closing costs!’” Fleming says. “But they build their profit into your interest rate.”
If you plan to hold the property for a short period of time, such a deal might be best, Fleming says. But over a longer period, paying the closing costs yourself in order to get a lower interest rate may be less expensive. Fleming recommends calling the “no cost” lender and asking what the interest rate would be if you paid costs too.
Similarly, some mortgage companies advertise that they’ll pay your mortgage insurance — but that guarantee usually comes with a higher interest rate. “The higher interest rate lasts forever, whereas the mortgage insurance may only last for two years,” Fleming says. “Call the lender, and ask them to compare a no-mortgage-insurance plan with one with a lower interest rate where you pay for the insurance. Have them calculate the total cost of the options over a set period of time, such as seven years.”
When you’ve found a lender with whom you feel comfortable, it’s a good idea to get prequalified before you start shopping. Pre-qualification involves discussing the various loan program requirements and determining whether the buyer has the minimum down payment, employment and income history, credit history, and payment reserves.
A lender shouldn’t have to check your credit to prequalify you for a loan. “In most cases, an underwriter (the loan professional who determines whether you qualify for a certain loan) will review the file and issue a Conditional Loan Approval,” Piazza says. “The formal pre-approval process is the next step, where a loan application and tri-merge credit report are submitted for review, along with the income and asset documentation.”
Understand the Real Costs
The down payment is far from your only up-front cost. “The lender will provide a good faith estimate of closing costs, but it does not encompass the entire list of fees charged,” says Piazza.
For instance, the title company, which researches the title or deed to the home to ensure that no one else has rights to it, will determine its own fees, as will the home inspector, and the homeowners’ association if applicable.
In some cases you can roll these fees into your loan or negotiate with the seller to cover some of the costs. According to Freeman, here are the fees to consider:
- Credit report
- Loan points (fees equal to 1 percent of the loan, which gets you a lower interest rate)
- Escrow (the fee paid to the title company, escrow company, or attorney for conducting the closing; generally calculated at $2 per thousand of purchase price, plus $250)
- Homeowners insurance
- Property taxes
- Recorder fees (paid to a government agent for entering the sale of a property into the public records)
- Notary fees
As you shop for a home, keep your budget in mind. Most experts say your mortgage payment should not exceed 28 percent of your monthly income, but a smaller percentage is always better.
When making your selection, “make sure you look at your home purchase not only as your place of residence but a great future investment,” says Michael Banovac, managing partner of RMB Luxury Real Estate in Phoenix. “Real estate is a great hedge against inflation, but be aware of the surrounding area and make sure you feel confident that its location will be desirable for many years to come.”
In addition to choosing the right home, choose the right type of mortgage. Freeman advises against applying for a risky mortgage, such as an interest-only loan (because you’ll still owe the entire principal balance when the loan term ends), or an adjustable-rate mortgage (because when the rate expires, the interest rate can double or triple).
Don’t Make Drastic Changes Before Closing
If you’ve gone through a loan pre-approval process, which most lenders recommend before making an offer on a home, don’t make any big changes — like switching jobs — until after your loan is closed. If you do, all the employment and salary data that your loan was based on is no longer accurate and you’re no longer approved.
“After closing, do whatever you want,” says Peter Costakos, branch manager of Mortgage Master in Brooklyn, NY. “But until the ink is dry [on your loan], keep your current job. Most lenders require mortgage companies to verify your employment all the way up to closing.”
Another no-no: Applying for and accepting new credit accounts during the process, such as buying a new car or transferring credit card balances to one card. “Every move affects the credit score and liabilities, which could ultimately affect your pre- approval status,” Piazza says.