We've had a number of clients in the office lately asking about qualifying for mortgages. Despite the fact that just about everyone and everything in U.S. policy is trying to get us to buy homes, we Americans are often confused about how our mortgage system works. So here are the basics to know before you go shopping for a mortgage:
Down Payment Realities
Before the 2008 housing market crash, banks had all sorts of inventive programs to get people in new homes. It turns out some of them were too inventive, and banks are back to some more familiar requirements. If you can do it, your best bet is to put at least 20% of the total price you are paying down on the house. Why? A 20% down payment will almost always get you a better interest rate. And since your large down payment is considered less risky for the bank, you won't be required to pay private mortgage insurance (PMI). Folding the PMI into a higher interest rate might help, but there is no way around the much higher cost, in loan terms and PMI if you dip below that 20% down payment.
If you are going to have trouble coming up with a larger down payment, you might qualify for a special loan through the USDA's zero-down payment for rural low-income buyers, VA loans for veterans, Fannie Mae's Homepath Program or a first-time home buyer program in your area. Start with the link to HUD's website at the bottom of this post if you think you might qualify for home buying assistance.
Know Your Ratios
For obvious reasons, most people figure that they can afford a mortgage if the monthly payments are comparable to their current rent payments. But banks takes a completely different approach to whether you can afford a mortgage—they use very specific income-to-debt ratios. Here's how the math works:
The first number the bank will calculate (the "front" ratio) is the percentage of your income that will need to go to housing costs. In this case, your income is everything you earn before taxes*, and the housings costs include mortgage payments, taxes, insurance and even homeowners or condo association fees. Let's say you gross monthly income is $5,400, and your monthly housing costs are $1,800. That give you a front end ratio of 33% (1800÷5400=.333).
Now for the "back" ratio—use the same numbers as above but add your consumer debt (car loans, student loans, credit card debt payment, etc...) to your housing cost. If the consumer debts were another $500 per month, you would add that to the $1,800 for a total of $2,300. Now divide that $2,300 by the same $5,400 income as before and you get about 43% (2300÷5400).
Your ratios will be written: 33/43 ...and you will probably have trouble with your bank. Why? Because while a 33% front ratio is just fine, banks are usually looking for a lower back ratio—something closer to 38. Some of the subsidized loan programs I mentioned above might let you go up to 41 on that back ratio.
Know Your Terms
In addition to interest rates, down payments and mortgage insurance, the way that you repay your mortgage loan can vary. A 10-year mortgage means lower monthly payments but less interest paid over time; a 30-year mortgage can lower your monthly costs, but means you will pay substantially more interest over the course of the loan.
You also need to watch out for the difference between fixed rate mortgages (your interest rate & payments stay the same until the mortgage is paid off) and Adjustable-Rate Mortgages (ARM's). Most banks will offer you a lower initial interest rate if you are willing to sign on to an ARM, but there's a big down side. ARM's mean that you (and not the bank) are taking the risk that rates might go up. In that case, you could end up paying much more per month or having all of your payments go to interest (which means that your loan could actually be getting larger!). Because of this unpredictability, we usually recommend fixed-rate loans if you are buying a home.
Now that you know how the calculations work, you should have an idea of what you can do before you go to the bank to put yourself in a position to get the best terms on your mortgage:
- Save up for a healthy down payment of 20% if at all possible (that will not only get you a better interest rate but also reduce your monthly payments, which means better ratios);
- Lose the consumer debt payments. As you can see, paying off some of those consumer debts can make all of the difference in qualifying for a mortgage. Even if you qualify, waiting until you have debts under control can improve the interest rate you get;
- Rehabilitate your credit score. This one gets lots of press, and for good reason. The interest rate you will get and often, you ability to qualify for a loan at all depend on your credit rating. Fortunately, you can improve your rating if it has fallen over the years.
Find A Good Bank
Mortgages work just like any other product—you need to shop around. If you belong to a credit union, start there, but be sure to talk to a few different lenders before you make a final choice. You might also consider a mortgage broker, who will scout around for you to find the best offer (be aware, though, her fee is paid by the bank that secures the deal so she is not working entirely for you).
Don't be tempted to skip this step! Banks can offer wildly different terms and rates for the same home purchase, which means you could end up paying thousands more for your home loan.
Check Out Resources
The U.S. Department of Housing and Urban Development (HUD) provides step by step information for home buyers, including links to home buyer programs in your area. Check them out on HUD's site.
*Note that you have to be able to document your income, usually through tax returns. Self-employed buyers can still qualify, but the process may be slightly more complicated.