So, you want to buy a house.
That’s great. You are now embarking on one of the greatest financial and personal journeys of your life.
This will be an exciting time. You will look at many types of houses of all sizes and designs in many neighborhoods. These houses will range in age, size, design, location, and most importantly, price.
The asking price of the house (the price the homeowner is initially asking to sell the house) is only one of the important factors in determining whether you can afford to buy the house.
The most important factor is whether you can afford it.
It’s true, this may be your dream home in terms of location, size, and design, but if you cannot afford to buy the house, it will not happen. This makes the process of purchasing a home part fantasy and part reality.
The fantasy is because you have an idealized version of your dream house. The reality is that everything is determined by dollars and cents. You decide to focus on the fantasy house. The mortgage company that is in charge of all the financial details also holds all the cards.
If you are a first-time buyer, you may not appreciate all the details and history of this important financial transaction.
Mortgages were originally only granted by a king to other nobles. That change happened around 1066 AD. But by the time of the Industrial Revolution (around the mid-1800s), local banks began making home and property loans to qualified non-royal, average citizen borrowers or others who wanted to be landlords.
Since then, the real estate purchase process has evolved greatly. An entire set of real estate laws were developed, accompanied by changes in civic taxation, registration, land use codes, and importantly, financing.
All this means that buying a house requires extensive financial documentation. When you start the buying process, your lender will begin to examine your financial situation in detail.
The mortgage company will conduct its own in-house due diligence test to determine whether your current and future financial situation will allow you to buy the house you can afford. This involves a financial analysis of your specific situation to determine if you can meet the needed down payment, closing, utilities, taxes, closing, and other required expenses before the mortgage closing will occur. If you pass this financial test, you get the keys to your new house.
The reality is that you can choose the house of your dreams, but the mortgage company is the gatekeeper. They will determine if you can buy the house or whether you will have to adjust your dreams.
Welcome to the dreams versus reality world. Welcome to the very realistic world of the home purchasing process.
Factors to Consider When Applying for a Mortgage
The first reality check any home buyer, especially first-time home buyers, will face is to determine how much they can pay in monthly mortgage and all the related expenses.
This is not the same as looking at homes that you think you can afford. It is the opposite. Instead of looking at the top home price you can afford, take the time to calculate your budget to see what you can afford in total monthly homeownership costs.
This requires an adult reality check. For many, it will be painful because to arrive at this critical number, you will have to assess what you own, what you owe, and all your income and expense sources.
This reality check involves essential research on all your sources of current income (payrolls, freelancing, inheritance, rent, portfolio), minus all living expenses (food, entertainment, utilities, incidentals, auto insurance, medical and dental, tuition repayments, credit card debt, child care, etc.), plus savings. The difference between the two determines what you should be able to comfortably afford to pay in mortgage expenses without altering your lifestyle.
Importance of Credit Ratings
Many homebuyers fail to consider the role of credit scores in the mortgage approval process.
Credit ratings are used by lenders to determine how you rate as a borrow. Do you pay bills on time? Do you borrow more than your income should allow? What is your credit and borrowing history? Have you ever defaulted on a loan?
All this affects your borrowing credibility. This determines what you will pay in interest and fees to obtain the loan. Most lenders rely on FICO scores, supplemented by your income, expenses, assets, and property type. This means the credit score is important, but it is also evaluated in context with other financial variables. An excellent credit score of 740 or above gets the most favorable loan rates.
According to Quicken Loans, the credit scores needed to qualify for a loan in 2021 depend on which type of loan you are applying for. A conventional loan requires a minimum credit score of 620. An FHA loan requires a minimum score of 580 (with a 3.5% down payment), while the same FHA loan with a 10% down payment requires a score of 580 from Quicken. VA loans commonly require a score of 620. Borrowers with a good or excellent credit score generally obtain conventional loans.
The link between credit scores and mortgage rates is illustrated in this chart from Credible.com.
As this chart shows, based on a $200,000, 30-year loan and interest rates as of August 13, 2020., borrows would pay the following based on their credit scores:
Note: All numbers here are for demonstrative purposes only and do not represent an advertisement for available terms. This example is based on a $200,000, 30-year loan and the interest rates as of August 13, 2020. Calculations were made using the MyFico loan savings calculator. Source: Credible.com
Credit scores matter. As the chart shows, the difference in interest paid over time between the top-and bottom-ranked credit scores over 30 years is $63,000.
Here are the Most Common Lending Ratios
Mortgage lenders also have favorite financial ratios, called lending or qualifying ratios, they use to assess your purchasing power as part of their due diligence process. This commonly involves a background check on the borrower, which includes their financial, credit, and legal histories, to determine their credit risk to the lender.
Eligible income and Debt-to-Income (DTI)
This ratio uses your most recent W-2s and tax returns. It is then compared to your credit report to determine your debt-to-income (DTI) ratio. This important ratio compares a borrower’s monthly expenses to their gross monthly income. It is calculated by dividing the borrower’s monthly debt into their monthly income. (It is important to note that income that is not declared on federal or state income tax filings cannot be applied to any mortgage calculations.)
A positive ratio is when borrowers have a DTI under 40%. This ratio applies to conventional, FHA, and VA loans. Some experts say the highest DTI ratio is 43%. Above that and the borrower is denied the loan. If the ratio is higher, borrowers may still be eligible for certain types of mortgage products offered by the VA or FHA.
This critical ratio also has two important variations that are both commonly used. The first, called the “front ratio,” includes all housing costs (such as mortgage principal, interest, mortgage insurance premiums, and property taxes). The second, the “back ratio,” covers non-mortgage debt. This includes credit card auto loans, child support, and student loan payments.
All of these expenses are divided by the borrower’s gross monthly income before taxes.
These DTI ratios are used to qualify for a loan, but they vary by lender and type of mortgage.
While this is an important ratio for most conventional borrowers, the DTI is not used in some federal loan programs offered by the VA, FHA, Fannie Mae home loan programs.
The Housing Expense Ratio
This ratio gives a monthly or annual snapshot of all housing expenses. These expenses include future mortgage principal and interest expenses, property insurance, local real estate taxes, and housing association (HOA) fees. The total of these expenses is divided by the borrower’s pre-tax income to produce the housing expense ratio.
This ratio is a good indicator to lenders that the borrower will be able to have the needed liquid cash on hand to make the monthly mortgage payments. Lenders don’t want borrowers to use all, or most, of their available monthly income to make mortgage payments.
The Loan-to-Value Ratio (LTV)
This is a basic ratio to determine the mortgage company’s lending risk for any property purchase.
The LTV ratio is derived from dividing the amount of the mortgage into the property value. One of the key inputs into this ratio is the borrower’s credit score. The higher the credit score, the more money the lender will provide. The goal here is for the borrower to have a low ratio. This means the borrower is a lower credit risk, so they would be entitled to a lower interest rate. The opposite is true of the ratio is high.
The All-Important Role of Interest Rates
When investigating how much house you can afford to buy, some factors are within your control. Others are not.
Among the most important factors no buyer can control is interest rates.
Interest rates impact what you must repay the lender monthly. Since interest rates have been at near 0% since 2020, many buyers have taken advantage of these low rates to buy more houses at a lower monthly cost. But these rates will not remain low forever.
A slight increase in mortgage rates, even one-quarter of 1%, could translate into a decrease of $10,000 in your financial ability to buy a house.
Interest rates also raise the critical issue of how expenses increase dramatically over time. The miracle of compound interest shows that a small increase or decrease in rates over 15 or 30 years amounts to a fortune at the end of the payment period.
None other than Albert Einstein called compound interest “the greatest mathematical discovery of all time.” While the math may be complicated, the idea in the borrowing world is simple: interest owed over time is added to your principal amount owed and that total amount is added to whatever you owe.
Here is an example: On a $200,000 mortgage loan amount over 30 years at a 4.5% interest rate, the borrower would pay $165,000 in interest. Using the same loan amount and interest rate, the borrower would pay $75,000 in interest over the loan period. The point is that even small changes in compound interest over time produce a significant increase in expense. That is why it pays to shop and compare for the best available interest rate and other non-recurring expense items (such as closing costs, appraisals, and related fees) when selecting a lender.
These payout figures are available on the mortgage loan amortization schedule, which is provided by your lender. In any mortgage, the amount the borrower pays monthly primarily applies towards interest, not the principal. This changes over time as the monthly mortgage payment increase monthly. For fixed-rate loans, the amount paid toward interest declines monthly.
How Much You Borrow Depends on the Mortgage You Choose
Thanks to new advances in financial technology accompanied by more federal agencies and private companies offering them, the mortgage industry is more flexible and has more types of mortgages to offer than ever before.
Today, mortgages are available as conventional and non-conventional and from private sources. While not as common, these private sources can include friends, family, or a business, as opposed to going through a traditional lender.
According to New American Funding, there are seven types and maturities of mortgages (excluding reverse mortgages) available to conventional mortgage borrowers. Selecting which mortgage is appropriate affects your monthly and down payment amounts.
For example, borrowers who want to budget ahead can choose fixed mortgages going out 15 or 30 years. Conventional loans can allow smaller down payments (sometimes as low as 3%) of the total cost and expedited loan processing compared to federal loans. The loan periods can be from 10 to 30 years, but the lender may require private mortgage insurance if the borrower puts down less than 20% as a down payment.
Loans fall into two main categories: conventional and non-conventional. Conventional mortgages are made by private lenders (banks, mortgage firms) and are not guaranteed by the government. The borrower is responsible for the mortgage insurance. Conventional loans are. Non-conventional mortgages are insured and made by federal government agencies.
Non-Conventional Mortgage Lenders
Non-conventional mortgages are available from the following facilities:
Government loans from the Veteran’s Administration (VA), Federal Housing Administration (FHA), and U.S. Department of Agriculture (USDA) are offered to borrowers who do not qualify or do not want to use conventional loans. Each type of federal loan has special provisions, including those with lower credit scores. These loans also are often accompanied by smaller down payments. For instance, according to the FHA, the minimum down payment for an FHA loan can be 3.5% with a credit score of 580 or higher but increase to 10% with a credit score ranging from 500 to 579. Self-employed people and those with non-consistent incomes can also apply for FHA loans.
The FHA loan is the most popular government-backed home loan in the country. These low-down-payment loans are made by qualified lenders and guaranteed by the Federal Housing Administration (FHA), according to www.fhaloan.com
FHA loans require a 3.5% down payment for borrowers with a 580 credit score or higher. For homebuyers with less-than-perfect credit, FHA loans offer additional significant benefits. The government backing means average FHA interest rates are typically lower than average rates for conventional mortgages.
Borrowers with credit scores as low as 500 can qualify for an FHA loan with a 10% down payment. Guidelines and policies will vary by lender.
VA loans are only available to soldiers on active duty or retirees, and in some cases, the spouses of military members. VA loans can offer lower interest rates, no down payments, no-prepayment penalties, and no monthly mortgage insurance premiums.
Getting the Important Pre-Approval Letter
The next step in determining what you can afford is to get a pre-approval letter from your lender, often a mortgage company, bank, or federal agency. To get this important document, you should have copies of your W-2s, federal tax filing, credit reports, and bank statements.
To obtain this letter, lenders commonly ask about your annual income and credit score; whether you are self-employed and for how long; are you the owner of more than 25% of a business; and, the amount of your liquid assets. Lenders will also want to know if you have been bankrupt, gone through a foreclosure, been involved in the short-sale of a home, and are a U.S. citizen.
With this in hand, you now have the basic financial information needed to get a pre-approval letter. This letter demonstrates to your real estate agent, the buyer’s agent, and buyer that you have been vetted by the lender to receive a loan up to a specific dollar amount.
Getting the Pre-Qualified Letter
It is important to note that there is a difference between a “pre-qualified letter” and a “pre-approval letter.” A “pre-qualified” letter is issued by only asking the borrower basic financial questions without seeing any supporting documentation. The pre-approval letter requires the borrower to complete a mortgage application and provide supporting documentation that is vetted by the lender. As a result, it is a much more authoritative document. The pre-approval letter is valid for 60 to 90 days. This financial verification process is why sellers will not accept a buyer’s offer unless it is accompanied by a pre-approval letter.
Next Steps in the Mortgage Approval Process
Since the decision to buy a house is often the largest financial obligation a person or couple will make in their lifetime, it involves a complex process that can require local and federal governments, federal agencies banks or other lenders, title, mortgage, real estate, and insurance companies, and lawyers. How many of these entities are involved in the actual closing depends on what type of mortgage and financing you require.
But since the purchase of property has such a complex legal history going back to medieval England, with much of this process tied to citizens’ representation, voting rights, and property ownership, it has been subject to strict legal, government, and banking supervision. Since you are entering into a real estate contract (one of the oldest types of contracts ever created), it involves many layers of civic, legal, and financial oversight at every stage in the entire mortgage application and approval process.
The mortgage process proceeds in sequential steps and each step takes time. Since you are an anxious buyer, you understandably want it to be completed as quickly as possible. Unfortunately, your time frame is different from the lender’s time frame.
As a result, be prepared to wait. Be prepared to sign many legal forms. Be prepared for the mortgage company to ask you for additional documentation or to clarify your sources of income. Despite their efforts at improving client communications, don’t be surprised if you do not hear from your mortgage company for days or weeks at a time.
However, since it is in the best interests of both the applicant and the mortgage company to approve the applications accurately and as quickly as possible, you should expect that the process is continuously moving ahead. No one gets paid for their work, the homeowner does not get paid, and the buyer does not get the keys until the real estate closing is completed.
Once the major decisions are made about whether to buy the house, the first financial step in purchasing a home is to write a check to the homeowner for the earnest money. Your earnest money check signifies your intent to the homeowner that you want to buy the house. It shows you are a serious buyer. This money (the amount varies depending on the purchase price and lender) is held in escrow by the title company or the real estate firm. Earnest money can be applied towards the closing costs or it can be refunded to you later at the closing.
The earnest money deposit differs from the down payment. The down payment is a percentage of the purchase price (often 20% in conventional mortgages), but this varies depending on the type of mortgage and the lender’s requirements. The down payment is the money you pay the lender. It represents your first step in buying the property. This amount can be affected by your credit history, the lender’s requirements, type of mortgage, and the home price. Once the entire process is completed, the lender releases the balance of the funds to the home seller to complete the purchase.
The down payment triggers the start of the mortgage approval (also known as underwriting) process. Depending on the mortgage company, this process can involve up to nine distinct steps.
Federal Scrutiny of Mortgage Applications
Since 9-11, mortgage lenders have begun to scrutinize mortgage applications more closely than ever. Part of this is to prevent money laundering, mortgage fraud, illegal use of drug money, or money derived from other criminal activities.
The other key reason is that the mortgage industry is interconnected. Federal agencies, such as Fannie Mae and Freddie Mac, purchase loans from lenders and hold a portion of these loans in their portfolios. However, most are re-sold as mortgage packages and sold to investors. Also, the FHA insures home loans against default. This bolsters the confidence of lenders to offer mortgages to high-risk borrowers. The ripple effect of fraud in the mortgage original process would cause a ripple effect to investors in the secondary markets that could easily impact the entire financial system.
To prevent this, lenders are asking for more information about the sources of a borrower’s income, as well as other key ratios. For instance, borrowers with a high debt-to-income ratio would be hard-hit in the event of an economic downturn. This meant more scrutiny of the variables and applicants covered in that ratio.
Self-employed and others in the gig economy are also facing more scrutiny due to their inconsistent earnings history and the shaky overall economy. Fannie Mae and Freddie Mac are asking for more documentation from this group because they are among the largest purchasers of U.S. mortgages.
In some cases, self-employed have been required to provide current audited profit-and-loss statements, unaudited profit-and-loss statements signed by the business owner, and recent bank account statements.
Close the Deal and Shop for Your Best Lender
Choosing a mortgage company or lender is a financially important decision that has lasting ramifications. While getting the best rate is important, it is not the single most important factor. The other key decision-making variables are choosing the mortgage product that meets your budget, so you can comfortably make payments and not become a financial slave to homeownership.
Thanks to the variety of mortgage products and lenders, it is now possible to shop for a mortgage firm that is best for first-time home buyers, best online lenders, best FHA and VA lenders, as well as those who offer low-down payments. There are even lenders for borrowers with bad credit.
The variety of these choices gives borrowers more power and choices than ever. The key thing is to enter into the process by being very well-prepared. Know your resources and limitations. If you have all the prepared documentation and know your bottom line and how the process works, you will have a better and more profitable home purchasing experience.