Many people think the first steps to buying a home are driving around neighborhoods, visiting open houses, and researching schools – but really, they’re not. Buying a home can be a lot like a long distance race. Getting prequalified for a mortgage is your first step. Starting is no guarantee of making it to the finish line, but you’ll at least be in the race and headed in the right direction.
Here are your first 5 steps to get you started on the right foot.
1. Rating Your Credit
The process of getting prequalified involves a lender, who may be a bank, credit union, or mortgage broker. They’ll start by asking you some basic financial questions. One of the first 3 pieces of information a lender needs to know is your credit score. If you have not received a recent credit report, a lender will likely order one. The Fair Isaac Corporation (FICO) offers lenders a way to calculate a borrower’s credit worthiness from information gathered through the three major credit reporting companies: TransUnion, Experian and Equifax. FICO credit scores range from 300 to 850. This number reflects your history of loan repayment, credit card usage, and other credit related information.
2. Measuring Your Assets
Your lender will also ask you about your assets. These questions are geared to piece together your financial picture that will ultimately be used in preparing your loan application. Your assets are money that could be available to make a down payment or pay closing costs. It’s important that you give as accurate a picture of your finances as possible because when you eventually submit your application, all the financial information you are providing now will be checked and verified.
This is important: If you are going to receive money as a gift from family members toward purchasing your home, you need to discuss this with your lender. Some types of loans allow a certain percentage of your down payment in the form of a family gift or grant.
3. Assessing Your Income
Lenders use your pre-tax income to calculate the monthly payments that you can manage to service the loan. Lenders will estimate the amount of principal, interest, taxes, and insurance (PITI) that you can afford as a percentage of your gross income. A general rule of thumb is that your PITI should not exceed 28% of your gross income. Some lenders may offer loans that allow over 30% PITI, and some as high as 40%.
Your maximum monthly payment is also a matter of personal preference. You need to look at the numbers carefully to see if you are comfortable with the lifestyle trade-offs that owning a home will require.
4. Improving Your Chances
If the initial loan amount falls short of what you were hoping for, there are still things that your lender may recommend for you to improve your chances.
- If there are errors on your credit report, now is the time to contact the agencies to have those items removed.
- If you haven’t already talked with your family about financial help for the down payment, do that now.
- If you have started a new job or paid off a major debt recently, that can affect your ability to get a loan. Waiting until you have established a two-year history of steady employment and no debt can help you get the loan you want.
5. Choosing The Best Loan For You
You will hear a lot about mortgage loans guaranteed by the Federal Housing Administration (FHA) that require a 3.5% down payment. These loans offer some of the best interest rates because the FHA guarantee greatly reduces the risk of default or foreclosure for the lender.
However, FHA loans are not necessarily the best option. While they reduce the upfront down payment, they add a 1.75% mortgage insurance premium (MIP) that is usually added to the principal of the loan. Additional monthly mortgage insurance is also required.
Banks and other lenders offer conventional mortgages (not guaranteed by the FHA) that require a 5% down payment. These loans do not add an MIP and their monthly mortgage insurance premiums are typically lower than for FHA loans.
To eliminate mortgage insurance completely, you will need to have a 20% down-payment. This is not simply a question of pay me 5% now or pay me 20% later. The savings are substantial. Buying a $400,000 home with 20% down rather than with 5% down will save you $30,000 to $40,000 in mortgage insurance premiums during the first 13 years of the loan.
Getting prequalified will help you choose the best loan possible for your situation. It can also provide a guide to improve your financial picture so you can afford a better house. In either case it’s an important first step on your way to owning your own home.