As the U.S. economy continues to rebuild slowly from the recession 7 years ago, lots of people are looking to buy homes after years of renting or staying put in a previous house.
As a result, the real estate market is competitive in many parts of the country, requiring buyers to put in aggressive offers and, in some places, compete with deep-pocketed investors paying cash.
What this means is that — now more than ever — you need to be qualified for a mortgage before you shop for real estate.
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, owning much more on their mortgage than their home was worth.
Even as the real estate market begins to recover, the mortgage crisis has left its mark. 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’s more important than ever to be prepared to prove to the bank that you’re financially prepared to take on a mortgage payment.
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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. (Use our simple calculator to estimate this.)
Your income and debts
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.
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Your credit health
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 for around $20 a month. You can cancel this after you close on your home.
As for your credit score, your estimated FICO credit score should be at least 680 and preferably above 700. Anything less and you may need to find a highly-qualified cosigner or take time to improve your credit before getting mortgage approval. The lower your credit score, the higher the mortgage rate you’ll pay which can add up to tens of thousands of dollars in extra interest.
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.
Your mortgage budget
Before ever speaking with a mortgage officer, 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, and you’ll find other readers here who are even more conservative.
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.
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. 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. Real estate agents, your own desires, and some unscrupulous mortgage lenders may try to tempt you into buying a more expensive home than you can afford, perhaps rationalizing the decision by reminding you that real estate is bound to appreciate. That may happen, but 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. You can meet with a local bank, credit union or mortgage broker or or get pre-approved online from any number of national online mortgage lenders.
Wherever you go, this pre-approval isn’t binding, but it’s a more formal indicator of your ability to get approved for the mortgage that you can send to sellers with your offer. Most sellers will want to see a pre-approval if not with an offer then within a couple days of making your offer.
If you are a prime borrower candidate (good credit and income), a reputable mortgage lender should offer you their best rates off the bat. Otherwise, don’t be afraid to shop around, as small differences in your mortgage rate can add up to big savings over the life of your loan.