Homeownership is part of the path to financial independence. But it can also be the path to financial ruin.
Buying your first home is a big step and a huge financial undertaking. Most homeowners finance their home purchase with a mortgage, which comes with many risks and rewards. Even though they pay interest on their mortgage, homeowners tend to pay less for housing in the long run. They build equity (ownership) in their homes with every mortgage payment. But not every mortgage achieves the American dream.
This article will provide you with the basics of understanding your mortgage options so you can make the best choice for you and your family. Let’s dig in.
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Why Understanding Home Finance is Crucial
Some homeowners find themselves in sticky financial situations only a few years or a few months into their loans. A common reason this happens? Under-informed financial decision-making. Sometimes too much trust is given to persuasion from the realtor or mortgage broker. Sometimes buyers buy too big as the result of social pressure.
Whatever the reason, homeowners are getting mortgages that they can’t really afford even if it looks like they can at the beginning. Homeowners find themselves in this situation likely because they don’t understand the long-term consequences of certain home financing options that make larger mortgages more affordable.
A good rule of thumb is to buy less. Give yourself a buffer between the largest amount you can afford and the actual mortgage payment. A smaller mortgage has many benefits including a lowered risk of financial stress.
Credit and Income Requirements
When it comes to home loan approval, buyers will need to have a few things in order:
- A high enough credit score and clean credit history.
- A high enough income to guarantee loan repayment.
- Low enough debt, like student loans and credit cards, to allow for more debt to be taken on.
When it comes to your credit score, the higher the better. Generally speaking, it is very difficult to find a mortgage lender when your credit score is below 620. There are options for borrowers with credit scores even as low as 500, but these loans will either be more expensive or require larger down payments.
You’ll want to take a look at your FICO credit score and credit reports before going to your lender for pre-approval. You should be able to access your credit report for free from the three reporting bureaus: TransUnion, Experian, and Equifax. If there are any derogatory marks or inaccurate information on your report, you’ll want to address that right away. If your credit score is lower than you’d like, there are steps you can take to raise your credit score.
Income and Debt
Your income will affect how much mortgage you can reasonably afford. We recommend that your mortgage payment plus housing costs be no more than 33 percent of your take-home pay. We also recommend that your total debt payments be no more than 40 percent of your take-home pay.
Your lender will have additional requirements for your income. Typically lenders like to see a debt-to-income ratio (DTI) below 45 percent, with the mortgage taking up no more than 41 percent of your pre-tax pay. If you use a government loan program like Fannie Mae or Freddie Mac, you may have caps on your income.
Your lender will determine your risk, and therefore your interest rate, based on your ability to pay. The higher your income and the lower your mortgage payment, the lower your risk. The lower your risk, the better your interest rate, and the cheaper your mortgage.
It’s (almost) as simple as that. A lower risk category also means you’ll have better negotiating power between you and your lender.
Down Payment Best Practices
The recommended down payment for a mortgage is 20 percent. However, many lending programs now allow for down payments as low as three percent. Mortgages with down payments less than 20 percent typically require borrowers to pay for mortgage insurance to protect the lender.
As a general rule, the higher your down payment, the more favorable the terms of your loan. At the very least, a high down payment gives you more negotiating power. But what if you don’t have 20 percent to put down?
You have a few options. The most common is that people purchase home insurance or a second mortgage (more on these below). Be advised that, for most people, the best advice is to save more money and/or look for a less expensive house. Restraint and thoughtfulness are your most powerful tools for finding a great mortgage.
Types of Home Loans
There are three main loan options available for first time home buyers. There are important differences between the products and their eligibility. Be sure to assess your situation carefully to find the right product for you.
This is the most popular mortgage product around. The conventional loan is typically the least expensive option, but with many exceptions to this rule. The affordability comes from typically lower interest rates.
However, conventional loans are more difficult to qualify for and usually require more cash upfront. A higher credit score and lower debt-to-income ratio may also be required for such a product.
Conventional loans are not backed by the federal government.
Conforming and Non-Conforming Conventional Loans
When talking about conventional loans, you’ll hear two terms a lot: conforming and non-conforming. These terms refer to conforming to guidelines set by federal loan programs. Conforming loans meet these guidelines, while non-conforming do not.
Yes, we did just verify that conventional loans are not backed by the federal government. But, as scholars of the 2008 financial crisis will know, many conventional loans are sold in packages to government-sponsored enterprises (GSEs), including Freddie Mac and Fannie Mae. Lenders do this because they also need to comply with limits on how much lending they can make.
Though mortgage rules are complicated, what’s important for you to know is that conforming loans are below $510,401. Loans at or above this threshold are known as jumbo loans. Jumbo loans come with higher risk and higher interest rates. The higher risk and non-conformity makes it harder for the lender to sell the mortgage on the secondary market, to GSEs for example.
If you’re buying in a major metropolitan area or another high-value area, be prepared to pay extra for your lending.
Conventional Loan Requirements Overview
- Credit Score: 620, the higher the score the more favorable the loan. Some lenders prefer credit scores above 680.
- Down Payment: 3 percent minimum, 20 percent to avoid mortgage insurance.
- Income Limits: No income limits unless borrowing through Fannie Mae or Freddie Mac.
- Debt-to-Income Ratio: 45 percent or less. Some borrowers with high credit scores may negotiate for a higher DTI ratio.
- Mortgage Insurance: 0.15 to 2.5 percent of the loan amount paid annually depending on the borrower’s credit score.
- Occupancy: Primary residence, second or vacation home, and investment properties.
Federal Housing Administration (FHA) Loans
Part of the Department of Housing and Urban Development (HUD), the Federal Housing Administration (FHA) offers several mortgage programs to first time home buyers. These programs can be great opportunities for low-income families or individuals with limited resources. The programs are meant to address economic disparities and revitalize communities by providing pathways to homeownership.
FHA loans have looser restrictions for credit score and down payments. Borrowers will also receive breaks for the upfront costs of lending. These looser rules make the loans easier to qualify for and, in some cases, cheaper than conventional lending.
The main drawback of using an FHA loan is that borrowers have to pay a mortgage insurance premium as part of their lending agreement. This amount will be paid in monthly installments until the borrower has sufficient home equity.
While mortgage insurance with FHA loans is less expensive than mortgage insurance for conventional loans, borrows should proceed with caution. The added costs add up quickly and can easily become more expensive than conventional lending.
FHA Loan Requirements Overview
- Credit Score: 580 is the lowest score before requiring a higher down payment. 500 is the lowest acceptable credit score.
- Down Payment: 3.5 percent of the purchase price. Credit scores between 500 and 579 are required to have a 10 percent down payment.
- Income Limits: No income limits, but FHA loans cannot be larger than $331,760.
- Debt-to-Income Ratio: 31 percent for housing costs and 43 percent for total debt.
- Mortgage Insurance: Upfront mortgage insurance premium of 1.75 percent of the loan amount, plus 0.45 to 1.05 percent of the loan amount paid monthly for mortgage insurance premium.
- Occupancy: Primary residence for at least the first year.
The Department of Veterans Affairs (VA) offers loans reserved for service members and veterans. To qualify for one, borrowers must show proof of service. Once they do, they’ll have access to generous lending opportunities. VA loans offer less strict credit and DTI ratio regulations. Borrowers can also opt to put less money down without the worry of paying for mortgage insurance. But keep in mind that low down payments may mean a higher interest rate.
VA loans typically won’t go higher than conforming conventional loan amounts. Additionally, the higher DTI limits aren’t necessarily in your favor. A higher DTI, while it may get you into a nicer home, ultimately means you’ll experience more economic stress. We recommend restraint with lending. The less you spend today, the more buying power you’ll have tomorrow.
VA Loan Requirements Overview
- Credit Score: No official requirement, above 620 is recommended.
- Down Payment: No official requirement, but your lender may have preferences.
- Income Requirements: No official requirement, but your lender will have income requirements based on the amount of your loan.
- Debt-to-Income Ratio: 41 percent recommended. Sometimes a higher DTI can be negotiated.
- Mortgage Insurance: None required, mortgages are backed by the VA.
- Occupancy: Primary residence only.
Fixed and Floating Mortgage Rates: Which Is Right For You?
When you speak to a mortgage banker, you’re going to hear about your interest rate options. That is, you’ll learn about fixed-rate and floating-rate mortgages. These types of mortgages have very important differences and can mean the difference between an affordable mortgage and one that puts you into bankruptcy.
As the name suggests, fixed-interest mortgages have the same interest rate from the first day to the final payment—that is, unless the homeowner refinances the mortgage for a lower rate. Fixed mortgages are useful for borrowers because the cost of the mortgage stays the same over the life of the loan. With fewer variables at play, borrowers can make more effective budgeting decisions.
The terms of these mortgage loans are typically 10 to 30 years. The fewer the years, the higher the monthly payments. Even so, shorter mortgages tend to come with lower interest rates. Plus, the loan is paid faster meaning the borrower pays less in interest over the life of the loan. Just don’t set the pay off term so low that the payments are more than you can afford. You can always pay a mortgage off early.
The main drawback of the fixed-rate mortgage is that even if federal interest rates go down, the mortgage stays the same. Borrowers can explore refinancing, but that does cost additional fees. However, in the current lending climate, a fixed-rate mortgage is a good bet for most borrowers.
Floating: Adjustable Rate Mortgages (ARMs)
The most popular type of floating mortgages is the Adjustable Rate Mortgage (ARM). As the name suggests, the interest rates for this type of mortgage adjusts over the life of the loan. These loans tend to come in one, five, or seven-year periods. The period refers to the amount of time at the beginning of the loan where the rate stays fixed. After this initial period, the interest rate on the mortgage fluctuates with the federal interest rate. How much it fluctuates will depend on the federal interest rate and the terms of your loan.
In practice, this type of loan is less expensive in the beginning and more expensive in the end. Many borrowers use this lending product to access higher borrowing amounts. However, ARMs have been a major cause of mortgage default in the past.
Floating: Interest Only Mortgages
This final floating rate mortgage is similar to the adjustable-rate but has an important difference. For the beginning of the loan, instead of paying a lower interest rate, you’ll only pay the interest on the loan. After a certain amount of time, as designated in your mortgage, you’ll start paying the principal as well as the interest, which will increase your payment.
While starting off with a lower monthly payment seems like a great way to save money, it’s not. Because you’re only paying interest, you’re not gaining any equity in your house. That means, when the day comes to pay both interest and principal, you’ll be starting for square one. Think of interest-only payments like paying rent to your lender.
Private Mortgage Insurance
Private mortgage insurance (PMI) is an insurance policy meant to protect the lender. The premiums are paid by the borrower as part of the mortgage payment. Mortgage insurance is required on most loans where the borrower has less than 20 percent equity in the home.
Borrows pay for mortgage insurance premiums until they own at least 80 percent of the home, which is when they can request mortgage insurance cancellation from their lender. However, the mortgage insurance premium won’t be automatically eliminated until the borrower has 22 percent equity in the home.
Conclusion: Choose Wisely
Real estate investment is key to most people’s retirement planning. But without proper planning, home buying can lead to financial disaster. Getting the best mortgage for you is all about knowing your financial picture and your financial goals.
A house that presses against the threshold of what you can afford is not a good plan. You leave yourself vulnerable to default and make it harder to get ahead on other savings goals. Choose your loan type and payment options carefully.
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