A home loan gives you the ability to buy a house without having to pay the entire sales price up front. And with mortgage rates being at historic lows, It’s a pretty sweet time to get one!
This article will show you the steps needed to get the best loan possible, what lenders and products are at your disposal, and how they work.
- Get Prequalified
- Improve Your Credit Score
- Income Source & Stability
- Increase Your Income
- Decrease Your Debt
- Stash Your Cash
- Assets Are Your Greatest Asset
- Don’t Overdo Your Down Payment
- Down Payment Funding Options
- Low and No Down Payment FHA and VA Loans
- 30 and 15 year Fixed Rate Mortgage
- ARM and Interest Only Loans
- Jumbo Loans
- Big Banks – Pros & Cons
- Community Banks and Credit Unions
- Online Lenders
- Subprime Lenders
- Mortgage Brokers
It’s important to make sure before you start your home search that you meet with a qualified mortgage lender to get prequalified or receive a fully underwritten pre-approval. This will let you know exactly how much money you qualify for, giving you a better idea of what price point you should be ‘shopping’ in, since home loans are not limitless.
There’s nothing more disappointing spending hours pouring over every detail of your dream home, only to find it’s out of reach. And on the flip side, how mad would you be if you settled for a home that wasn’t your favorite, only to find out that you could’ve done better? Being financially self aware is your key to an optimum home purchase.
Lenders will assess your eligibility based on your income, credit score, and a few other criteria to determine an appropriate loan limit. Below is a breakdown of what exactly lenders look for, and tips on how to get your financial ‘house in order’, prior to approaching a lender.
Improve Your Credit Score
The first thing a lender will look at is your FICO credit score. This number gives them a snapshot of who you are financially.
Your score tells them what type of debt you currently hold, what types of loans and limits you’ve already been approved for, and your overall credit behavior. For example, do you make your payments on time? Are you late? if so, how often – and by how much? They can see if you have defaulted on any loans and/or if you have filed for bankruptcy.
That is why it is a good idea to pull your credit report to know what exactly, if anything, is lurking in your financial past. You can obtain that report and check your credit score though a variety of ways. Credit Karma shows you 8 places to get your free FICO score in this article.
Your actual credit score is determined by the credit you hold and your payment behavior. You are given a numeric score ranging between 300 to 850 – and as you probably guessed – the higher the better.
According to Rebecca Lake from U.S News, your FICO score is based on the following five factors
- Payment history (35%)
- Credit utilization (30%)
- Credit age (15%)
- Credit mix (10%)
- New credit inquiries (10%)
In terms of securing a home loan, your credit score needs to be at least 620 for a conventional loan, but can be as low as 500 for an FHA loan. Here’s 5 quick tips to help increase your score
1) Use 30% Or Less Of Your Available Credit
This concept is pretty frustrating. You would think the whole point of having credit available would be being able to use all of it. After all, if you pay your balance every month in full – why should your credit score be punished? But remember, your credit card is not like your debit card where when you make a purchase, money is instantly drawn from your account. With a credit card, the lender takes the hit for you until you pay them back. The bigger the “hit” you make them take, the more strain you put on their financial resources. For an optimum score, credit should be used for emergencies only.
It doesn’t help that lenders are sending mixed messages with their cash back and points programs that “reward” you for racking up a big credit bill. If you find yourself continually far exceeding the 30% available credit guide line, and are financially able to pay it off with a debit card, consider making the switch.
2) Pay Your Bills – On Time, Everytime.
Missing a bill payment can make your score drop like a rock, and the longer it goes unpaid, the harder your score falls. But surprisingly, not all bills are created equal. According to Christine Digangi from Credit.com, the following bills are rarely reported to the credit bureau agencies responsible for your credit score.
- Rent payments
- Utility bills
- Cable and internet bills
- Cellphone bills
- Insurance payments
But be careful, forget to pay your Credit, Car, Mortgage, or Student Loan payments, and your score will likely be in for a world of hurt.
Whenever you can, do yourself a favor and set up autopay on your bills. Even if you DO have the money in your account, it’s way too easy to get overwhelmed by life and forget to make a payment.
3) Don’t Frequently Apply For New Credit Accounts
While applying for new credit accounts isn’t as heavily weighted as your payment history, it’s still a good idea not to apply more than once every 90 days. Opening up multiple accounts in a short period of time looks bad from a lender’s perspective, as it appears you are gearing up to make large purchases that are outside your financial means. And when it comes to applying for a mortgage ( the largest loan most people ever acquire), you don’t want to give the impression you are already on the edge financially before taking on additional debt.
4) Leave Older Accounts Open, Even If You No Longer Use Them
The more “aged” a credit account is, the better it looks to credit bureaus, especially If its status has always been in good standing with no missed payments. If you no longer use an account – sometimes a year or two later, your lender will close the account due to inactivity. You want to avoid this, as your score can drop due to the closure, partially because your total credit utilization ratio will immediately increase due to the available credit decrease. Since each lender has different standards for what they consider “inactive” ( could be 6 months or 2 years), a best practice to prevent this from happening is to write yourself a reminder note to make a purchase on each of your active credit accounts every 3 months – even if it’s just a few dollars.
5) Check And Challenge Any Errors On Your Credit Report
In general, humans make mistakes – and the ones responsible for reporting information to the credit bureaus are no different! If you see any information on your credit report that is not true, i.e late payment, account closure, new credit inquiry – etc, you can challenge this information with your credit bureau. To contest something on your credit report you can reach out directly to the credit bureau like Experian, Transunion, or Equifax. You can also use a free service like Credit Karma that will contact the Bureau and challenge the information on your behalf.
Just as every loan type varies, every housing market can vary as well.You should consult with a loan officer, based on what type of loan that you are looking to secure. Before selecting a loan officer, make sure you ask them these 5 questions first.
Lenders are not only going to look at just how much money you make, but also at how much debt you are currently carrying. This gives them a better idea of how much additional debt you can take on, and how much you can afford to pay back. For example – If you are making $70,000 a year, but between rent, a car loan, student loans and living expenses you are breaking even, you are deemed more of a credit risk than someone who is making only $35,000 but has no car payment, no debt, no loans, and good credit.
Try to make sure that your debt-to-income ratio does not exceed 43%. You can calculate this amount by dividing your recurring monthly debt by your recurring average monthly income.
Income Source & Stability
If you have been employed with one company for the last 10 years, lenders are going to perceive your job as very stable. Or, if your income has consistently climbed with consecutive employers within the same time frame, that looks great too.
If you are currently a contractor, freelancer, or have gaps in your employment, be prepared to “prove” your income with substantiating documents and tax returns. The good news is that being self-employed is more common today than in years past and does not necessarily have the same stigma it used to. Lenders will look at the bigger picture and your total income.
Increase Your Income
There’s two ways to do this. The ideal way is to get a raise at your current job, since consistent salaried income is viewed as the most stable.
What will take you to the next level? If there is a particular skill set your company is seeking, there’s a very good chance an online course exists that will teach you about it.
Check out Udemy.com and search through their course catalog. They’ve got tons of great ones, and they often have sales, discounting them to as low as $10 a course!
You can also boost your income with a part-time or freelance income. There are a lot of options in the growing online and “gig-style” economy. Whether it is casual bookkeeping, contract graphic design work, or driving an Uber after work, there are many ways to increase your monthly income. Remember, the more you make, the more you qualify for.
Here’s 22 awesome side hustle ideas From Bobby Hoyt to get you started!
Decrease Your Debt
Before you approach a lender who is going to assess your eligibility for a new loan based on your ability to handle and repay existing ones – pay off or pay down your loans, as much as possible. If you have multiple accounts with outstanding balances, you can consolidate them with one, single, and lower interest loan. The bottom line here is that the less outstanding on your balance sheet, the better.
Stash Your Cash
If you have cash in the bank, that alone proves to a lender that you have disposable income well above and beyond your expenses. This means that you can comfortably take on more debt and handle the repayment of your home loan. In a lender’s adjudication process, a cash positive account also increases your overall net worth, and shows them that you are both disciplined with your savings and determined to reach financial goals. The best time to start saving was yesterday. The second best time is today!
Assets are Your Greatest Asset
Lenders are always looking for potential security against a loan, which an asset instantly provides. An asset also increases your overall net worth. If the asset ( like a car) was paid off via a loan, you have proven that you are responsible with lended money, and therefore a lower risk applicant.
So, if you are close to paying off a car -or another asset, try to pay it off prior to applying for your home loan. That way it will be viewed as an asset, and play to your advantage on an application.
Don’t Overdo Your Down Payment
For a conventional loan, your down payment on a property will typically be 20% of the asset value. Conventional lenders usually view it too risky to lend any more than 80%.
Just because you can afford to do down a payment over 20%, doesn’t necessarily mean you should. Sure, the more you put down the lower your principal and interest payments will be, but also consider the following perspective.
Mortgage rates are nearing historical lows right now. Since the cost of “borrowing” money is relatively cheap, you should consider the opportunity cost of tying up capital in your home.
If that money is just going to be sitting there anyways, you might want to consider other investment vehicles to park your money in. Check out Jame Royal’s list of the best 15 places to invest your money in 2020 to get started.
You can also do a down payment of less than 20%, however your lender is going to add private mortgage insurance (PMI), to make up for this. PMI is a monthly premium that will be rolled into your mortgage payments.
PMI can be cancelled once you’ve made enough payments to reach 20% equity in your home, or if your home has appreciated in value enough over time to make up the difference. The latter you will have to prove by ordering an appraisal.
Down Payment Funding Options
Your down payment usually comes out of your own pocket, but it doesn’t have to. Here’s 3 alternatives.
Family & Friends – According to Holly Welles from My Mortgage Insider, It can come from a family member or friend in the form of a gift, as long as you can prove the relationship between you and the donator.
Government Grants – It can also come from a government grant program. Here’s a handy list of 15 first time home buyer grants you can get in Illinois. Some of them never have to be repaid, while others are forgivable loans that can be repaid once the house is refinanced or sold.
Personal Loans – The last option is to get a personal loan for your down payment, and not exactly recommended. It won’t look good in the eyes of a lender since they are already providing you with a large loan.
If you decide to go this route, it’s recommended that you have the money in your bank account at least 4 months before you purchase the home. According to Peter Warden from The Mortgage Reports, this will effectively “season” the money, making it look more stable.
When lenders are doing their due diligence and deciding whether to lend to you, they are going to be viewing new money that has landed in your bank account within the last 60 – 240 days, depending on the specific lender.
If your lender sees a large deposit of money that recently landed in your account, they are going to ask about it. Regardless of the seasoning period, a personal loan is going to effect your debt to income ratio – and if your ratio goes too high, this could disqualify you from a loan – or change the terms offered. To be clear, there is no hiding here. By law, you have to disclose any personal loans you have when applying for your mortgage.
Last Note On Down Payments: Since lenders base loans and down payments off the asset value, and not the purchase price, it’s important that your offer price is indicative of how much the home is worth. A lender won’t approve a loan for a home that doesn’t appraise, and will require you to make up the difference of value in cash.
Choose The Right Loan Product For You
Depending on your situation, you may opt to pay down your loan faster, or stretch it out over a longer term. You can also choose between a fixed or a variable rate mortgage. Below explains the benefits of each type of loan.
30-Year Fixed Rate Mortgage – A 30-year fixed rate mortgage gives you a longer term at a locked in rate that will not increase or decrease. This is the ‘preferred loan’ if you plan on living in your home indefinitely and want more predictable repayment terms.
15-Year Fixed Rate Mortgage – A 15-year fixed rate mortgage has you pay off your home in half the time of a 30 year mortgage. Your rate will also stay the same throughout the duration of this loan. The potential benefits of this strategy is that you pay off the principal of your loan faster, and pay less interest overall.
Of course, the interest rate you lock in and your personal “discount rate” a.k.a your next best investment option will determine if this is actually a good use of your money.
Adjustable Rate Mortgage – An Adjustable Rate Mortgage (ARM) loan has an interest rate that will fluctuate after a fixed period of time of 3-10 years has passed, depending on the lender. Since the initial fixed period typically has a low interest rate, this option is attractive for those who plan to sell their home within the next 3-5 years, or know they will be paying off the entire loan in that time frame.
This option can be a risky roll of the dice for those that intend to hold on to the home long term, as they could find themselves at the mercy of the economy and the interest rates that come with it.
Interest Only Mortgage – An interest only mortgage is a mortgage that involves a fixed period where your payments only go towards paying off the interest on your loan. The interest only payments term is either at 60 months for a 30 year loan, or 120 months for a 40 year loan.
With monthly payments being low, this is ideal for short term situations where you are cash strapped, and need cash flow for immediate expenses other than your mortgage.
The trade-off is that during the interest only payment period, you are not paying off any of the principal on your loan. So you’re not building equity and are essentially just renting your home from the bank.
Jumbo Mortgage – A jumbo mortgage is a non-conforming loan that can help you make a large real estate purchase when a conventional loan won’t cut it. For example, If you are seeking a loan amount over $548,250 – the conventional limit for a single family home in Cook County, Chicago – you’re going to need to go jumbo.
Due to the increased risk for the lender, getting approved for these loans will often require great credit and a larger down payment.
FHA Loan – FHA loans are insured by the Federal Housing Administration, and are a great option for first time home buyers that don’t have a large chunk saved for a down payment.
Here’s of brief overview of the qualifications for an FHA loan, and what kind of down payment and other fees you can expect.
1) The home must be your primary residence
In order to qualify for an FHA loan, you must live in the property for at least one year, with it being your primary residence during that period. After 1 year passes – you’re free to do what you want. Maybe you want to live in it for the next decade, or perhaps you want to convert the property into a rental or vacation home. The choice is yours!
2) You must have consistent income and proof of employment
Although FHA loans have less strict credit standards than conventional loans, in order to get approved you will still need to prove that you have a source of income – and where that source of income originates.
According to FHAloans.com, If you are employed at a traditional job with a salaried income, It’s typical to be asked to provide the following:
- 30 day paystubs
- W-2 forms from the last 2 years
If you have worked in your field for less than 2 years, lenders may want to see proof of any training or education programs you are enrolled in that would imply career development and future income increases.
If you have changed jobs more than 3 times in a year, lenders will want to see documentation illustrating benefits or income increases that came with each job switch. If you are currently employed by a temp agency or in a field where you have a variety of employers ( ex. Union Tradesperson), this does not apply.
If you have had a period of unemployment greater than 6 months in your job history, lenders will require additional documentation proving the stability of your current job ( at least 6 months), and two years of steady employment prior to the period of unemployment.
If you are self employed, you must be able to prove that you own at least 25% of your business, and will be asked to provide the following:
- 2 years of individual and business tax returns
- Profit & Loss Statements
- Balance Sheet.
If you have been self employed for less than two years, it will likely be difficult to get approved for an FHA loan, especially without documentation from employment prior to that period, assuming that the employment was in a related field.
3) FICO® score of 580+ may* be eligible for a 3.5% down payment
The recommended credit score of above 580 is set by HUD guidelines. According to Brandon Cornett from FHA Handbook, lenders can also “overlay” their own requirements on top of the minimums set by HUD – so their credit score requirements may be higher. For the 3.5% down payment, many lenders want to see scores in the 580- 620 ballpark.
4) FICO® score between 500 – 579 may* be eligible for a 10% down payment
The bare minimum score for FHA approval is 500, and If your FICO is between 500 – 579, you may be approved for a 10% down payment, subject to lender overlay requirements.
5) Mortgage Insurance Premium is required
Be aware, there’s no “free lunch” with FHA loans. As Brandon mentions, FHA loans will require two fees to compensate for the low down payment:
- An upfront insurance premium of 1.75% of the loan
- An annual insurance premium ranging from .45 – 1.25% of the loan balance.
For a $200,000 30 year FHA loan, Penny Mac reports a typical annual premium of $1,700 ( .85%).
6) Debt-To-Income Ratio must be less than 43%
Lenders do not want your debt-to-income ratio to exceed 43%. You can calculate your DTIR by dividing your monthly debt payments by your average gross monthly income. For example, if you take home $3,000 a month, and your monthly debt payments are $1,290 – that would be a DTIR of 43%.
7) You have to wait at least 6 months before refinancing into a conventional loan
Since Mortgage Insurance Premiums (MIP) must be paid for the life of the FHA loan, you may want to consider refinancing into a conventional loan once you reach 20% equity in the property. Before doing this, lenders require at least 6 months of payments on the FHA loan to be made before accepting a conventional loan application. Keep in mind, refinancing does come with significant costs, which are typically 2-5% of the loan balance.
Because of potentially high refinancing costs, it typically only makes sense to do so if you are planning on living in the property for a longer period of time, where the cost of the closing will eventually be offset by the lack of MIP payments. For example, on a $250,000 FHA loan balance with monthly MIP payments of $169.35, and a refinancing closing cost of 3.5% percent ( $8,750), it would take almost 52 months (4.3 years) before you started saving money from the refinance.
You can use the following FHA loan calculator from HSH.com to calculate loan fees for your own property purchase.
Even with the insurance premiums, FHA loans are still pretty awesome. Because of how low the down payments are, they also make great finance vehicles for the ambitious cash strapped investor who wants to quickly build up a portfolio of rental properties – and doesn’t mind moving once a year.
VA Loan – If you served in the military, the mortgage industry is doing its part to now serve you. As a service member, you qualify for exclusive military benefits with a VA loan.
VA Loans are guaranteed by the department of veteran affairs, which gives lenders the confidence to offer 0% down mortgages. VA loans are fairly forgiving of credit, and you can get one even with a past bankruptcy or foreclosure on your record.
According to Natalie Campisi from BankRate, if you or your spouse meet the criteria below, you may be eligible for a 0% down VA loan.
- Active military service member, veteran, or honorably discharged.
- 90+ consecutive days of active service during wartime, or 181+ consecutive days of active service during peacetime.
- National Guard or Selective Reserve ( 6+ years of service).
To qualify for a V.A loan, you still need to have decent credit – 620 is recommended, and you also need to have proof of income that shows you can make your mortgage payments.
Choose the Best Home Lender
There are a variety of lenders that service the mortgage industry, and provide different products, with different rates and different terms. The information below will help you decide whether you want to go with a traditional big bank, or explore other options.
Big Banks – ‘A’ lenders
National Banks are the brick and mortar of the financial industry. Not only have they been in the game for years, they basically invented the game. Who are the “Big Banks?” Names like Wells Fargo, Chase, and Bank of America come to mind. According to Kelsey Dean at F&M Bank, here are the pros and cons of using a Mega Bank for your mortgage:
- 24/7 customer support
- Streamlined online applications
- A big selection of loan programs & products
- Stricter criteria for lending ( freelancers and low credit applicants beware)
- Higher loan origination fees
- Longer loan processing wait times
- No consistent point of contact
- Longer hold times when contacting via phone
- Your loan may be sold to another lender, with worse customer service!
Ultimately, your decision to go ( or not go) with a big bank will come down to your personal situation. If you have great credit and stable salaried job at a well known company, a national bank might be a good option for you. If your situation is different, read on! You’ve got lots of options.
Community Banks – A community bank is similar to a big bank, but has a smaller footprint nationally, and doesn’t have all the needless “red tape” that plagues large organizations, which can speed up your loan process.
F&M Mortgage found that instead of being bounced around from rep to rep like you would at a big bank, you will likely have one point of contact, and be able to reach your loan officer quickly via email or their personal cell phone.
For the most part, they will offer you the same products, terms and rates you would get at a big bank, and will be more forgiving of low credit and gaps in your employment. Generally, if you’ve been a long-standing customer, you will find that they are much more likely to make special concessions for your loan.
Credit Unions – What is the difference between a credit union and bank? Banks are for profit – institutions owned by their shareholders, where credit unions are non profits and owned by their members.
Similar to community banks, credit unions are local, and being a long time member has its perks when it comes time to apply for a mortgage.
According to Kevin Mercadante from Money Under 30, starting your mortgage search with a local credit union or bank you already do business with is also going to be the most simple option from a logistics perspective.
You probably already have a credit card, checking, savings or even a CD and IRA account with them, so they already have your financial information in their system. Because of this, it’s likely they have existing pre- approvals ready for you should you approach them for a home loan as well.
As Mercadante mentions, another plus of credit unions and community banks is their ability to help you access a HELOC, or “Home Equity Line of Credit”. Once you have obtained a mortgage and start making payments, this will help you get a secondary loan ( should you need one), by borrowing against the equity you have built up in your home.
Need funds for a home renovation, expansion, or even a personal investment? Use a HELOC!
HELOCS are great because of the amount of money they allow you to borrow. Getting a 50,000k+ loan is not unusual, compared to the 10 -15k credit limit you typically see with most credit cards. As a double bonus, the interest rate you pay tends to be lower than credit cards too!
Thanks to a burgeoning tech industry, mortgages can now be obtained via online lenders.
Although not done in person, this AI, computer-driven lending option still will leverage the same home loan criteria, such as your income and credit score.
- Online application process is quick and easy
- Lower rates and fees
According to Rebecca Lake with SmartAsset, because of their lack of a physical storefront, online lenders have less overhead costs and can pass those savings on to you in the form of lower interest rates and loan origination fees.
- Lack of face-to-face contact with lender
- Customer support may be slower
- Advertised rates may not be guaranteed
It’s important to make sure you do your research with online lenders – which may promise extremely low rates. Don’t jump on board until you have confirmed that you qualify for the rate offered.
Check out Nerd Wallet’s top 10 online mortgage lenders, as of March 2020.
Sub-Prime Lenders – ‘B’ and ‘C’ Lenders
These alternative lenders are specifically set up to accommodate clients with lower income and or credit scores. So, if you have had credit problems or a bankruptcy in your past, they might end up being your best bet. However, you should note that your loan approval comes at a cost – you will likely pay a much higher interest rate than an “A” lender would offer.
Also, not all sub-prime lenders are created equal, so do your due diligence and look into their institutional reputation. You do not want to be locked into an unmanageable repayment contract. Check out Nerd Wallet’s 2020 list of the top 10 mortgage lenders for low credit score borrowers.
If you are not comfortable dealing with a lender directly or you want someone to hold your hand during the loan process, a professional mortgage broker can be your mediator. They will shop around with different lenders to help you find the best rates, offer special financing options, and will generally get you through the entire loan process faster with their quick response times.
Of course, they do charge a fee for their services. To learn more about Mortgage brokers and whether you should hire one, check out Deborah Kearn’s awesome NerdWallet article.
Remember, a home purchase is likely going to be one of the biggest financial transactions you make in your lifetime. Don’t go at it alone.
A Real Estate transaction involves many moving parts, and you’ll come in contact with many professionals who won’t know everything, but will have lots of knowledge related to their specific part of the field. Your best bet is to add as many experts to your team as possible during your buying process, so you get a wide range of advice and expertise.
I hope this article has better equipped you to maximize your home loan potential and better position you for home buying success.