So you’re thinking about buying your first piece of real estate? Congratulations!
But before you even begin to comb through real estate listings, you need to make sure you can actually qualify for a mortgage. And the best way to do so is by getting pre-qualified/pre-approved.
That said, the following are some useful “tips for first time home buyers” and seasoned buyers alike to ensure you qualify for the best mortgage possible:
The first thing any potential homeowner should do is obtain a free credit report, either from AnnualCreditReport.com or via a free trial website.
The latter actually provides a credit score so you can see where you stand (what credit score do I need to get a mortgage?). The first link only provides your credit history, which is useful, but you shouldn’t go into a mortgage without knowing your credit scores too.
Once you’ve got your credit report at your fingertips, analyze it and determine what your monthly expenditures are. You will see a monthly payment next to each liability on the credit report. Add up all those payments and jot it down somewhere. These are your total monthly liabilities and will be important when determining how much house you can afford.
Also scan the credit report for derogatory accounts and clean them up as best you can. If you’ve got delinquent accounts, resolve them. If you see collections/charge-offs, call the associated creditors and ask to get them removed (or dispute them online). If everything looks good, you can move on. If not, you may want to work on your credit before applying for a mortgage.
A credit score of 620 or higher is probably the minimum you’ll need before beginning your property search. Just know that the lower your credit score, the higher your mortgage rate, assuming you are able to qualify at all.
*One important note: Do NOT open any new credit accounts or make any large purchases using your credit cards within a few months before applying for a mortgage. This includes buying that plasma screen on a Best Buy card for your new crib. It can drive your credit score down needlessly which will result in a much higher interest-rate.
Now that you’ve got your credit in order, it’s time to figure out how much you can afford. Most banks and lenders allow borrowers to have a debt-to-income ratio up to 45%, though that number has probably dropped post-mortgage crisis. Read more about debt-to-income ratios.
By taking your total liabilities and adding it to a monthly housing payment, and dividing that number by your monthly gross income you’ll come up with your DTI ratio.
Let’s look at an example:
$10,000 monthly gross income
$1,500 total monthly liabilities
We know from the above example that your total monthly payments can’t exceed $4,500, or 45% DTI based on your $10,000 gross monthly income.
So if you already have $1,500 in total monthly liabilities, you can add a housing payment of $3,000 a month. That doesn’t leave much room in this market.
Let’s look at the same example with a housing payment, including taxes and insurance, based on California rates:
$550,000 purchase price
$440,000 loan amount
6.25% interest rate
$2291.66 monthly interest-only payment
$572.92 monthly taxes
$128.33 monthly insurance
$2,992.91 total monthly housing cost
In the above scenario, a prospective homeowner making $10,000 in gross income a month can barely afford a $440,000 loan making just the interest-only payment. What does this tell us?
It tells us that there are a ton of homeowners out there living paycheck to paycheck and overstating income to qualify for homes they simply can’t afford. At least not in the eyes of banks and lenders that require borrowers to keep their DTI below 45%.
So now you’ve got an idea of what you’ll be able to afford. There are a number of mortgage calculators out there that will give you a better idea of what you can qualify for.
Now that you’ve got your credit profile in check and you know what you can afford, you’ll need to make sure you’ve got a verifiable housing history and seasoned assets.
Most lenders ask that you verify your last 12 months housing history. You can do this with cancelled checks or a VOR (Verification of Rent) from your landlord. This is important to determine the payment shock effect on the borrower.
Liquid assets are always helpful when applying for a loan, and are almost always a necessity for a first-time homebuyer. Make sure you have an account with at least two months PITI (Principal, interest, taxes and insurance) available.
Also make sure the money in said account has been there for at least two consecutive months to ensure that it is seasoned. Banks and mortgage lenders don’t give much weight to unseasoned assets, as any friend, relative, or even a mortgage broker or loan officer can easily dump assets into your account before you apply for a mortgage to boost your net worth.
Now that you’re prepared, it’s time to be vigilant and proactive. Avoid predatory lenders and do your interest rate homework. Check out a rate sheet from the bank or lender that you’re being quoted from. Ask what the interest rate adjustments are. Ask if the loan carries a prepayment penalty and for how long? Get all the facts before you sign anything. And once you like it, lock it!
With all this preparation behind you, the loan flow will be a comfortable process with few surprises. It might not be perfect, but if you follow these rules you will definitely save money and reduce stress!
- Order a free credit report and view your credit scores
- Review your credit and clear up any derogatory accounts
- Do NOT open any new credit accounts or make any large purchases
- Calculate your total monthly liabilities
- Figure out your DTI and what you can afford
- Make sure you have a 12-month verifiable housing history
- Make sure you have a seasoned asset account with at least 2 months PITI
- Do your interest rate homework
- Get pre-approved