So you’re thinking about buying your first piece of real estate? Or you’re considered a “first-time home buyer” simply because you haven’t owned a property in the past three years. Either way, congratulations! It’s an exciting time.
But before you even begin to comb through real estate listings and attend open houses, you need to make sure you can actually qualify for a mortgage on your dream home. And I hope you actually took a moment to compare renting to buying.
The following are some useful tips for both newbies (first-time home buyers) and seasoned buyers alike who are looking to experience a loan process with as few surprises as possible. Because those types of surprises aren’t fun.
Tip #1: Check Your Credit Report and Know Your Credit Scores!
The first thing any potential homeowner should do is obtain a free credit report and view your credit scores, either from AnnualCreditReport.com or via a free trial of some kind. Some credit card issuers are now providing genuine FICO scores for free.
However, it’s important that you see all three of your credit scores because mortgage lenders pull all three and then use the middle credit score. The Annual Credit Report website only provides consumers with credit reports, which is extremely helpful, but you shouldn’t apply for a mortgage without knowing your credit scores as well.
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.
Tip #2: See What You Can Really Afford
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 current mortgage 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 mortgage payment. What does this tell us?
It means 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 in the eyes of banks and lenders that require borrowers to keep their DTI below 45%.
And you should never assume you’re qualified for a mortgage simply by being able to make the interest-only payment. You should be able to afford the fully-amortized mortgage payment, and any payment rise if it’s an adjustable-rate mortgage. Otherwise you’ll need to lower your loan amount and live within your means.
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.
It’s also important to have budgeted for closing costs, while leaving an emergency fund in place to ensure monthly mortgage payments can be made if/when something unexpected comes up.
Tip #3: Be Ready to Document Rental History and Assets
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 (if any) on the borrower.
Liquid assets are always helpful when applying for a loan, and are almost always a necessity for a first-time home buyer. 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 mortgage loan officer can easily dump assets into your account before you apply for a mortgage to boost your net worth.
It’s also important to sock away money for your down payment months, or even years, in advance. Most prospective home buyers have difficulty saving enough for the down payment, and sometimes miss out on their dream home as a result. So saving early and often is key to achieving the dream of homeownership.
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 should save some money and reduce stress!
The Definition of a First-Time Home Buyer
One final note about first-time buyers. As I alluded to up above, some entities, like Fannie Mae, also define first-time home buyers as those who haven’t owned (sole or joint) a residential property during the three-year period preceding the date of the home purchase in question.
This means you can be a previous homeowner who just hasn’t owned for a few years, and take advantage of programs intended only for those buying their first home. So if you sold your old home three years ago, you might qualify as a first-time home buyer today.
Additionally, Fannie Mae considers displaced homemakers or single parents as first-time home buyers if they had no ownership interest in a principal residence (aside from joint ownership interest with their spouse) during this preceding three-year time period.
So if you just recently went through divorce, or another life event happened, it’s possible to earn the first-time buyer distinction even if you recently owned a home.
Let’s review key tips for first-time home buyers in a condensed format:
- 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 before/during the loan process
- Calculate your total monthly liabilities
- Determine how much you want to put down and if you want to pay mortgage insurance
- Figure out your DTI and subsequently 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
- Set aside money for a down payment in a verifiable account
- Do your interest rate homework
- Get pre-approved for a mortgage and obtain a pre-approval letter
- Shop around with multiple banks and lenders, not just the one that pre-approved you
- Compare mortgage rates extensively
- Lock your mortgage rate when you’re satisfied to ensure it doesn’t fluctuate
- Get a better understanding of mortgage closing costs so you know what to expect in the way of fees
Read more: How to get a mortgage.