When you embark on the search for a new home, you may think you know the steps to take: Read the listings, visit some open houses, sign on with a realtor, make an offer. In fact, there's a biggie missing from that list - a step as important financially as the house you decide to buy itself: Getting a mortgage.
It's widely understood that most houses and apartments are purchased using mortgage loans, which the Consumer Financial Protection Bureau defines as "an agreement between you and a lender that gives the lender the right to take your property if you fail to repay the money you've borrowed plus interest." Sounds serious - and it is. Mortgages come with a wide variety of lengths (called the term), repayment provisions and interest rates. Locking in the one that's best for you means getting something of an education. Especially if you're a first time homebuyer, it pays to learn the ins-and-outs of mortgage financing so you'll know what to expect.
Before you even start to look for a mortgage, you'll want to understand how they work. The most common type of mortgage is what's called a 30-year fixed rate loan. As it sounds, you have three decades to pay the money back with the rate of interest that you lock in initially fixed for the entire time. You'll also see 20, 15, and 10-year fixed rate loans. These require you to pay off the home in a shorter period of time, but because the bank is lending the money for a shorter term, the risk that you won't repay the money is lower. That's the reason interest rates on shorter-term loans are lower than those on longer-term ones.
The other primary type of home loan is an adjustable rate mortgage or ARM. Here, the initial monthly payment is lower than prevailing interest rates (which allow buyers to qualify to borrow more money), but over time the rate adjusts in sync with current interest rates or another financial index. If rates rise, your monthly payment will rise (there's typically a cap that limits how far up it's allowed to go). If rates fall, your monthly payment may fall as well. Hybrid ARMs, which you may see represented as 5/1 or 7/1 ARMs, are fixed for the first 5 or 7 years of the loan, then begin adjusting. If you believe you will only live in a home for 5 or 7 years before moving, for example, this can be a way to lower your monthly payments without taking on too much risk.
Getting the best rate on a mortgage involves two things: shopping around (there are often significant interest rate differences among lenders) and your own credit. Before you begin shopping for a house, do your own homework to determine your creditworthiness and prepare for a conversation with a lender, says Bob Collins, a mortgage broker at Signal Hill Mortgage in California.
First, gather tax returns, pay stubs and other paperwork that documents your income for the past two years. You'll also need documentation of liquid assets, cash on hand, as well as credit history and your current income. That may include credit union, bank and investment account statements. If you're not familiar with your credit rating, request a free copy of your credit reports from the three major credit bureaus, Equifax, Experian and TransUnion and pull a free copy of your credit score. You may be able to do this through your credit union. If you find an error on your credit report, file an error report with the bureau in question on the bureau's website. They typically have a month or two to correct it.
As you gather information, keep in mind what lenders are looking for. Harrine Freeman, a credit expert and owner of H.E. Freeman Enterprises says these things will help you get the loan you're looking for.
Better yet, sit down with a loan consultant at your credit union and talk through your specific situation. They may or may not be the lender you go with in the end, but it's a terrific first step toward getting an education (and credit unions are often very competitive when it comes to interest rates!).
Getting that education will help you when it comes to shopping around. Many lenders advertise deals, but it's unlikely you'll save a lot with such marketing efforts, says Casey Fleming, author of "The Loan Guide: How to Get the Best Possible Mortgage." "Lenders get calls by advertising, 'We never charge points!' or 'We pay your closing costs!'" Fleming says. "But they build their profit into your interest rate."
If you plan to hold the property for a short period of time, such a deal might work in your favor, Fleming says. But over a longer period, paying the closing costs yourself in order to get a lower interest rate may be less expensive. Fleming recommends calling any "no cost" lender and asking what the interest rate would be if you paid costs, too.
Similarly, some mortgage companies advertise that they'll pay your mortgage insurance - but that guarantee usually comes with a higher interest rate. "The higher interest rate lasts forever, whereas the mortgage insurance may only last for two years," Fleming says. "Call the lender and ask them to compare a no-mortgage-insurance plan with one with a lower interest rate where you pay for the insurance. Have them calculate the total cost of the options over a set period of time, such as seven years."
When you've found a lender with whom you feel comfortable, it's a good idea to get pre-qualified before you start shopping. Pre-qualification involves discussing the various loan program requirements and determining whether you will have the minimum down payment, employment and income history, credit history and payment reserves.
A lender shouldn't have to check your credit to pre-qualify you for a loan. In most cases, an underwriter (the loan professional who determines whether you qualify for a certain loan) will review the file and issue a conditional loan approval. The formal pre-approval process is the next step, where your loan application and credit report are submitted for review, along with income and asset documentation.
Once you’ve made an offer for a home and it’s been accepted, you can move on to scheduling a closing date. Just keep in mind there are costs there as well. By law, all lenders must provide a good faith estimate of closing costs, but that list doesn’t include all the charges you’ll face. For instance, the title company, which researches the title or deed to the home to ensure that no one else has rights to it, will determine its own fees (for “title insurance”) as will the home inspector, and a homeowners’ association if applicable.
If you’ve gone through a loan pre-approval process, don’t make any big changes – like switching jobs – until after your loan is closed. If you do, all the employment and salary data that your loan was based on is no longer accurate and you may no longer be approved.
And finally, if you don’t qualify for a home loan right away, don’t panic. There are things you can do to move the needle on your credit score. It won’t happen overnight, but with hard work and diligence in paying your bills on time, every time, it can happen.