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Getting your financing together is an
important first step in the home buying process. Once these
financing issues are resolved, you will be able to proceed to locate
your new home.
| Getting Your Finances together | How Much Can You Afford? |
| Your Credit History | Different Types of Loans |
| Adjustable-Rate Mortgages | Length of Mortgage Payback |
Getting Your Finances in Order
For lenders to verify this information, though, they're going to need to look at your financial records. It is also important to remember that you should include records for each person who will be an owner of the house. So before you even visit the bank, make sure you'll be able to provide copies of these important documents:
- Paycheck Stubs
Remember that lenders are most interested in your average income. Not only will they want to see this month's paycheck, but also how much you've been making for the past two years. Steady employment is also more attractive to lenders, so if you've been hopping from job to job, be prepared to discuss the reasons why.
- Bank Statements
In order to qualify you for a loan, most lenders will also ask you for copies of your bank statements. Ideally, they'd like to see a steady history of savings--or at the very least, that you're not bouncing checks every month.
- Tax Records
It's always a good idea to save copies of your tax returns, especially if you're self-employed. If you own your own business, it's important to note that lenders generally consider your income as the amount you paid taxes on--not the gross income of the business.
- Dividends
& Investments
Lenders will usually consider long-term investment dividends, as well as your investment portfolio, when evaluating your income.
- Alimony/Child
Support
If you receive steady payments as part of a divorce settlement or for child support, you can also include this as part of your gross income. Just remember that lenders will want to see a copy of your divorce/court settlement verifying the amount of the payments.
- Credit Report
Virtually every lender will want to see a copy of your credit report as part of the loan application process. The report lists all of your long-term debts, as well as your payment history. In general, they will require you to pay for the credit report (approximately $50), but if you have a recent copy, they may accept that instead.
How Much Can You Afford?
Bear in mind, however, that lenders will look at more than just your income to determine the size of the loan. Likewise, you may find that there are some creative financing options that can help boost your purchasing power.
Loan prequalification
vs. pre-approval
One of the best ways to determine your budget is to have your real estate
agent or lender pre-qualify you for a loan. Prequalification is different
from pre-approval, because it is only an estimate of what you'll be
able to afford. On the other hand, pre-approval is a more formal process
where a lender examines your finances and agrees in advance to loan you
money up to a specified amount.
What factors are
important to lenders?
Banks and lending institutions will use several criteria to determine how
much money they'll agree to lend. These include:
- Your gross monthly income
- Your credit history
- The amount of your outstanding debts
- Your savings--or the amount of money you have available for a down payment and closing costs
- Your choice of mortgage (i.e. 30-year, FHA, etc.)
- Current interest rates
Two important ratios
Lenders also use your financial information to figure out two, very
important ratios: the debt-to-income ratio and the housing expense ratio.
- Debt-to-income
ratio
Many lenders use a rule of thumb that the amount of debt you are paying on each month (car payment, student loan, credit card, etc,) shouldn't exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient.
- Housing expense
ratio
It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income.
Down payments make a
difference
If you can make a large down payment, lenders may be more lenient with their
qualifying ratios. For example, a person with a 20 percent down payment may
be qualified with the 33 percent housing expense ratio, while someone with a
5 percent down payment is held to the stricter 28 percent ratio.
Other ways to improve your purchasing power
- Gifts
If you're having trouble saving money, many lenders will allow you to use gift funds for the down payment and closing costs. However, most lenders require a "gift letter" stating the gift doesn't have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash.
- Negotiating Closing
Costs
Through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice.
- Loan Programs
Many local governments have special loan programs designed to help first-time homebuyers. Loans may be available at reduced interest rates, or with little or no down payments. Check with your local housing authority for more information.
- Loan Types
Some homebuyers choose Adjustable Rate Mortgages (ARMs) because of low initial interest rates. Others opt for 30-year loans because they have lower monthly payments than 15-year loans. There are significant differences between different loans, so make sure to discuss the pros and cons of different loans with your agent or lender before making a decision.
Your Credit History
However, most real estate experts agree that it is a good idea to obtain a copy of your credit report several months before you apply for a loan. This is so you have a chance to resolve any problems with your credit before your bank sees it. U.S. Federal law ensures that you have access to your credit report, which may be obtained from your local credit bureau or any of several national firms that specialize in credit reports.
Late payments
For most people, problems with their credit report are likely related to
late payments on a debt. If you were late one month in paying off your
credit card, but otherwise have a good payment history, chances are most
lenders won't be too concerned. But if you have a history of late payments
you'll need to document the reasons why. A slow payment history won't
necessarily get you turned down for a loan, but you may have to pay a higher
rate of interest or otherwise prove to the lender that you can repay your
loan in a timely fashion.
Errors on your credit
report
Many people are surprised to learn that credit reports can often contains
errors or inaccurate information. If this is the case with your credit
report, you'll need to contact the reporting agency or creditor to have the
problem resolved. This can sometimes be a slow process, so make sure to give
yourself time to clear up the mistake.
Bankruptcies and
foreclosures
While the different choices
may seem overwhelming at first, the overall goal is really quite simple: you
want to find a loan that fits both your current financial situation and your
future plans. Though this article discusses some of the more common loan
types, you should spend time talking with different lenders before deciding
on the right loan for your situation. General categories of
loans Other hybrid loans may
start with a fixed interest rate for several years, and then later
change to another (usually higher) fixed interest rate for the remainder
of the loan term. Lenders frequently charge a lower introductory
interest rate for hybrid loans vs. a traditional fixed-rate mortgage,
which makes hybrid loans attractive to homeowners who desire the
stability of a fixed-rate, but only plan to stay in their properties for
a short time. Balloon payments Time as a factor in your
loan choice FHA and VA loans Bear in mind, however, that
FHA and VA loans are not issued by the government; rather, the loans are
made by private lenders but insured by the U.S. government in case the
borrower defaults. Remember too, that while any U.S. citizen may apply for a
FHA loan, VA loans are only available to veterans or their spouses and
certain government employees. Conventional loans
Why choose an
adjustable-rate mortgage? Components of
adjustable-rate mortgages Adjustment periods and
teaser rates An ARM can also have an
initial adjustment period based on a "teaser rate," which is an artificially
low introductory interest rate offered by a lender to attract homebuyers.
Usually, teaser rates are good for 6 months or a year, at which point the
loan reverts back to the calculated interest rate. Remember, too, that most
lender will not use the teaser rate to qualify you for the loan, but instead
use a 7.5% interest rate (or calculated interest rate if it is lower). Rate caps Payment caps and
negative amortization For example, if the
interest rate rises during an adjustment period, the additional interest due
on the loan payment may exceed the amount allowed by the payment
cap--leading to negative amortization. This means the balance due on the
loan is actually growing, even though the homeowner is still making the
minimum monthly payment. Many lenders limit the amount of negative
amortization that may occur before the loan must be restructured, but it's
always wise to speak with your lender about payment caps and how negative
amortization will be handled.
Deciding what length is best
for you should be based on several factors including: your purchasing power,
your anticipated future income and how disciplined you want to be about
paying off the mortgage. What are the benefits of
a shorter loan term? With a 15-year loan,
however, the monthly payments on the same loan would be approximately
$956--for a total of $172,080. The monthly payments are more than $200 more
than they would be for a 30-year mortgage, but over the life of the loan you
would save more than $92,000. What are the advantages
to a 30-year loan? Furthermore, with a little
bit of financial discipline, there are a variety of methods that can help
you pay off a 30-year loan faster with only a moderately higher monthly
payment. One such choice is the biweekly mortgage payment plan, which is now
offered by many lenders for both new and existing loans. Biweekly mortgages If you're interested in a
biweekly payment plan, make sure to check with your lender. In many cases,
lenders also offer direct payment services that automatically withdraw funds
from your bank account, saving you the trouble of having to write and mail a
check every two weeks. Making extra payments
yourself--do it early! For example, if you had a
30-year loan, you might decide to send the equivalent of one or two extra
payments a year (which could shorten the overall length of the loan by many
years). But if your financial situation suddenly took a turn for the worse,
you could always fall back on the regular monthly payment. One important note, though,
is that if you do decide to send extra funds, make sure to do it EARLY in
the life of the loan. This is because most home loans are calculated in such
a way that the first few years of payments are almost entirely interest,
while the last few years are mostly applied towards the principal balance.
Thus, you can get the most bang for your buck by making the extra payments
early in the life of the loan.
There's no getting around it, a bankruptcy on your credit report is not a
good thing. But that doesn't mean you still can't obtain a loan. Even though
a bankruptcy may stay on your credit report for seven to ten years, lenders
will often consider the circumstances surrounding a bankruptcy (family
illness, injury, etc.). Moreover, if you have re-established good credit
since the bankruptcy, a lender will be more inclined to approve your
application.
Understanding Different Types of Loans
Most loans fall into three major categories: fixed-rate, adjustable-rate,
and hybrid loans that combine features of both.
As the name implies, a fixed-rate mortgage carries the same interest
rate for the life of the loan. Traditionally, fixed-rate mortgages have
been the most popular choice among homeowners, because the fixed monthly
payment is easy to plan and budget for, and can help protect against
inflation. Fixed-rate mortgages are most common in 30-year and 15-year
terms, but recently more lenders have begun offering 20-year and 40-year
loans.
Adjustable-rate mortgages differ from fixed-rate mortgages in that the
interest rate and monthly payment can change over the life of the loan.
This is because the interest rate for an ARM is tied to an index (such
as Treasury Securities) that may rise or fall over time. In order to
protect against dramatic increases in the rate, ARM loans usually have
caps that limit the rate from rising above a certain amount between
adjustments (i.e. no more than 2 percent a year), as well as a ceiling
on how much the rate can go up during the life of the loan (i.e. no more
than 6 percent). With these protections and low introductory rates, ARM
loans have become the most widely accepted alternative to fixed-rate
mortgages.
Hybrid loans combine features of both fixed-rate and adjustable-rate
mortgages. Typically, a hybrid loan may start with a fixed-rate for a
certain length of time, and then later convert to an adjustable-rate
mortgage. However, be sure to check with your lender and find out how
much the rate may increase after the conversion, as some hybrid loans do
not have interest rate caps for the first adjustment period.
A balloon payment refers to a loan that has a large, final payment due at
the end of the loan. For example, there are currently fixed-rate loans which
allow homeowners to make payments based on a 30-year loan, even thought the
entire balance of the loan may be due (the balloon payment) after 7 years.
As with some hybrid loans, balloon loans may be attractive to homeowners who
do not plan to stay in their house more than a short period of time.
As has been discussed, the length of time you plan to own a property may
have a strong influence on the type of loan you choose. For example, if you
plan to stay in a home for 10 years or longer, a traditional fixed-rate
mortgage may be your best bet. But if you plan on owning a home for a very
short period (5 years or less), then the low introductory rate of an
adjustable-rate mortgage may make the most financial sense. In general, ARMs
have the lowest introductory interest rates, followed by hybrid loans, and
then traditional fixed-rate mortgages.
U.S. government loan programs such as those of the Federal Housing Authority
(FHA) and Department of Veterans Affairs (VA) are designed to promote home
ownership for people who might not otherwise be able to qualify for a
conventional loan. Both FHA and VA loans have lower qualifying ratios than
conventional loans, and often require smaller or no down payments.
A conventional loan is simply a loan offered by a traditional private
lender. They may be fixed-rate, adjustable, hybrid or other types. While
conventional loans may be harder to qualify for than government-backed
loans, they often require less paperwork and typically do not have a maximum
allowable amount.
All About Adjustable-Rate Mortgages
The low initial interest rates offered by ARMs make them attractive during
periods when interest rates are high, or when homeowners only plan to stay
in their home for a relatively short period. Similarly, homebuyers may find
it easier to qualify for an ARM than a traditional loan. However, ARMs are
not for everyone. If you plan to stay in your home long-term or are hesitant
about having loan payments that shift from year-to-year, then you may prefer
the stability of a fixed-rate mortagage.
Adjustable-rate mortgages have three primary components: an index, margin,
and calculated interest rate.
The interest rate for an ARM is based on an index that measures the
lender's ability to borrow money. While the specific index used may vary
depending on the lender, some common indexes include U.S. Treasury Bills
and the Federal Housing Finance Board's Contract Mortgage Rate. One
thing all indexes have in common, however, is that they cannot be
controlled by the lender.
The margin (also called the "spread") is a percentage added to the index
in order to cover the lender's administrative costs and profit. Though
the index may rise and fall over time, the margin usually remains
constant over the life of the loan.
By adding the index and margin together, you arrive at the calculated
interest rate, which is the rate the homeowner pays. It is also the rate
to which any future rate adjustments will apply (rather than the "teaser
rate," explained below).
Because the interest rate for an ARM may change due to economic conditions,
a key feature to ask your lender about is the adjustment period--or how
often your interest rate may change. Many ARMS have one-year adjustment
periods, which means the interest rate and monthly payment is recalculated
(based on the index) every year. Depending on the lender, longer adjustment
periods are also available.
To protect homebuyers from dramatic rises in the interest rate, most ARMs
have "caps" that govern how much the interest rate may rise between
adjustment periods, as well as how much the rate may rise (or fall) over the
life of the loan. For example, an ARM may be said to have a 2% periodic cap,
and a 6% lifetime cap. This means that the rate can rise no more than 2%
during an adjustment period, and no more than 6% over the life of the loan.
The lifetime cap almost always applies to the calculated interest rate and
not the introductory teaser rate.
Some ARMs also have payment caps. These differ from rate caps by placing a
ceiling on how much your payment may rise during an adjustment period. While
this may sound like a good thing, it can sometimes lead to real trouble.
15-Year, 30-Year, or a Biweekly Mortgage?
Some homeowners choose fixed-rate loans that are less than 30 years in
order to save money by paying less interest over the life of the loan. For
example, a $100,000 loan at 8 percent interest comes with a monthly payment
of around $734 (excluding taxes and homeowner's insurance). Over 30 years,
this adds up to $264,240. In other words, over the life of the loan you
would pay a whopping $164,240 just in interest.
Despite the interest savings of a 15-year loan, they're not for everyone.
For one thing, the higher monthly payment might not allow some homeowners to
qualify for a house they could otherwise afford with the lower payments of a
30-year mortgage. The lower monthly payment can also provide a greater sense
of security in the event your future earning power might decrease.
As the name implies, biweekly mortgage payments are made every two weeks
instead of once a month--which over a year works out to the equivalent of
making one extra monthly payment (compared to a traditional payment plan).
One extra payment a year may not sound like much, but it can really add up
over time. In fact, switching from a traditional payment plan to a biweekly
mortgage can actually shorten the term of a 30-year loan by several years
and save you thousands in interest.
Another way to pay off your loan more quickly is to simply include extra
funds with your monthly payment. Most lenders will allow you to make extra
payments towards the principal balance of your loan without penalty. This is
especially attractive to homebuyers who are concerned about their future
earning power, but still want to be aggressive about paying off their loan.