Several people in my office are thinking about buying a home and since I’m known as the resident real estate nerd, they’ve started asking me what they should do to prepare. I always start with finances–in my experience, that’s where people are most likely to get tripped up. Borrowing hundreds of thousands of dollars is complicated — and it should be! It’s not for everyone. It’s essential for potential home buyers to understand their finances and how much they’re comfortable spending before talking with a realtor or mortgage broker.
Welllllll, not really. Realtors and mortgage brokers only get paid if you spend money, and they get paid more if you spend more. The incentives here are not in your favor. But fear not, let’s talk basics first.
What is a mortgage?
At the most basic level, a mortgage is a loan that is secured by property. What this means is that a lending institution (aka a bank) will give you a loan specifically to buy a property. If you don’t pay the loan back on schedule, the bank can take back the property (aka foreclosure) and sell it to someone else in order to recoup the money they loaned you. While you are paying off your mortgage, the bank holds the title to your property. If you sell the property before paying back the loan, the bank must be paid back before the title can be transferred to the new owner (or new mortgage lender). If you pay back the loan in full, the lender will transfer the title back to you and notify the county recorder’s office that the property no longer has a lien (aka mortgage) on it and that you own it free and clear. *happy dance*
What does a mortgage lender want?
To be paid. In order for the rules we’re about to discuss to make sense, it’s helpful to understand the motivations of a mortgage lender. Their worst nightmare is to get stuck repossessing a property and trying to sell it off. Even worse if it’s a down market and they can’t sell the property for the amount of the outstanding mortgage. Deep in the heart of every mortgage loan executive reside two fears:
- That you won’t pay back the loan. Then they have to spend thousands of dollars in a lengthy foreclosure process. Meanwhile, you’re not paying on your loan and, perhaps you’re trashing the place. When the bank finally takes possession, they have to spend money cleaning up the property and marketing it for sale. Then they pay a broker’s commission and all associated selling costs. Banks never, ever want to do this.
- That the market for real estate will decrease and your house will be worth less than you owe on the mortgage. When this happens, everything listed above is even more unprofitable. See the recent real estate recession.
All of the rules you’ll gripe about when applying for a loan are intended to weed out people who won’t be able to pay their loan and properties that aren’t worth what you want to pay for them.
What do lenders look for?
Steady employment. Mortgage lenders want to know that you have job security. Think you’ll get a mortgage after you’ve achieved early retirement? Fat chance. Get all your borrowing done before quitting that 9 to 5 because without 2 years of W2s, no ordinary lender is going to come near you.
Good credit score. Over 720 is best. Lower than 660 is likely to raise major red flags. A credit score indicates how likely you are to pay your debts. From a lender’s perspective, one of the best predictors is how well you’ve kept your previous financial commitments. Your credit score is an aggregation of your past usage of credit. If you’ve had credit cards and paid them off on time, you’ll probably be fine. Ironically, your credit score will likely soar once you’ve purchased your first home. Mine went from 740 the month before I bought a house to 765 the month after.
Good downpayment. What constitutes a good downpayment?
- Your realtor and mortgage broker will tell you that all you need is 3.5% of the purchase price as a downpayment. Don’t listen to them! With a 3.5% downpayment, you’ll only qualify for an FHA (Federal Housing Administration) backed loan which comes saddled with a lifetime of extra fees and less preferential interest rates. As I said, they do NOT have your best interests at heart.
- The smarter way to go is a 20% downpayment, which ensures good rates on a “conventional” mortgage. If you can’t put 20% down, it’s probably a good idea to keep saving. A solid downpayment signals to a lender that you’re a responsible saver and reduces the chance that the property will be worth less than the loan’s outstanding value in the future.
Low Debt to Income (DTI) ratio. DTI is often quoted as “28/43.” This means a front-end DTI of 28% and a back-end DTI of 43%.
- Front-end DTI = the maximum percentage of your monthly gross income that can go towards housing. If you make $48,000 a year, you can spend a maximum of $1,120 per month at a front-end DTI of 28%. (48000/12) * 0.28
- Back-end DTI = the maximum percentage of your monthly gross income that you can spend on ALL debt payments, housing included. This means your credit card debt (which you don’t have, right?), your car loan (please tell me you don’t have this either), and student loans (oh crap, this just got real).
A correctly priced property. The lender wants to know that the home you’re buying is not overpriced. But don’t be lulled into thinking they’re looking out for you! They are not. They just want to ensure that if you default on your mortgage, they would be able to sell the home for at least what you owe. In order to determine what the house is worth, a lender will order an appraisal from a certified real estate appraiser. The appraiser will examine the home and nearby comparable recent sales (the jargon here is “comps”) to see if the price you agreed to pay is fair market value.
Handy “Am I ready to borrow a crap-ton of money” Checklist:
- Do you have enough savings for a 20% downpayment for the price range of homes you’re looking at? For those who are bad at math, that’s $40,000 for a $200,000 home. If not, keep saving or look at cheaper houses.
- Do you have good credit? Do what you can to establish that you are worthy of being loaned hundreds of thousands of dollars.
- Do you have sound employment history? If you don’t have at least 2 years worth of W2s, you will encounter significantly greater hurdles. Greater enough that it’s likely best to wait until you hit that 2 year mark.
- Do you have a low enough debt load? If you have a ton of student loans, you may need to pay them down before your DTI will be acceptable to lenders.
Wrapping It Up
Believe me, coming to a mortgage broker knowing your DTI ratios puts you ahead of 90% of the population. And, sadly, we all know you can get a mortgage without knowing this. But, understanding how mortgage qualification is calculated made the process of shopping for one a lot easier when Mrs. Frugalwoods and I bought our house. It also helped us know exactly what we could afford and feel confident in that number.
Have you shopped for a mortgage recently? What was your experience?