What does it take to get a mortgage these days?
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?
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Awesome post! Even though I have never missed a payment on anything and have a perfect credit score and no bad debt I wasn’t able to get a loan. This explains why though. My income was too low compared to the debt I wanted to take on for a rental property. If only banks could understand its now how much money you make it’s how much you keep that’s important!
Yep, DTI is a major block for getting a mortgage. Especially if you are FIRE. We plan on never borrowing money again once we quit our W2 jobs… because it’s practically impossible.
This is particularly galling for folks who are living off of after-tax savings. You can have 20 years of mortgage payments in the bank, but without that w2 income things are going to be tough.
Along the same lines of realtors and mortgage brokers not exactly being on your side, I recently shopped around out of real estate newbie curiosity and was offered a mortgage in excess of $1 million.
Based on my income, this is completely crazy! We would never use the space in a house costing that much being just a couple, and it is a recipe for serious financial trouble in the event of a job loss any time in the next 30 years. Basically, this is just a reminder that mortgage debt scales very quickly in absolute terms, and it very important not get financially trapped by your house just because a mortgage professional is willing to offer you a ton of money today.
So true! It’s absolutely insane what lenders will offer people. “Technically” affording it is super different from “responsibly” affording it.
It seems like the loose credit pendulum has swung back in the borrower’s favor. For a while there banks were probably a little too strict… but now it’s definitely too lax again! It hasn’t been that long since the last mortgage crisis!
Hello Frugalwoods! I stumbled on your site and love it. Query: Given today’s low mortgage rates, if you could put down more than 20%, would you? We’re actively open housing (I call it “house stalking”) in the DC area, and we’re debating putting down more like 30%+ but realize we could probably do better in the market. Thoughts? Thanks!
Personally, I think that rates are so low that over the long term the stock market will give a better return than paying off a mortgage. That’s the strategy we’re following. But there is a realy psychological benefit to reducing that overall debt burden no matter the math involved. I know plenty of smart, successful people who choose to put extra money towards the mortgage.
At the end of the day, what’s most important is that you are saving that extra money in one manner or another. Whether in the market or in your mortgage… you are already ahead of the game.
I agree with most above’ however I don’t think 20% maxim necessarily applies in every area, especially in metro Boston, where 20% constitutes $100-150K. This amount is nearly impossible for many individuals or couples to come up with. Given rates as low as they are, and the strength of the housing market in many towns, I think people can be willing to go in with 10-15% if they can get the appropriate rate. I wish I had done this years ago, but I waited for 20%. While the stock market may increase at a higher return than real estate, you need a place to live, and if you are looking to buy it is likely you aren’t willing to risk the capital for that return.
Yeah, in markets like this it’s really tough. If we were looking today, I don’t think we could afford our current house since the value has changed so much. And that’s just 3 short years!
Just how bad is it to get a FHA-backed loan? I understand that the mortgage insurance adds a lot for the first few years, but what other extra costs are involved?
I’m currently renting in a housing market where rental prices are inflated, especially in relation to how much I would pay monthly for a mortgage. I haven’t run ALL the numbers on it yet (homeowner’s insurance, taxes, etc), but I’m 90% sure that I could be saving a lot more if I bought a home. Like you, I want my home to have good potential as a future rental. I don’t have 20% saved yet for a downpayment, but could have it in about 3 years. I don’t really want to wait 3 years to buy, so the FHA loans look pretty appealing right now.
Great article. People tend to overlook the fact that everyone you work with in the home buying process is making money somehow, and that a certain dose of skepticism is necessary when buying a home. I bought a home last year in a very competitive seller’s market (Denver) and one of the most valuable things I did was to get quotes from multiple Mortgage Brokers. Doing this created competition for my business, and I ended up saving about 0.5% and $2000 in closing costs from my first quote to closing.
I will say that though I love the article and the blog in general, non W-2 employees shouldn’t be discouraged from purchasing a home if all of their financial ducks are in a row. I have been a 1099 contractor for several years, and at the time I purchased, I had two full years’ tax returns with an income that was rising each quarter. There were some additional hoops to jump through, but overall I was able to secure a very favorable mortgage. Just don’t expect to be able to do this if you are a 1099 contractor who over states his/her deductions and can only show $20,000 in earned income on your tax return.
As a former Realtor and one who comes from a family in the real estate business, I can honestly say my clients interests were by far my priority. Working with lenders to be sure they are going to be able to afford a home, rather than go outside of a payment they are comfortable with just so I can get a bigger commission has never been a priority for myself. I would say that is many Realtors feel this way as well. There is a Code of Ethics Realtors must abide to and I suggest if one feels they are not being treated properly by their Realtor they speak with the Principal Broker of the company. Please do not throw all people in this profession into one basket. There is a lot of work done behind lines that many do not see and it is done with the clients best interest at heart.
Can’t agree more with the advice here. To add to it do your due diligence and shop for mortgage refi. It will save you some money. Go to a bank, broker and aggregators like http://www.leanmeanmortgage.com. They can offer good rates and downpayment options. Best luck!
I actually was inspired to start saving for a home after reading your book, but I wonder—in what kind of account should you save your money, depending on how soon you’d like to buy a house? Is it worth investing it or keeping it in a high interest savings account, instead?