Home Loan Guide
Home loans (also known as mortgages) are loans you take out to buy a home or land to build a home. Unless you are independently one of the “super rich,” or a strict devotee of the Dave Ramsey method, you probably can’t afford to just pay cash outright for a house or condo you’d actually like to live in. Rather than settling for a home with inadequate space or less-than-optimal amenities, most Americans get a mortgage to help them buy a house they actually like.
Lenders (banks, credit unions, or independent brokers) and borrowers agree to basic terms, including a time frame, payment schedule, and cost, by which the borrower will pay back the loan (sometimes referred to simply as a “note”) and the lender will provide the financing needed to acquire the property.
Most loans typically involve the following items:
Down payment: Part of the purchase price you pay as a direct contribution to the purchase.
Interest rate: Rate of interest the bank or lender charges for extending the loan (your cost of borrowing).
Purchase price: The price you agree to when purchasing a home
Term: Length of the loan, the term of the mortgage defines how many months, or (in most cases) years, the loan extends.
With all of these different cost factors to consider, it’s important not to get in over your head. You need to carefully consider whether or not you’re really ready to buy your “forever home,” or if you maybe need to start a little smaller and save up, or advance in your career before getting your very own Barbie Dream House.
Home Mortgage Types
When a borrower accepts more risk in their loan, they can often get a better deal from the bank, whether it’s lower monthly payments, lower interest rates, and/or lower transaction costs associated with the loan. Borrowers can take on more risk by choosing a longer term for their note and opting for an adjustable instead of a fixed rate.
Beyond simply choosing the length and type of interest rate, there are several different types of mortgages on the market. The table below describes each one alongside its pros and cons:
|Fixed Rate Mortgage||Provide a known, unchanging loan payment amount for the life of the loan. If rates increase, the loan interest rate stays the same. If rates drop, the loan could be refinanced at a lower rate.||Rates associated with them will be higher than initial rates on ARM mortgages.|
|Adjustable Rate Mortgage (ARM)||ARM loans have lower initial interest rates, and therefore monthly payments, than fixed rate loans.||Borrower can have their rate adjusted substantially higher than what they initially started with, and in some cases this makes the mortgage payments unaffordable.|
|Home Equity Loan||Sometimes they have offers of introductory rates that provide a lower initial rate for a set period of time before the regular interest rate is applied.||Generally have much higher interest rates than those of regular home loans. Additionally, they are usually limited to a loan-to-value ratio (the total borrowed amount vs. the value of the home) of 80%.|
|Reverse Mortgage||They do not have to be repaid until the property is vacated, either through moving or death, but there are no prepayment penalties.||Very high costs associated with them, relative to other types of loans. They are also limited to those who meet the age requirements.|
How Much Home can You Afford?
When entering the market for home buying, one of the first questions you have to ask yourself is, “How much home can I afford?” Unless you’re purchasing your home with all cash, you will be need a mortgage lender. There are a handful of considerations that will come into play.
How Much You can Borrow
The amount of money a lender will make available for a loan to you will be based on your housing payment. Housing payments are calculated with the following factors in mind:
Interest rate—the baseline market rate is set by the Federal Reserve and your specific rate is dependent upon your credit score.
Length of time—number of years the loan will last, typically 15 or 30.
Down payment—how much money you pay towards the principal up front.
Taxes—total amount of taxes owed to governmental entities.
Insurance—insurance payments for the home, including Private Mortgage Insurance (PMI) where applicable.
Most lenders will not allow you to borrow any more than 28% of your total income. Additionally, they look at your total debt relative to your income and generally try not to exceed 36% in total. If you have any outstanding credit card payments, these will count towards your debt.
What are the Upfront Costs?
Not everyone remembers that there are a lot of costs associated before the home loan is finalized at closing. Below are some that you should consider:
Mortgage application fees—fees charged by the lender such as origination fees, appraisal, and underwriting fees.
Earnest money—money used to secure the contract
Closing costs—usually ranging from 2%-5% of the loan total, these may include application fees, buying down mortgage points, attorney costs, any inspections, surveys, and appraisals, insurance for title and title search, and recording fees.
What are the Ongoing Costs?
Like purchasing a car, purchasing a home requires owners to keep up with the home and all its associated costs over time. Here are some ongoing costs to consider:
Private mortgage insurance (PMI)—insurance for when the down payment is less than 20%. Normally part of monthly payments.
Homeowners insurance—general home insurance that will typically be paid in the monthly payments for the home.
Utilities—things like water, electric, trash, etc.
Repairs—ongoing maintenance of the home
Property taxes—governmental property taxes that can vary widely by area.
Homeowners association (HOA) fees—fees that can be assessed if the property is part of a HOA.
Despite the steep upfront and ongoing costs associated with home buying, it makes more financial sense to buy rather than rent in the vast majority of states in the US. Once you’ve made the calculations and decided to buy, it’s important to know what types of loans are available and where to turn to actually get the loan you’ll need.
Home Loan Types
Home loans can be issued by banks or other lenders. The types of loans available come in several different categories.
- Federal Housing Administration (FHA): These loans are insured by the U.S. Government through the Federal Housing Administration (part of the Department of Housing and Urban Development). FHA loans include special considerations for first time home buyers, for example putting as little as 3.5% down, and they also apply to conventional loans. In order to qualify for FHA consideration, you must meet the following criteria:
FICO score of 580 to qualify for 3.5%, otherwise you will need 10% down.
Steady employment history over two years.
Valid Social Security number and lawful residence in the U.S.
Be able to pay the 3.5% down, or receive it as a gift from a family member.
Must be your primary residence.
Receive approval from an FHA-approved appraiser.
Front end ratio (mortgage payment plus any HOA fees, taxes, mortgage insurance, and home insurance) must be less than 31%, with no higher than 40%, of gross income. Anything higher than 31% requires additional justification from the lender.
Back end ratio (mortgage plus any other monthly debt) must be less than 43% of gross income. Up to 50% is allowed, but the lender will be required to provide additional justification.
Borrowers must be two or more years out of bankruptcy, with extenuating circumstances allowable on a situational basis.
Borrowers must be three or more years out of foreclosure, with extenuating circumstances allowable on a situational basis.
Additionally, FHA loans have limits up to $729,750 for 3.5% down and $625,000 for conventional financing.
- Veterans Affairs (VA): VA loans are specific to members of the military, including veterans, reservists, and National Guard, as well as spouses of members who died on active duty, or as a result of service-connected disability. In order to qualify, you must meet these additional requirements:
Must be in service for six months for active duty, or six years for National Guard and reservists, unless called up for active duty, in which case they are eligible after 181 days.
Borrowers must get a Certificate of Eligibility (COE).
VA loans have some substantial advantages over regular loans including:
No down payment.
Mortgage insurance requirement is waived.
Funding fees are typically lower than conventional loans.
Credit score is not required, however, some lenders will have internal requirements, typically of 620 FICO minimum.
If the borrower begins to struggle with the loan, the VA can negotiate with the lender on behalf of the borrower.
- Conventional: Conventional loans are those that lenders retain in their own portfolio of mortgages and not sold off like government-sponsored loans such as the VA or FHA loans. Conventional loan requirements are up to the individual lender’s discretion. Those that match the guidelines set by the FHA are known as “conforming” and those that do not are “non-conforming.” Their requirements generally include:
20% down payment, though 5%-10% may be available.
Available in fixed rate or adjustable rate.
Will typically require a minimum 620 FICO score, but you’ll need 740 for a good interest rate.
Generally cheaper by foregoing mortgage insurance premiums.
Can be used to purchase investment properties and second homes.
- Jumbo: A subset of conventional loans, jumbo loans are simply those above $625,000. These often come with stricter requirements in terms of credit score and money down, as well as higher interest rates.
What to Expect in the Process (Time Frames)
Once you’ve done all of your research and decided you can afford the loan, and figured out what type you want to apply for, it’s time to purchase a home. Here is a timeline of how you can expect the events to play out:
- Before shopping around: 5-7 days
Pre-approval letter: You’ll want to obtain a pre-approval letter from a qualified lender before making any offers on a home. Unless you’re paying cash, most sellers will not accept an offer without one. Lenders will require you to provide basic information such as income, debts, and expected purchase price range.
Select a realtor: Family and friends provide a great resource for realtors. You can also look up ones in your area through the National Association of Realtors.
- Finding a home: 2 - 26 weeks
Be prepared to provide your realtor with your preferences in a home including(but not limited to):
Searching for a home may take as long as 6 months before settling on a property. Your flexibility should be based on whether the current market is a buyer’s or sellers’ market, the urgency of your need, as well as the number of options available. Take the time to view enough homes in the area to have a good selection. Note that most lenders will have a time limit on how long your pre-approved interest rate is good for. Sometimes they will extend the “lock” for a fee.
- Placing an offer: 5-10 days
Your realtor will be the one placing the offer with the seller. They will normally submit it along with any conditions and an escrow amount that shows your serious about the purchase. The amount in escrow varies but usually is a few thousand dollars. Once the seller receives the offer they will usually have a few days to respond.
When a seller accepts the offer, the money in escrow will be used towards the closing of the home. You will only get this money back if the sale falls through due to the seller walking away from the sale or the property failing to meet your offer criteria (such as passing a home inspection). Typically, if you walk away from the deal for any other reason the amount in escrow goes to the seller.
- Home inspection & processing: 5-10 days
Once everyone agrees to the deal, the home inspection begins. This gives you an opportunity to ensure that the property doesn’t have any defects that you don’t know about. During this same period, your lender will begin the formal processing of your loan application. You’ll likely be asked to provide additional documentation such as pay stubs, tax filings, bank statements, and anything else that shows your incomes and debts.
- Appraisal & title search: 7-21 days
During this time the lender will hire an appraiser to come to the property and do an appraisal. This ensures the price is similar to those with similar home values. They’ll also hire a title company to perform a search on the property’s title for any issues. They’ll look for things such as claims, liens, legal actions, or encumbrances on the property.
- Closing date: 7-14 Days
The day finally comes when you sign all the paperwork to buy the home. You’ll be given a time and location where you and the seller will meet together or separately to sign all the closing paperwork. At closing, you’ll need to provide all the necessary funds for closing costs as well as the down payment.
Quick Fact: The total time it takes from offer acceptance to closing is typically 30 days.
Mortgage Shopping Tips
When you’re ready to shop around for a mortgage, here are a few tips to get the right deal for you:
- Talk to multiple lenders: Many people start and end with the bank they have a checking account with. Take some time to look at a few lenders, both through online searches and referrals. Your realtor should have a few options for you to consider as well.
- Compare the costs: Mortgage costs come down to two primary components—your interest rate and closing costs. The majority of the time, lenders will have a 3rd party service the loan, so it’s not really necessary to consider the service of the lender beyond purchasing the home.
- Get pre-approved: Since you’ll need a preapproval letter for making an offer, make sure you have this in hand from an approved lender before you start looking at homes.
- Check reviews: Spend time online and speaking with people who have worked with the lender to get an idea of how easy they are to work with. Some lenders treat you like a number, having you submit the same paperwork over and over; others work with you to quickly and efficiently close your loan.
Frequently Asked Questions
- What is the difference between being pre-approved and being pre-qualified?
Being pre-qualified means that a lender obtained basic information from you that you would qualify for a loan program. Pre-approved means that the lender has collected and verified all information needed for loan underwriting and approval.
- What’s included in closing costs?
Closing costs will include fees such as appraisal, title insurance, attorney fees, prepaid interest, document and loan origination fees. In total, these will range anywhere from 2-5% of the purchase price. This does not include any down payment.
- If a home fails inspection will I lose my escrow?
Generally, you will not lose your escrow if the home fails inspection. Most realtors submit an offer to the seller that is contingent upon the property passing a home inspection.
- Do I have to pay PMI?
PMI may be required if you put down less than 20% of the value of the home.
- Will my loan be an FHA loan?
That depends on what type of loan you get. If you’re getting a first-time homebuyer loan then you will likely have a FHA loan. If you’re purchasing a second home you will not be able to obtain a FHA loan.
- What are the the FHA requirements?
According to the FHA website you will need:
A credit score > 580
Down payment of at least 3.5%
Debt to income ratio < 43%
Private mortgage insurance
Based on a 30-Year Fixed rate mortgage monthly payment for a $200,000 loan at 4.5%