Eager to purchase the home of your dreams and start building equity for the future in this thriving housing market? For many, shopping for a home is the fun part, but obtaining a mortgage is another story. Whether you know a little about the mortgage process or have no idea how to get a home loan, don’t fret. This guide to getting a mortgage breaks down every step of the process so you’ll know what to expect.
Step 1: Strengthen your credit
A strong credit score demonstrates to mortgage lenders that you can responsibly manage your debt. So, you’re likely to get approved for a mortgage with a competitive interest rate if you have good or excellent credit. If your credit score is on the lower side, you could still get a loan, but you’ll likely pay more in interest.
“Having a strong credit history and credit score is important because it means you can qualify for favorable rates and terms when applying for a loan,” says Rod Griffin, senior director of Public Education and Advocacy for Experian, one of the three major credit reporting agencies.
To improve your credit before applying for your mortgage, Griffin recommends these tips:
- Make all payments on time and reduce your credit card balances. Your payment history on your report goes back two years or longer, so start now if you can.
- Bring any past-due accounts current, if possible.
- Review your credit reports for free at AnnualCreditReport.com. Check for errors on your credit reports, and contact the reporting bureau immediately if you spot any. An error might be a paid-off loan that hasn’t been recorded as such, or an incorrect address, for example.
- Check your credit score (often available free from your credit card or bank) at least three to six months before applying for a mortgage. When you review your score, you’ll see a list of the top factors impacting it, which can tell you what changes to make to get your credit in shape, if needed.
Follow these steps to help boost your score and nab a lower interest rate on a home loan.
Step 2: Know what you can afford
It’s fun to fantasize about a dream home with every imaginable bell and whistle, but it’s much more practical to only purchase what you can reasonably afford.
“Most analysts believe you should not spend more than 30 percent of your gross monthly income on home-related costs,” says Katsiaryna Bardos, associate professor of finance at Fairfield University in Fairfield, Connecticut. This includes home maintenance and utilities.
Bardos says one way to determine how much you can afford is to calculate your debt-to-income ratio (DTI). This is calculated by summing up all of your monthly debt payments and dividing that figure by your gross monthly income.
“Fannie Mae and Freddie Mac loans accept a maximum DTI ratio of 45 percent. If your ratio is higher than that, you might want to wait to buy a house until you reduce your debt,” Bardos suggests.
Even with the 45 percent threshold, the lower your DTI ratio, the more room you’ll have in your budget for expenses not related to your home. That’s why many financial advisors recommend keeping the ratio closer to 36 percent, if feasible.
Andrea Woroch, a Bakersfield, California-based finance expert, says it’s essential to take into account all your monthly expenses — including food, healthcare and medical costs, childcare, transportation, vacation and entertainment expenses — and other savings goals.
“The last thing you want to do is get locked into a mortgage payment that limits your lifestyle flexibility and keeps you from accomplishing your goals,” Woroch says.
You can determine what you can afford by using Bankrate’s calculator, which factors in your income, monthly obligations, estimated down payment and other details of your mortgage, including the interest rate and homeowners insurance and property taxes.
Step 3: Build your savings
Your first savings goal should be your down payment.
“Saving for a down payment is crucial so that you can put the most money down — preferably 20 percent to reduce your mortgage loan, qualify for a better interest rate and avoid having to pay private mortgage insurance,” Woroch explains.
It’s equally important to build up your reserves. One general rule of thumb is to have the equivalent of roughly six months’ worth of mortgage payments in a savings account, even after you fork over the down payment. This can help safeguard you if you lose your job, for example, or something else unexpected happens.
Also, don’t forget closing costs, which are the fees you’ll pay to finalize the mortgage. They typically run between 2 percent to 5 percent of the loan’s principal. They don’t include escrow payments, either, which are a separate expense. Generally, you’ll also need around 3 percent of the home’s price for annual maintenance and repair costs.