Homeownership can be an excellent long-term financial decision, but there are a few things you need to know before you apply for a mortgage. Among other things, you need to know what your loan options are, how much your loan will really cost, and how to make sure you get the best deal. With that in mind, here are three things you should know before you buy a home and sign on the dotted line.
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Know what a pre-approval is, and why you need one (or several) Before you begin shopping for a home, you should have already spoken with a mortgage lender and obtained a pre-approval. Not to be confused with a pre-qualification, which is just based on information you provide, a pre-approval means that the lender has already checked your credit, verified your income, and has gone through the steps to make sure you'll actually be able to qualify for a home loan.
You don't need to start the mortgage process until you find a home, but a pre-approval letter is an important tool to have for two reasons. First, it lets sellers know that you can afford to buy their home, and are unlikely to run into any financing issues during the closing process. And secondly, it establishes you as a serious homebuyer, and your offer may be taken more seriously than if you haven't been preapproved.
Better yet, you should apply for a mortgage pre-approval with more than one lender in order to obtain the best interest rate possible. Most mortgage lenders offer similar interest rates and fees, but a seemingly minuscule difference in rates can make a big difference over the life of a loan.
For example, when applying for my own mortgage earlier this year, I filled out pre-approval paperwork with two banks and received interest rate offers of 4.00% and 4.10%. On a standard $200,000 30-year mortgage loan, this translates to monthly payments of $955 and $966, respectively. This $11 per month difference may not sound like much, but it adds up to $3,960 over the 30-year life of the loan.
Thanks to a special provision in the FICO credit scoring formula, multiple mortgage inquiries that occur within a short timeframe only count as a single inquiry for scoring purposes so you don't need to worry about too many applications hurting your credit. Whether you apply for one loan or 20, it will have the exact same impact on your credit -- so it pays to shop around.
Know how much you can really affordBefore you attempt to qualify for a mortgage, it's smart to have a good idea of how much you can afford to spend on a home. Some lenders and mortgage programs have different standards, but generally your housing payment alone can be up to 28% of your income (called the front-end ratio) or your entire debt load (called the back-end ratio) can be as much as 36% of your income -- whichever results in the lower mortgage payment.
As an example, consider a homebuyer with a $60,000 annual income ($5,000 monthly) whose other debts add up to $500 per month. 28% of that income translates to $1,400 per month, but 36% comes to $1,800. Subtracting the borrower's other debt produces a back-end total of $1,300 per month, so this is what the maximum allowable payment would be. Using a standard mortgage calculator (like this one) and a 4% interest rate, a $1,300 monthly payment appears to show that our borrower could obtain approval for a $272,000 mortgage.
However, it's important to know that this monthly amount refers to the total housing payment -- including taxes and insurance. These costs vary considerably, but if a particular home comes with $2,500 annual property tax and $1,000 homeowners' insurance bills, the maximum mortgage amount drops considerably to $211,000. Make sure you account for these expenses when determining your budget.
Know your FICO score and how much it can help or hurt youFinally, all prospective homebuyers should know their FICO score, which is the credit scoring model most lenders use when making decisions. Several credit card issuers now offer free FICO scores to their customers, but generally only provide a score from one of the three credit bureaus -- while your lender will see all three.
Also be aware that there are other (older) FICO scoring models widely used by mortgage lenders, which may be slightly different than the scores you see. These mortgage-specific scores can be purchased on myFICO.com, and while they should be close to your main FICO scores, they can be slightly different, and it may be worth the investment to obtain them.
The reason it's so important to know your FICO score is that it helps determine the interest rate you receive. As we've seen already, small differences in interest rates can make a big difference over the life of a mortgage -- and a good credit score can make more than a small difference in the rate you get. These are the current interest rates that can be expected for borrowers in different credit "tiers," and the impact they can have over a 30-year mortgage term.
Rates listed are the national averages, current as of 9/4/2015
My point is that if you are just a few points from the next tier, it may be worth putting your home search on hold for just a few months in order to work on boosting your credit. Large improvements in credit scores can take years, but it can be possible to boost your score by a few points in a short period of time.
The takeawayThe more you know about the mortgage process before you get started, the better positioned you'll be to make your home purchase go smoothly, and to get the absolute best deal possible. After all, negotiating on a home's price is only one piece of the puzzle -- the mortgage determines how much you'll pay over the next few decades, and finding the right one can save you thousands.
The article 3 Things You Need To Know Before Applying For a Mortgage originally appeared on Fool.com.
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