You’re ready to buy a home. Maybe it will be your first, or maybe it’s one you saw a for-sale sign in front of and instantly fell in love. Maybe you’ve been saving for this big purchase for many years. No matter the circumstance, it’s a big deal, because a home typically is the biggest purchase you’ll ever make. Here, The Motley Fool tells you several things to know about, and ways to prepare, before applying for a mortgage.
Assess your financial big picture
Do you have a lot of debt? If so, is it wise or even possible to add a lot more? Do you have ample cash—for the down payment and to spend on home-buying expenses such as inspections? What about the home you live in now—do you own it, and if so, will you be selling it? Don’t rush into buying a home and taking on a mortgage until you’re sure that you have all your ducks in a row.
Think twice before changing jobs
Changing jobs is not a great thing to do right before you buy a home. That’s because mortgage lenders are going to be handing over a huge chunk of money for your purchase, and they want to feel comfortable that you’re a good risk and that you’ll be able to make the monthly repayments on your debt. One thing they like to see is that you’re well employed, with ample income to cover your mortgage payments (and all of life’s other obligations) and some years at your job, which suggests stability.
Try not to take out other loans
Just as lenders like to know that you are stably employed, they also like to see that you don’t already have a significant debt burden, which you’re looking to add to significantly. If you’re planning to buy a home with a mortgage and you also want to take out a car loan or some other loans—or you plan to charge a major purchase onto a credit card and not pay it off quickly—it would be smart to get the mortgage first. Of course, it’s always best to pay off all credit card bills in full and on time to avoid accumulating costly debt.
Check your credit score
Before getting a mortgage or even shopping for one, it’s also smart to check your credit score. That’s because those with the highest scores get offered the lowest interest rates. You may be able to find your credit score printed on your credit card’s monthly statements. If not, you can buy access to your score—or get it for free. Consider going right to the source, too. At myFICO.com, you can get a one-time copy of your FICO credit score and a credit report from one of the three credit reporting agencies for $20 or scores and reports from all three agencies for about $60.
Understand the components of your credit score
You always can improve your credit score. Knowing the components of a typical FICO credit score (which is the score most widely used by mortgage lenders) and the influence that each has on the score can help you see how to boost your score: payment history accounts for 35 percent; how much you owe 30 percent; length of credit history 15 percent; new credit 10 percent; and other factors, such as your credit mix 10 percent. Clearly, some components are far more influential and important than others.
Increase your credit score by paying bills on time
If paying bills on time hasn’t been a strength of yours, that’s likely reflected in your score, and you can improve your score by changing your ways. Start paying all bills on time, and pay any late bills as soon as you can—because having a bill that’s overdue by two months counts against you more than a bill that’s overdue by one month. Changing your ways won’t cause your score to spike immediately, but every on-time payment will help offset a late one.
Increase your credit score by paying down debts
Paying down debts can help boost your credit score. A good way to measure this is by calculating your “credit utilization” ratio, which reflects the percentage of the total of your credit card credit limits that you owe. The lower the ratio, the happier your would-be lenders will be, as they aren’t eager to let you borrow a hefty sum when you’re already straining against your credit card limits. A high credit utilization ratio can suggest that you’re not in great control of your finances. A good rule of thumb is to aim for a ratio of about 10 percent to 30 percent. One trick to shrink your ratio is to ask for increases in your credit limits. Take care of any collections against you, too, as they will not be helpful to your credit score and lenders don’t like to see outstanding collection accounts.
Protect your credit score by not closing accounts
Never close accounts, especially old ones, right before you apply for a mortgage. Lenders like to see that you have some active and long-lived credit accounts, and closing out an old account or two could ding your credit score, even though it doesn’t reflect you managing your money poorly. If you close out some credit card accounts, you also will lose some of your total credit limit, and can thereby cause your credit utilization ratio to increase.
Increase your credit score by correcting errors in your credit report
You should check not only your credit score, which is a single number, but also your credit report, which can be multiple pages of details on just about all the debt accounts you’ve had and your payment histories for each, among other things. It will show, for example, your various credit card accounts, car loans and previous mortgages, and will note when payments were made late. Each of the three major credit reporting agencies should have a credit report on you, and it’s important to review them (ideally, all of them), looking for any errors. False negative information can depress your credit score needlessly. You can get free copies of your credit reports once a year from each of the main credit reporting agencies at annualcreditreport.com. If you spot errors (such as payments incorrectly listed as having been made late or incorrect sums of debts, each agency has ways for you to go about getting them fixed.
Think about how big of a down payment to make
It’s tempting to aim to pay as little down as possible, but if you have done so and real estate values suddenly head south, it could wipe out whatever equity you’ve built in your home and could leave you “underwater”—owing more on your home loan than the home is worth. That can complicate matters if you need to sell the home. If you make a down payment of less than 20 percent, you also will probably be required to take on an extra loan in the form of private mortgage insurance (PMI), which will increase your monthly payment. A low down payment might result in a higher interest rate, too. On the plus side, though, if you start with less than 20 percent, once your home equity passes 20 percent, you should be able to have your lender cancel the PMI. Making a down payment of 30 percent or more will shrink how much you have to borrow, and thereby, make your monthly payments smaller.
Determine how much house you can afford
You can end up borrowing more than you should for a home you really shouldn’t buy, which could leave you with little financial wiggle room if you encounter unexpected expenses or if your household income drops. One rule of thumb is to spend no more than 25 percent to 30 percent of your gross monthly income on housing (including property taxes and insurance), but for many people, it’s smarter and safer to spend no more than 20 percent on housing. Buying less home than you can afford will give you a margin of safety and help you be able to meet other financial goals, such as saving for retirement or college.
Decide whether a fixed-rate or adjustable-rate mortgage is best for you
If you’re not planning to be in the home long, an ARM can make a lot of sense as it will lock in low rates for a few years. ARMs typically give you a few years at an interest rate that’s more attractive than those for fixed-rate loans, but then the rate starts being adjusted regularly, to reflect prevailing rates. So, with a 5-1 ARM, for example, the initial rate will hold for five years before being adjusted annually. If interest rates are rising, your mortgage rate will rise, too. If you think you’ll be in the home for many years or decades, it can be better to lock in a fixed interest rate for the entire long life of the loan.
Decide whether a 15-year or 30-year mortgage is best for you
You’ll often be offered a lower rate for a shorter-term loan, which can make a 15-year loan seem well worth it, as you’ll pay off your home faster and you’ll pay far less in interest, too. But 15-year loans have significantly higher monthly payments. If you think that will stretch you too thin, consider buying a less costly home or opting for the 30-year loan. Shorter-term loans might be better for those who are closer to retirement and who don’t want to enter retirement with a decade more of mortgage payments to make. Longer-term loans are good for those who want their monthly payments to be low and who don’t mind that they’ll be paying much more in interest.
Gather documents
Before you begin the process of applying for a mortgage, you would do well to start collecting some documents that you’ll have to provide. Here are some that are commonly required:
Recent pay check stubs
Recent bank statements
Recent brokerage account statements
Your tax return from the last year(s)
Your most recent W2 form(s) from your employer(s)
Proof of timely rent payments if you’re a renter
The home sale agreement
An accounting of your income from all sources
A list of all your assets — such as current balances in various accounts
A list of all your debts
Your employment history
Your divorce decree, if you’re divorced
Bankruptcy discharge papers, if you’ve declared bankruptcy
Note: If you’re self-employed, you may have to jump through additional hoops and provide more information, such as profit-and-loss statements. Those borrowing particularly large sums (via “jumbo” loans) often have to provide extra information, too. If you’re buying the home with a spouse or partner, the information above will be needed for both of you.
