If you’re thinking about buying a house, you likely need a mortgage or a loan to buy the house. A mortgage loan is a secured loan that helps you buy one of the largest investments in your lifetime.
The process isn’t as overwhelming as most people think and there are many options for buyers in any situation. Keep reading to learn all about mortgages, how they work, and how you can get approved for one.
What is a Mortgage Loan?
A mortgage loan is a loan secured by real estate property. When you buy a home with mortgage financing, your home is the collateral. In other words, if you can’t make your payments for too long, the bank will repossess your home, selling it to make back the money they lost.
A mortgage is the only way to finance the purchase of a property because of its high cost and the risk involved. Lenders have a strict underwriting policy they use to determine who qualifies.
How Does a Home Loan Work?
When you borrow money to buy a home, you need a down payment. A down payment is a portion of the cost of a home that is paid upfront. The more money you put down on the house, the easier it is to get approved. Lenders call this ‘skin in the game.’ You are investing your own money in the home. This makes you more likely to make your payments on time or you risk losing the money you invested.
Principal and Interest
The difference between the home’s sales price and your down payment is the amount you borrow or the principal balance.
You’ll pay interest on the balance borrowed based on the type of home loan you borrow.
Here are the options:
Fixed-rate loan – A fixed-rate loan has one interest rate. You lock in the rate before you close on the loan and that’s the rate for the life of the loan. If you borrow a 30-year loan, your rate won’t change for 30 years unless you refinance it.
Adjustable-rate loan – An ARM has an introductory interest rate that is fixed for 3 – 5 years and is adjusted according to the index it’s tied to. For example, a rate could be tied to the Prime index. Each year your mortgage rate would adjust to the Prime rate plus a predetermined margin the lender set.
You will also choose a loan term. This is how long you have to pay back the loan and how your loan is amortized or broken up.
Most first-time homebuyers take a 30-year term, but there are also 10, 15, 20, and 25-year terms available. The shorter the term, the higher your mortgage payment is because you have less time to pay it off. However, you’ll likely have a lower interest rate because there’s less risk for the bank. After all, you’ll pay the loan off faster.
If you put less than 20% down on a home or you borrow a government loan (FHA or USDA loan), you will pay mortgage insurance. This is a small premium you pay monthly to have the loan. It protects the lender when you cannot make your payments and could last for the life of the loan for government loans or be canceled when you owe less than 80% of the property’s value for non-government loans.
How to Get Approved for a Home Loan
It’s not as hard as it seems to get approved for a home loan. If you have decent credit, stable income, and manageable debts, you could be a good candidate.
Here’s how to get approved.
Check your Credit
Your credit score is the first thing lenders look at when you apply for a mortgage loan.
Try to avoid any late payments (any payments over 30 days late would need to be reported to the credit bureau) or overextended credit. Ideally, any credit card balances shouldn’t exceed 30% of your total credit line, and you should have a decent mix of credit cards (revolving debt) and installment debt (car loans, student loans, etc.).
-> Read more: What Credit Score do you Need for a Mortgage?
Assess your Debt-to-Income Ratio
Your debt-to-income ratio compares your monthly debt obligations to your gross monthly income (income before taxes).
Ideally, your DTI shouldn’t exceed 43% with the new mortgage payment included. Anything higher than that makes you a high risk of default and less likely to get approved.
Included in your debt ratio are any debts that report on your credit report, such as:
Minimum credit card payments
Student loan payments
Car loan payments
Personal loan payments
Make Sure you Have A Stable Income and Employment
It’s best if you have a stable income and employment for the last 2 years. If you changed jobs in that time, it helps if it was in the same industry and if you didn’t have any employment gaps.
If you recently graduated college or changed careers, you can prove your ability to succeed in the industry by providing proof of your education or training that led to the new career path if you have less than a 2-year history.
Find a Home Worth its Sales Price
Lenders will order an appraisal on the property you purchase. An appraisal is a professional report about the property’s fair market value based on the recent sales in the area and the home’s features/conditions.
A home must be worth at least as much as you offered to pay for your mortgage loan to get approved. If it’s not, you might be able to buy it, but you will pay the difference between the sales price and the loan amount in cash upfront.
Knowing how much you can afford is crucial when it comes to purchasing a home. Work on your qualifying factors to get a mortgage loan and then get pre-approved to see what you can afford.
A home loan is the largest loan you’ll borrow in your lifetime. Choose the loan wisely to ensure you get the terms you can afford and that will cost you the least in the end.