A First Time Home Buyer's Guide to Getting a Mortgage

A First Time Home Buyer's Guide to Getting a Mortgage

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Buying a home is a major life milestone that deserves to be celebrated. But there's no question that it can also be stressful and intimidating. After all, most of us never learned how to take out a mortgage, compare loan options, save for a down payment, or budget for closing costs. Plus, the mortgage process brings with it a whole new set of vocabulary words, complexities and nuances. So let's break it down into some FAQs. Consider this your ultimate guide to the mortgage process—what to know, what to avoid, and exactly how to manage buying your first home.

What is a mortgage?

Since most of us can't afford to pay cash upfront for a home worth hundreds of thousands of dollars, we have to take out a mortgage, which is a loan on our home. We put down some money upfront, and the bank lends us the rest of the money we need to buy our house. In return, we make monthly payments back to the bank over the life of the loan, plus interest. Our home then becomes collateral, meaning if we stop making loan payments, the bank has the right to take possession of our property. In other words, the bank can foreclose on it. That's a mortgage in a nutshell!

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What credit score do I need to qualify for a mortgage?

A mortgage is a large loan, so the lender has to be comfortable that you'll be able to pay them back. That's where your credit score comes in. If you have a credit score lower than 620, you may have a harder time securing a mortgage, or you'll have to pay a higher interest rate to compensate the bank for the risk. If you have a credit score in the mid-700s or higher, you won't have a problem getting a mortgage, and you'll get optimal interest rate pricing. So how do you find out your credit score? Many credit card companies offer cardholders access to their scores. If yours doesn't, Credit Karma is a great app that will help you track and monitor your score for free.

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How much money should I put down?

The baseline down payment for a mortgage is 20% of the price of the home. But very few people actually have enough cash on hand to meet this 20% threshold. So how does home buying become accessible to the average person? The good news is that many lenders will allow you to put as little as 5% or 10% down towards your home. However, they will charge you private mortgage insurance (PMI) to account for the higher risk associated with your loan. This amount can vary from 0.5% to 1% of your loan amount per year. But you don’t have to pay mortgage insurance forever! Once your loan-to-value ratio reaches the 80% mark, your lender will let the PMI go.

Let’s see how all of this works in real life. Let’s say you want to buy a $400,000 home, but you only have $40,000 to put down, or 10% of the purchase price. That means your loan amount will be $360,000, or 90% of the purchase price (loan- to-value ratio). In this case, you will pay PMI until you have built up enough equity so that your loan amount drops to 80% of the home value, or $320,000. So once you pay an additional $40,000 of loan principal, you are free from PMI.

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Fixed vs. Adjustable Rate Mortgages: What's the difference?

There are a few different types of mortgages you can choose from that vary in interest rate, structure and term. One of the first decisions you'll have to make is whether you want a fixed rate or an adjustable rate mortgage. Here's the difference:

Fixed Rate Mortgage

A fixed rate mortgage means the interest rate stays the same (“fixed”) for the entire loan term. So if you have a 30-year mortgage at a 4.5% interest rate, you know exactly what your principal and interest payments will be every month for the next 30 years.

  • Pros: No surprises! Since your interest rate is fixed, you know with certainty what your payments will look like over the term of the loan.
  • Cons: The interest rate on a fixed mortgage may be higher than the interest rate for other mortgage options. That’s the trade-off for certainty!

Adjustable Rate Mortgage (ARM)

An adjustable rate mortgage means that the interest rate floats ("adjustable") after a certain period of time. For example, if you choose a 5/1 ARM, your interest rate will stay fixed for the first 5 years and then adjust every 1 year after that until your 30-year term is up (assuming you choose a 30-year term). With a 7/1 ARM, your rate is fixed for 7 years and then adjusts every 1 year for the remaining term. With a 10/1 ARM...I think you get the idea. The beginning interest rate on an ARM is lower than the rate on a fixed rate mortgage, but it could end up higher during the adjustable period.

  • Pros: Lower interest rate than a fixed rate mortgage for the first 5, 7 or 10 years (depending what loan you choose).
  • Cons: You can't control where the interest rate goes after the fixed period, and you could end up paying significantly more in interest expense.
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What type of mortgage is right for me?

If you know you are not staying in your home for more than 5 years, then a 5/1 ARM could be a great option. You'll pay a low interest rate for the first 5 years, and when it's time for the rate to adjust, you'll already be out of the house anyway. If your timeline is closer to 7-10 years, then you should consider a 7/1 ARM or a 10/1 ARM. (Chris and I chose a 7/1 ARM).

If you envision yourself staying in this home for a longer period of time, I would consider a fixed rate mortgage so you don't have to deal with any negative surprises. You'll know exactly what your monthly payment will be for the next 15, 20, or 30 years (depending on the term you choose). A 30-year fixed rate mortgage is the most popular mortgage loan.

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What are mortgage points, and should I pay them to lower my interest rate?

Your lender may offer you a lower interest rate in exchange for paying extra fees at closing. These fees are known as "mortgage points" or "discount points." One point is 1% of the mortgage loan. A quarter point is 0.25% of the mortgage loan. You get it. Basically, you are paying some extra cash upfront in exchange for a lower interest rate over the life of the loan.

Sometimes it makes sense to pay points, and sometimes it doesn't. It all depends on:

  • How many points the lender is charging.
  • How much they are willing to lower the interest rate in exchange for those points.
  • How long you are planning to stay in the house.

Let's use our previous example of a $360,000 mortgage loan. Let's say the lender offers to lower the interest rate from 4.5% to 4.0% in exchange for 1 point, or $3,600 upfront. We have to make sure that we will be in the home long enough to recoup the benefits of the lower interest rate. Basically, we want to make sure the payback period on our cash upfront makes sense for us. This mortgage points calculator allows you to plug in all of your data and will determine the breakeven period on your points. In this case, it's 3.4 years. So if we plan to be in the house longer than that, it makes sense to pay the points.

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What is an FHA mortgage loan, and do I qualify?

An FHA loan is a mortgage offered to first-time home buyers that is insured by the Federal Housing Administration (FHA), a government agency, and issued by an FHA-approved lender. These mortgages are designed for people with low-to-moderate incomes and have more lax requirements when it comes to credit scores and down payments. You can generally be approved for an FHA loan with a credit score of 580, while only putting 3.5% down.

Since the FHA is insuring the loan, the borrower has to pay those insurance premiums. You will have to pay an upfront and annual mortgage insurance premium with an FHA loan. The upfront premium is 1.75% of the loan, while the annual premium (actually paid monthly) is 0.45% to 1.05% of the loan. The difference between FHA mortgage insurance and private mortgage insurance is that PMI will go away once you reach a certain level of equity. However, you have to pay FHA insurance for the life of the mortgage, no matter how much you pay down.

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What are the mortgage closing costs?

One of the biggest mistakes people make in buying a home is forgetting about closing costs. When you secure a mortgage, a lot of behind-the-scenes work happens with the lender, the appraiser, the title company, attorneys, the state, the insurance company, etc. All of these groups have to get compensated, and that money usually changes hands at closing when you deliver your final down payment. Closing costs are comprised of things like bank fees, title insurance, escrow fees, credit report costs, and all kinds of document preparation and legal fees.

Closing costs can range in magnitude from 2-5% of your loan amount. Using the prior example of a $360,000 mortgage loan, your closing costs could be up to $18,000!

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How much house can I afford?

Let me make this very clear: Just because you can afford the minimum down payment does NOT mean you can afford the house or the mortgage.

Calculating the monthly payment on your home is not as easy as dividing the mortgage loan amount by the term of the loan and adding interest. You also have to account for monthly payments for private mortgage insurance (if your down payment is less than 20%), homeowner’s insurance, property taxes, and maintenance costs. Gone are the days when you can call up your landlord and have your air conditioning fixed for free within 48 hours. Additionally, closing costs can leave a serious hole in your wallet upfront.

This home affordability calculator will give you a ballpark idea of what your monthly payment will look like and whether you can afford it.

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How long should I stay in my home?

Because of the closing costs associated with a mortgage, it usually doesn’t make sense to stay in your home for any less than 3 years. The longer you’re in your home, the more months you can theoretically stretch your closing costs. If you buy a house and then sell it quickly, you will pay a lot in fees, and these can become a burden and outweigh any equity you built in the house during that short period of time. So if your life is more transient, renting is probably the way to go right now.

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What does the mortgage process look like?

Now that you have a good idea for what a mortgage is, how much you can afford, and what type of loan best fits your scenario, let’s dive into the process of actually getting a mortgage.

1. Get pre-approved for a mortgage. You can complete this step before you even start looking at homes. This will give you an idea of how much the bank is willing to loan you, so you can look at homes in the right price range. Sellers will also treat you as a more serious buyer if you are pre-approved. You do NOT have to ultimately choose the same lender that pre-approved you.

2. Decide what type of loan is best for you. Conventional or FHA? Fixed or Adjustable Rate? 20-year or 30-year? Reference the information above for a refresher.

3. Go mortgage shopping! Do your research, and get estimates from multiple mortgage lenders. It's best to get at least three estimates, and don't be afraid to let them compete for your business. You can also hire a mortgage broker to do the shopping for you, but they will charge you a fee.

4. Submit your mortgage application. Once you have chosen your lender, you'll need to officially apply for the mortgage (even if you're pre-approved) and provide all kinds of personal data including W-2 forms, tax returns, pay stubs, and bank statements.

5. Navigate the underwriting process. After you submit your mortgage application, the lender will do their diligence to determine whether you are a eligible for the loan. They will pull credit reports, perform an appraisal on the house, and review all of your documentation. Try not to take out any new debt, switch jobs, or do anything that might harm your credit score during this time. And be as responsive as possible if your lender requests any new documents to keep the process moving quickly.

6. Prepare for closing. Once you're approved, there are a few last-minute things you'll need to do ahead of closing. Do a final home walk-through, make sure your homeowner's insurance is lined up, and prepare all of your funds for closing. You will receive a closing disclosure from the lender three days before closing, which will detail exactly the cash due at close. Get your cashier's check or wires prepped for closing day!

7. Closing day! Head on over to the title company, sign your life away (just kidding), and pick up your keys. Congratulations, homeowner!

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