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Most starry-eyed would-be home buyers go from watching HGTV to browsing listings online, and then finding a real estate agent to serve as a tour guide for them through potential properties.
But they would be better off first knowing if they can get a mortgage and for what amount.
They can start by checking their credit scores for a small fee at www.myfico.com and reviewing their raw credit data for errors at annualcreditreport.com (one free check per credit bureau per year).
Assuming their credit status is accurate and in decent shape, then it’s off to see a lender for a preliminary conversation and assessment. It’s probably easier if they start with one at their current bank or credit union.
Once they’re ready to actually apply for a mortgage, they may want to shop around at a couple of other nearby institutions, as well as a national lender such as Quicken.
The most important initial question the borrowers should ask of a lender is “How much can we borrow?” The final answer depends on the borrowers and the lender, but the general rule of thumb is that the total monthly costs of the home (mortgage payment, insurance, and property taxes) should not exceed 28 percent of the borrowers’ gross monthly income.
Another guideline is that the monthly cost of the home added to the borrowers’ total monthly debt payments shouldn’t exceed 40 percent of borrowers’ gross monthly income.
But the borrowers might not want to get the maximum mortgage amount the lender will approve, especially if their earnings are volatile or one member of the couple might soon choose to leave the workforce to become a stay-at-home parent.
The standard minimum amount that lenders like the borrowers to have is 20 percent of the purchase price of the home. However, certain borrowers may not necessarily need or want to put that much down.
The lender should be able to suggest any low down-payment programs for which the borrowers may qualify, similar to the ones offered by the Federal Housing Administration or the Veteran’s Administration.
If the down payment is less than 20 percent of the purchase price, the borrowers may have to obtain private mortgage insurance, which will then be added to their monthly housing costs.
But that relatively small expense could be worth paying if it allows the homebuyers to get into a house sooner rather than later and keep any leftover cash on-hand for moving expenses, home improvements or emergencies.
When the homeowners’ equity eventually exceeds 20 percent of the home’s value, the borrowers can apply to have the PMI payments canceled.
Once the borrowers know how much money they might need to save, they can swing into “cash accumulation” mode.
The lender may direct the would-be borrowers to use extra cash to pay down or eliminate their other debt(s). But if the current debt level won’t hurt the borrowers’ mortgage prospects, they should reduce debt payments down to the bare minimum, especially on low-interest loans, such as student debt. They may also want to temporarily reduce or eliminate contributions to retirement accounts. Finally, they should look at their spending and see what other expenses can be sacrificed, at least until they move into their new home.
If the borrowers’ parents or other family members are willing to help with the down payment, that money should be transferred to the borrowers asap, so that it can “age” under the borrowers’ ownership for at least a few months. The lender may require that the generous family members sign a letter attesting that the assistance is a gift—not a loan that needs to be repaid.
If the borrowers plan to purchase a new home within a year or so, any funds that are earmarked for a down payment should be invested in the safest, most liquid account the borrowers can find—usually a high-yielding money market account or short-term certificate of deposit.
Sensible borrowers will realize that if they get, say, a 15-year mortgage instead of a traditional 30-year loan, their slightly higher monthly mortgage payments could also mean a lower interest rate. They would also pay it off in half the time the 30-year would take, saving tens of thousands of dollars in interest during the process. But they still may be better off getting the longer mortgage with the slightly higher interest rate for several reasons.
First, since mortgage approval is based in part on the proportion of the monthly mortgage payment to the borrowers’ gross monthly income, the lower monthly payment required by the 30-year means that the borrowers are more likely to get approved for the mortgage, and for a higher amount than the 15-year loan would allow.
Second, they can always pay the mortgage off early, usually with little or no penalty. But they are probably better off instead saving any extra money toward retirement, future college expenses or emergencies.
Last but not least, if they take the 30-year mortgage and then make a monthly payment in the amount that would have been required with the 15-year loan, they still will likely pay off the 30-year mortgage in 15 ½ or 16 years. But if interest rates rise, or they need the money for more urgent purposes, they can always lower the monthly payment back down to the more manageable amount associated with the 30-year loan.
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