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4 Tips For Applying For a Mortgage

Posted on | May 1, 2008 |

Finding a mortgage and buying a home

My wife and I are currently in the process of selling our home, and looking to upgrade our living space. The house we live in now is getting smaller everyday. Personally, I blame the kids - they just keep growing!? I tell my wife that’s because we keep feeding them, but she doesn’t think that’s an option. But I digress..

While the U.S. housing market is not so great for selling, it’s pretty nice for buying. That doesn’t mean we can buy the house of our dreams with no money down, and an interest only mortgage though. That’s the kind of thing that got the market where it is today. Besides, we’ve worked hard to put ourselves on strong financial footing, and we don’t want to take the wrong actions that send us back to square one with a mountain of debt, and no money to pay the bills.

Buying a home is the single biggest investment that most people will ever make. It’s either a huge amount of money that you’re parting with or a huge amount of debt that you are taking on, most likely the latter. It’s a big deal, so it pays to do your homework and get it right. This article is about getting it right, when it comes to applying for a mortgage.

1.) Check Your Credit.

Nobody likes surprises when it comes to money, especially when borrowing large sums of money. Having a good credit score can save you thousands of dollars in interest AND get you a lower monthly payment. If you’re thinking about buying a home years from now, keep your credit in good condition. You’ll want to get your score up to 650 at least, to qualify for the better rates that are available. There are many things you can do to improve your credit score, like paying your bills on time and paying down debt.

If your time frame is much nearer, then you’ll want to check your credit report and credit score at the very least. I suggest AnnualCreditReport.com since it’s free! It’s best to do this at least 3 months before applying for a mortgage; since it will give you time to dispute any discrepancies or false accusations that you may find.

2.) Determine How Much House You Can Afford.

As a general rule of thumb, multiply your total annual income by 2.5 and that will give you a good idea of how much you can comfortably afford. I would guess that most people with a mortgage today, have a mortgage that is at least 4x their income. If you have a mortgage, feel free to leave a comment at the end of this post about it - I’d be very interested to learn where other people are regarding their mortgages. My mortgage is currently 1.75x my annual income, but I was lucky to buy before the housing boom. I don’t know if I could do as well today.

But the key here is that lenders will tell you that you can afford more than 2.5x your income, but this factor will ensure that you can afford your home AND continue to save for the future, without eating cat food.

If you’re looking for a better idea than the general rule of thumb, you should calculate your loan-to-value (LTV) ratio. This is one of the formulas lenders use to determine how much they will lend to you as well as how risky that loan will be for them. To calculate your LTV, divide the loan amount by the value of the property. Rates will likely be significantly higher if this value is greater than 80% (.8). This is where the often talked about 20% down payment factor comes from. Responsible lenders want to know that the property is worth more than they are lending you, in case they can’t collect what you owe them, they can salvage their investment.

The companion ratio to the LTV is the D/I, or debt-to-income, ratio. This is another big factor for lenders. Just like the LTV, your D/I ratio should be as low as possible. Calculate your debt to income by dividing your total monthly debt by your monthly income. A ratio of less than 20% to 30% is considered good, so if your debt-to-income is higher than that - pay down your debt!

3.) Start Small and Increase if Needed.

Just because your prospective lender says they’ll give you 5x your annual salary to buy a house, doesn’t mean it’s the financially smart thing for you to do. Start with low to medium priced houses. If you find it difficult to meet your needs with what’s available in that price range, then gradually work up toward the larger figure. For example, if the bank says they will lend you $300,000 for a new home, but that figure is 4-5x your annual income then start closer to the 2.5x figure ($150,000 - $187,000) and work up to what you think is affordable. If you find that there isn’t anything in that price range, then you should probably go back to saving some more for a bigger down payment, and try again at a later time.

4.) Pick the Right Mortgage.

There are more types of mortgages than there are opinions. Well OK, not really, but sometimes it seems like a close competition. A few of the major types are: Fixed Rate, Adjustable Rate, Short Term and Long Term.

Fixed Rate mortgages are the simplest type. You (the borrower) agree to borrow a specific amount of money and pay the lender a fixed interest rate for the term of the loan. If the interest rate is 5.5% at the time you sign the contract, and 5 years later the rate is 8%, you still pay only 5.5%. Fixed Rate loans are great for the stability that they offer, but may have slightly higher rates in the beginning than an adjustable rate mortgage.

Adjustable Rate mortgages start at a low, teaser rate but will change, or adjust, to the going rate at a fixed period of time in the future. For example, a 5 year adjustable rate loan will start at an initial rate that is lower than other fixed rate mortgages at the time you sign, but will automatically adjust in 5 years time to the going rate. This kind of loan is great when the rates go down, but when rate increase over that 5 year period you can get a nasty increase in your monthly mortgage payment. It’s basically a bet on where you think rates will be in the future. I am not a fan of these loans for most people, though they can be beneficial if conditions are right.

Short Term mortgages are loans for less than 30 year terms. These mortgages typically have lower rates, but higher monthly payments. A 15-year mortgage fits this category.

Long Term mortgages are loans of 30 years or more. Long Term mortgages have higher rates than Short Term mortgages, but they also have lower monthly payments. Because the payments are lower, they tend to be easier to qualify for (they have less impact on your D/I).

Many people recommend getting a 30 year fixed rate, but making at least an extra payment per year. This has the effect of paying off the loan in little more than 20 years, thus giving the borrower the best of both long and short term worlds. The key with this is that your lender must allow for extra payments with no pre-pay penalties, and you have to be disciplined in making those extra payments.

We have already secured approval from a local bank for a 30 year fixed rate with bi-weekly payments and no pre-payment penalty. This will enable us to pay off the loan in about 22 years automatically, or sooner if we have the cash.

Every borrower’s situation is a little different, and there are many opinions on this subject. These are tips I’ve learned from going through the process, but I’m sure there are many more out there. Perhaps you have had some experiences you’d like to share?

Resources:

Mortgage payment and refinance calculators

Search for the best rate mortgage in your area

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Category: Home Buying, Real Estate

Comments

2 Responses to “4 Tips For Applying For a Mortgage”

  1. Can You Live on One Income? | Simple Debt-Free Finance
    February 9th, 2009 @ 12:10 pm

    [...] Save up a sizable down payment to purchase the house, and don’t buy more than you can afford. My wife and I are currently in the process of buying a larger house. Despite the fact that it is a [...]

  2. The Almighty Debt-to-Income Ratio | Simple Debt-Free Finance
    February 16th, 2009 @ 11:26 am

    [...] I stumbled onto a guest post about the Debt-to-Income Ratio over at MoneyNing today. It stuck out because it’s not something I’ve seen blogged about much. In fact, until I saw that post the only time I’d ever seen it referred to in a blog was when I wrote 4 Tips For Applying For a Mortgage. [...]

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