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Most people need a little help buying a home. A mortgage allows you to get into a home without having to provide the entire purchase price in cash upfront. Instead, you can borrow the money you need and make monthly payments.
“A mortgage gives you the ability to keep savings in your pocket and make payments on the house,” explains Michelle Velez, producing branch manager at Supreme Lending in San Mateo, Calif. Even better, “in most cases, the mortgage interest is tax-deductible.”
What it takes to qualify
Lenders typically consider three main factors when deciding whether you can qualify for a mortgage and, if so, how much you can borrow. These factors are your credit reputation, capacity and collateral, sometimes called “the three Cs.”
Credit primarily refers to whether you usually make your monthly payments for your credit cards, auto loan, student loans and any other debts you may have on time. If you haven’t missed a payment, you may have good credit. If you often make late payments or your credit cards are perpetually maxed out, your credit may need a little work. Having good credit can help you qualify for a mortgage and save money when you buy a home.
Capacity is usually referred to as your debt to income ratio, or DTI, and is meant to figure out whether you’re able to make monthly mortgage payments. Your capacity may depend on the type of loan you want, how much cash you have and how much of your income you need to set aside every month for your car loan, student loans, credit cards and other debts. Lenders consider all of your various financial obligations because they want to make sure you have the means to take on a mortgage.
Collateral refers to the type of home you want to buy (e.g., a house or condominium), how big of a down payment you can make, and whether you plan to live in the home or use it as a vacation or rental home.
Lenders may also look at an additional “C” — your capital (also called “cash reserves”) — to determine how much money you have readily available to help pay the mortgage.
How to get pre-approved
Before applying for a mortgage, you may want to get pre-qualified or pre-approved.
These terms are often used interchangeably, but technically, they have different meanings.
Pre-qualification typically involves a preliminary screening that determines how much you may be approved to borrow. This screening is usually based mainly on your credit and basic financial information you provide, Velez explains.
Pre-approval usually goes further. For this step, the lender typically looks at some documentation of your financial situation. Lenders handle this process differently, so the specifics of what you’ll be asked could vary from lender to lender.
Documents you might have to provide either for preapproval or later in the loan process include:
- Driver’s license or passport
- Bank statements
- Investment or retirement account statements
- W-2 forms from the past two years
- Schedule K-1 (Form 1065) tax form, if you’re self-employed
- Income tax returns
- Divorce decree, if you want to use alimony or child support you receive as income to qualify
Generally speaking, a pre-approval is better than a pre-qualification because a pre-approval gives you a better idea of how much you can borrow and puts you further through the mortgage process.
A pre-approval also may make a better impression on the home seller when you make an offer. Some sellers and real estate agents may not consider you a serious buyer without a lender’s pre-approval.
Once you’ve been pre-qualified or pre-approved, the lender may give you a letter that shows how much you might be able to borrow and what else you’ll need to do to get the loan you want.
Keep in mind that just because you can borrow a certain amount doesn’t mean you should borrow that much. Think about your budget and stick with a loan amount and payment that fit comfortably with your other financial obligations.
The down payment decision
Most buyers pay part of their home’s purchase price in cash. This is known as a down payment, and it can be expressed as a dollar amount or percentage of the total price. For example, $25,000 would be a 10 percent down payment for a $250,000 home. If the home cost $500,000, $25,000 would be a 5 percent down payment.
Your down payment amount will likely depend on how much cash you have, whether you’ll get a gift (e.g., from your parents) and the type of loan you want. Most states and some cities offer down payment assistance for home buyers who meet certain requirements.
If you make a larger down payment, your monthly payment may be smaller and you’ll start out with more equity (i.e., share of ownership) in your home. Equity can be important if you want to borrow more later on, or if you decide to sell your home and don’t want to pay the costs out of pocket.
If you make a smaller down payment, you won’t have to save as much to buy a home and you might have more cash to pay for home improvements after you move in.
Keep in mind that if your down payment is less than 20 percent of your home’s purchase price, you might have to pay for mortgage insurance, which typically costs 0.5 to 1 percent of the entire loan amount on an annual basis. Mortgage insurance protects your lender if you don’t repay your loan.
“It allows the consumer to come in with less of a down payment,” Velez says.
Mortgage insurance comes in two types. Private mortgage insurance (PMI) comes from private companies. Government mortgage insurance comes from federal government agencies. If you need mortgage insurance, you should discuss with your lender which type makes sense for you.
Buying a home involves making a lot of important financial decisions. Rather than try to figure out all the complexities on your own, it’s best to connect with a reputable mortgage lender who can explain your options and help you decide which mortgage is a good fit for your personal situation.