What to Know When Shopping for a Mortgage to Purchase a Home
So, you’re looking to buy your first home, a financial decision that will likely be the biggest you’ll ever make. In order to make an informed decision, you should educate yourself about the mortgage process. There are several steps you should take before you even begin shopping for your new home. This article will break the process into three steps: 1) the pre-application/pre-qualification process; 2) the application, underwriting and approval process; and 3) the closing.
Pre-application / Pre-qualification:
1. Pull your credit report
One of the first things a mortgage broker or lender will do when they receive your loan application is to obtain a copy of your credit report. If there are errors or discrepancies on your report, it could delay your approval process, it could cause you to be viewed as a higher risk resulting in a higher interest rate being charged or it could even cause your loan application to be denied. You can avoid these potential problems and save valuable time by making sure your report is accurate before you begin the mortgage process. If your report is not accurate, you can take the necessary steps to correct the errors so that it doesn’t cause problems during the mortgage process. You are entitled to a free copy of your credit report once every 12 months. To order your free annual credit report from each of the three major credit bureaus (Experian, Equifax and TransUnion) you may call 1-877-322-8228 or visit www.annualcreditreport.com.
2. Understand your debt-to-income ratios and how much you can afford
This is a very important step in order for you to make an informed decision. For a good reference, you can access Ginnie Mae’s Homeownership Mortgage Calculator at www.ginniemae.gov which will be helpful to you in determining the amount of loan you can afford. If your down payment will be less than 20%, it is likely that you will have to pay “private mortgage insurance” which will be included as part of your monthly mortgage payment. The larger the down payment you make, the less money you will need to borrow which will result in a lower monthly payment.
When determining the monthly payment you can afford, you should figure out your “debt-to-income” ratio. This ratio consists of two parts: your housing expense, or front end ratio and your total debt-to-income, or back end ratio. As a general guideline, your housing expense should not exceed 28% of your gross (pre-tax) monthly income. For example, if you earn $4,167 per month ($50,000/year) before taxes, your monthly mortgage payment should not exceed $1,167 ($4,167 x .28). The maximum monthly mortgage payment includes principal and interest, homeowners insurance, property taxes and private mortgage insurance, if applicable.
In addition, your total debt-to-income should not exceed 36% of your gross (pre-tax) monthly income. In this example, your total monthly debt payments, including your proposed mortgage, should not exceed $1,500 ($4,167 monthly pre tax income x .36). Your total debt-to-income ratio includes other recurring debt such as car payments, credit card payments, child support, student loans, and any other similar obligations. Let’s say you have a $350 per month car payment, payments of $150 per month in student loans and minimum monthly payments of $200 in credit card bills. Your total monthly payment for those items equals $700. As we mentioned earlier in this example, your total monthly debt payments should not exceed $1,500. After deducting the $700 in monthly payments for recurring debt, the maximum amount of mortgage payment you would likely qualify for is $800 ($1500 - $700), much less than the $1,167 mortgage payment figured on your front end ratio. As you can see, having substantial monthly debt payments will significantly reduce the amount of mortgage for which you’ll qualify.
While these ratios have been common thresholds that lenders use, lenders have also become creative with qualifying borrowers for loans. Qualifications may be based on lower initial payments that can change at a later date. The initial payment may conform to traditional ratios however, those monthly payments are likely to go up and you could quickly find yourself in a situation where your payment is above these “safe” ratios. This could put you into a risky situation where you may not be able to afford the new payment. The use of adjustable rate mortgages, interest only mortgages, option mortgages and other similar products have all become loan products that allow you to qualify for a larger mortgage than you would have otherwise been approved. There are also certain governmental insured loan programs such as VA or FHA loans that allow for slightly higher ratios. Regardless of the loan you choose, be sure that you completely understand that mortgage product and what the risks are to you if the payment increases.
Although you may ultimately be approved for a loan amount, you are the one who should know best as to whether you will actually be able to afford the payment. Be sure to not to make emotional decisions. Losing your home to foreclosure because you can not afford the payments can quickly turn your dream into a nightmare.
3. Get pre-qualified
After completing the above-mentioned steps, you are now in a very good position to start shopping for a home. Once you find a home and have your offer accepted, you are now ready to begin the application process.
Application, underwriting and approval process:
1. Choosing a lender or broker
Shop around. Visit your bank and speak to a loan officer to see what kinds of loans are available and at what rates they are being offered. Look in the real estate section of the newspaper for the rates that other lenders and brokers are offering. Also, use the power of word-of-mouth. Check with friends and family who have obtained mortgages in the past and ask whether they would recommend the company they did business with. Understand that you have a choice of using the services of either a broker or a lender.
A mortgage lender will lend you the money directly and will make the decision as to whether to approve your mortgage and extend you credit. A lender could be a bank or another company whose business is to make mortgage loans. A lender may have a limited number of loan products to offer you. With a lender, you are not dealing with an intermediary; you are dealing directly with the company who is responsible for making the credit decision on your loan. Lenders also have the ability to act as brokers, so you should be sure to ask what capacity they will be acting in when deciding whether to use their services.
A mortgage broker is an intermediary who can deal with a number of different lenders to obtain your loan. They have the ability to make inquiries to those lenders on your behalf in order to obtain a loan product that best fits your needs. Mortgage brokers also have the ability to work with “wholesale” lenders. Wholesale lenders will only accept applications from a mortgage broker, not directly from a borrower. An experienced broker may also be able to find a lender for you if you have special financing needs or if you can’t find a loan by dealing directly with a lender. Typically, a mortgage broker earns their fees based on the loan amount. They may be paid by you directly and/or they may receive compensation from the lender as a “yield spread premium” for placing the loan with that lender. It is important to keep in mind that although a broker is acting on your behalf, they are not your agent. The terms you are offered may not necessarily be the best terms that may available to you. This is why it’s very important for you to do your homework and compare rates and loan products to insure you’re getting the best deal.
All mortgage brokers and mortgage lenders must be licensed to do business in Connecticut when making mortgage loans to consumers where the proceeds of the loan will be used for personal, family or household purposes. Certain entities, such as banks, are exempt from licensing requirements. You may visit the Department of Banking to see a full list of licensed mortgage lenders and brokers. You can also check with the Department of Banking at 860-240-8299 or 1-800-831-7225 to see if the company you are considering has had any problems or if they have had complaints lodged against them.
2. Understand and choose the type of mortgage that best fits your needs
As was discussed above, make sure you completely understand the type of mortgage you are applying for. Know whether the rate will be fixed or adjustable. In a fixed rate mortgage, the principal and interest portion of your payment is guaranteed to remain the same for the life of the loan. Keep in mind, however, that any increase in taxes or homeowners insurance will cause your monthly payment to increase if those items are escrowed and included as part of your mortgage payment.
An adjustable rate mortgage (“ARM”) is any mortgage where the interest rate can change. Typically, the rate will be fixed for a certain period of time and will then adjust periodically. A common type of ARM is a one year ARM. For this type of product, the rate will remain fixed for one year and will then adjust annually thereafter. Another product is referred to as a 2/28 ARM. With this product, the fixed period is for two years and then will adjust annually thereafter. These are just two examples of the many types of adjustable rate mortgages that are available.
3. Gather documentation and complete the mortgage loan application (form 1003)
You will need to provide the lender or broker with certain financial and employment information and documentation during the application process. Typically, you will need to provide information about your income, employment, assets and liabilities. To support this information you will likely have to provide pay stubs, bank statements, tax returns, investment reports, divorce decrees, and any other documentation to support your information. If you have all of this information available when you submit your application, the process will move ahead much quicker.
4. Pay attention to the Good Faith Estimate (GFE) and Truth-in-Lending (TIL) disclosures
Within three business days after receiving your application, the lender must provide you with, or place in the mail, a GFE and a TIL. You should look closely at these documents to insure that the mortgage you have applied for is what the lender is processing.
The GFE is a document that discloses an estimate of either the amount or range of charges that you will have to pay at the closing. These charges include the lender and/or broker fees, taxes, hazard insurance, attorney fees, prepaid interest, mortgage insurance and similar charges. You should question any charges that appear out of the ordinary to you. For example, if you applied for a “no point loan” and there are “loan origination fees” or “loan discount fees” listed on the GFE, you should question the broker or lender about these fees. Although the GFE may contain other loan information, it is not a contract or commitment to lend. It should only be relied upon as an estimate of costs you will be required to pay at the closing.
The TIL is a document that will disclose many items including the cost of the transaction to you. Your interest rate will be expressed as an annual percentage rate (APR) and the TIL will disclose the total finance charge over the course of the loan which includes interest and other fees you may be charged. Your APR is likely to be higher than your interest rate because any points and fees that you will have to pay at closing are reflected in this rate. If there were no points or other fees to be charged, the interest rate would be identical to the APR. The APR is the rate you should use when comparing one loan to another. For example, a loan with an interest rate of 6.0% with an APR of 6.75% is not as good of a deal as a loan with an interest rate of 6.25% with an APR of 6.50%. A higher APR will result from a larger amount of points and fees that are charged to you prior to and/or at the loan closing. Do not make the mistake of simply focusing on the interest rate.
5. Rate Locks
Most lenders offer a rate lock option. If you’re working with a broker, they can facilitate the rate lock with the lender. A broker is prohibited from issuing a rate lock directly because they are not making the loan. Connecticut law requires that any rate lock be in writing. If you don’t have a rate lock in writing, your rate is not locked. This means that the rate is “floating” and can change until you close the loan. If you want to lock your rate, ask your loan originator to do so and then get it in writing. The rate lock agreement should state the interest rate that is locked and the period of time for which the rate is locked, typically 30, 45 or 60 days. Do not accept any verbal assurance that your rate is locked and do not accept any excuse for not getting it in writing. Without a written rate lock, you have little recourse if your rate is different when you arrive at the closing. In a rising interest rate environment, the change in rate between the time you submitted your application and the time you arrive at your closing can be substantial.
Once you have decided on a loan product, your loan will be underwritten. This essentially means that the lender will review your credit history, verify all your financial information, have an appraisal of the property conducted and make a determination as to whether to approve your loan.
Loans with the best terms are generally offered to individuals with excellent credit who represent the least risk to a lender. If you have had credit problems in the past you may not qualify for the best loan rates. If you’re told you do not qualify for the loan you applied for and you’re given a counteroffer, be VERY CAREFUL in these situations. A counteroffer could mean a slight change in the loan terms or it could change the terms substantially. Be sure you completely understand the terms of the counteroffer. The new loan will likely differ from the original loan by a change in one or more of the following: 1) a higher interest rate; 2) a larger amount of points and fees; 3) an adjustable rate provision; and 4) a prepayment penalty provision.
If the terms of a counteroffer are not acceptable to you or the loan no longer makes financial sense, you should refuse the counteroffer, ask for a denial of the original loan you applied for and walk away from the transaction. A written denial of your original loan may be very important to you in terms of getting a refund of any deposit you gave to the seller of the property.
The loan closing:
After you’re approved for a mortgage, a loan closing will be scheduled. This is the final step to owning your new home. Although it’s not required, you should give serious thought to having your own attorney represent you during the closing. The lender will have an attorney there to represent their interests. You may be given the opportunity to have the lender’s attorney represent you as well. This is referred to as dual representation. However, your own attorney will be looking out for your best interests and will have no relationship with the lender. Your attorney’s primary job will be able to explain each document to you and to make sure that those documents accurately reflect the terms of the mortgage you had applied for. There will be an abundance of documents that you will need to sign. Three of the most important documents you need to review and understand are the Note and the Settlement Statement and the final Truth-in-Lending (TIL) disclosure. You or your attorney should ask the lender or the lender’s attorney for copies of these documents at least 24 hours prior to closing. This will give you an opportunity to review them prior to arriving to the closing. It will also give you additional time to clear up any issues or even reschedule the closing if you do not agree with the terms. If you are unable to obtain copies prior to the closing, make sure you thoroughly review them at the loan closing.
The Note is the legally binding document which outlines your financial responsibility to the lender. It includes your loan amount, interest rate, payment amount (principal and interest only), maturity date (30 years for example), information about interest rate changes if the loan is an adjustable rate transaction, prepayment penalty information and late charge and default information.
The Settlement Statement outlines the disbursement of the loan including the closing costs that you will pay. You should compare these costs closely with the costs that were originally disclosed to you on the Good Faith Estimate (GFE). Although there may be slight differences, the total closing costs that were disclosed to you on the GFE should be relatively close to your actual closing costs. You should question any differences and be prepared to cancel the closing if the terms of your loan have changed substantially.
The final TIL will disclose the total cost of the transaction. The APR, finance charge and payment schedule should be very close to the TIL you received at the beginning of this process. Substantial differences should only occur if you accepted a counteroffer. The final TIL will disclose the financial cost of the counteroffer.
Do not sign these documents unless you agree with the terms. If you are satisfied with the terms of the loan, you will sign the appropriate documents and become the proud owner of a new home.