Taking on a mortgage loan should involve more than using a mortgage calculator to figure out whether you can afford the monthly mortgage payment. That matters, of course, but you also need to consider:
- your financial situation over the life of the loan,
- whether there's anything that may impact your ability to repay the loan, and
- the financial institution you'll be partnering with.
Getting a mortgage takes a lot of work, and it’s important to have some basic things in order before you start the process.
Understand the basic type of mortgage loans
It’s important to know the different kinds of mortgages. For example, there are two common loan terms:
- 30-year mortgage loans: You have 30 years to pay the loan off.
- 15-year mortgage loans: You have 15 years to pay the loan off.
And there are two common types of interest:
- Fixed-rate mortgage loans: The interest stays the same for the term of the loan.
- Adjustable-rate mortgage (ARM) loans: The interest rate can change, usually at specific intervals.
You can get a 30-year fixed-rate loan, a 15-year adjustable-rate loan, or any other combination.
Adjustable-rate mortgages can be risky and generally make more sense when you intend to sell the property quickly. A 15-year loan, which is less common, can be tempting, but it means higher monthly payments.
And, of course, there are many different loan amounts, based on your down payment and the price of the house.
In most cases, there's no penalty for paying your loan off in less time than the standard term. You save a lot of money in interest, too. With a mortgage loan, you pay interest for each day you take to pay the loan off. Paying down the principal ahead of time will save you money in the long run.
If you make extra payments, tell your mortgage lender that you want the money applied to the principal balance. You might think the lender should know this, but it’s best to be careful.
People often make one extra payment per year to shorten the life of their loan. One way to do that is to make your payment every two weeks instead of once a month. This results in 13 full payments, rather than 12, in a year. Consult your mortgage lender to figure out the best way to make this happen.
Start with the mortgage loan basics
Getting a mortgage loan can be daunting, but it helps to break it down into some basic steps:
- Know your income and debts: To figure out how much of a monthly payment you can afford, you need to fully understand your finances. In general, you should be pessimistic if your income or expenses fluctuate.
- Understand your credit score: It’s easy to learn your credit score (most credit cards and checking accounts offer the ability to check it), but you should also know how your score makes you look to banks. We’ll cover that in greater detail later on.
- Know where you want to live: The more flexibility you have, the better. The location of a house impacts its price -- sometimes significantly.
- Get your paperwork in order: Most mortgage lenders require two years of taxes, at least a year of bank records, documentation on any significant financial holdings, and personal identification.
That seems like a simple list, but it can get complicated. Don’t let that scare you away. Many people with less-than-perfect finances and mediocre (or even bad) credit can find a financial institution willing to extend them a mortgage loan.
Get your finances in order
Many people don’t have a clear picture of their finances. That might be because you’re making so much money you don’t have to consider it -- but it's probably because nothing ever forced you to take a hard look.
Before you apply for a mortgage, audit your finances. Look at your income, your fixed costs (car loan, student loan, utilities, rent, food, and anything else you have to pay every month), and your discretionary budget. Once you've done that, you can see if you can follow the unofficial 28/36 rule.
Banks and other financial institutions want your mortgage loan payment to be no more than 28% of your gross monthly income. All of your debts together shouldn't exceed 36%. This isn’t a hard-and-fast rule, but it’s a good guideline as to what you can afford.
You may want to examine what debts with monthly bills you can pay off to improve your financial situation. Paying off a car loan or student loans will improve your standing. Paying off credit card debt will do that, too -- and should raise your credit score (sometimes by a lot).
It may make sense to put off buying a home until you can get your finances in decent shape. This can include paying off debt, saving up for a down payment, or increasing the length of time you've spent in a job (lenders generally want to see two years of salary and employment history).
More about your credit score
Your income is important, but even with a solid down payment and a high-paying job, your credit score can keep you from getting an affordable loan. It's important to know the numbers and do as much as you can to raise your score.
Here are some guidelines on how your credit score ranks:
- Less than 580: poor.
- 580 to 669: fair.
- 670 to 739: good.
- 740 to 799: very good.
- 800 or higher: exceptional.
If you want to improve your credit score, it helps to know how it's calculated:
- Payment history: 35%.
- Amounts owed: 30%.
- Length of credit history: 15%.
- New credit: 10%.
- Credit mix: 10%.
Try not to open new credit card accounts or take out any loans for as long as possible before applying for a mortgage.
There's one major exception: If you don’t have much available credit, adding a new card with a high limit can raise your score by lowering your credit utilization ratio.
This ratio looks at the percentage of available credit you're using. You can lower that number by taking on more credit or paying down existing cards. It's good to get your utilization below 30%, but lenders also consider how much you owe compared to your income. To get a mortgage, it’s best to owe $0.
To figure out the best credit moves for you, try a credit simulator tool. Some mortgage brokers can also look at your application and credit report to see if adding a card makes sense for you or whether paying down balances is a better choice.