Home ownership is arguably the most significant piece of the pie that is the American Dream. However, even in the wake of the housing market downfall, many Americans are still not knowledgeable about the particulars of the mortgage application process, the types of mortgages available or the amount they should reserve for a down payment. Knowing a few simple facts and requirements could make all the difference when it is time to sign on the dotted line.
The first step in securing that much needed mortgage is the application process. This is when a loan officer verifies that a person does or does not qualify for a mortgage. The loan officer will be trying to answer a few questions during this process including how much money you make or have saved, how much debt you carry and how financially reliable you are. Basically, the bank wants to ensure that you are a well established and reliable borrower. To make this process easier, you should have proof of your monthly or yearly income in the form of a pay stub or W-2. You should also have a copy of your most recent bank statement proving your checking and savings balances. Documentation or proof of any long-term debts plus monthly expenses is also useful.
Based on the items and information loan officers receive from applicants, banks will use a few ratios to determine the financial suitability of the potential borrower. One such calculation, DSR, or Debt Service Ratio, divides your monthly income by your monthly debt. “A DSR higher than 40 percent generally disqualifies a borrower from receiving the mortgage”. GDS or Gross Debt Service, divides your gross monthly income by your total monthly housing costs. “Banks will generally not accept an applicant that has a higher GDS than 32 percent.
After taking your financial temperature, the bank will want to know how reliable you are. One way to gauge your reliability is to evaluate past performance. In other words, check your credit score and history. By checking your credit score, banks get a snap shot of your payment history on other debts, whether you have ever defaulted or not paid a debt, and if you have been prompt with your payments. Credit score is important in determining eligibility for a loan and what interest rate a borrower qualifies for. It is a good idea to make sure there are no discrepancies on your credit report before applying for a mortgage. This is because items such as credit errors can significantly slow down the application process.
The application process is just the first step potential home owners should be aware of concerning mortgages. Borrowers should also understand some of the types of mortgages available through lending institutions. Most have heard of fixed and variable-rate mortgages. Fixed means the interest rate is locked in for the life of the loan, be it a 10, 15 or 30 year term. An adjustable rate mortgage or ARM features a low starting interest rate that increases over the years or after a certain time period. This type of loan is good for someone who intends on paying their mortgage off in the time period of the given ARM. For instance, if a home owner intends on paying off their home in seven years he or she may save significantly by taking the ARM option and taking advantage of the low starting interest rate in the first few year of the ARM. This way the borrower could pay off a significant portion of the principle in the first few years by paying less interest. With more money going towards principle, by the time the ARM interest rates increase in later years, the borrower should be paying less overall than with a fixed rate mortgage if this type of loan is used successfully. As with anything, the ARM is not for every borrower. Those who want more flexibility and do not plan on paying their loan back in a quick or highly scheduled fashion would likely not benefit from the ARM and would be more suited for the fixed rate mortgage. Always research all options thoroughly before making a decision on the type of mortgage that is best for you.
Now for the dreaded question that many people have. How much do you really need to pay for a down payment? The standard answer that most banks and even financial advisors will give you is simple. They say always pay twenty percent down on a home purchase to avoid PMI charges and instantly gain equity in your new home. For example, if you are buying a $100K home, experts would recommend that you pay $20K as a down payment. PMI or private mortgage insurance is basically like having to throw money down the drain. “Basically, 1.75 percent of the purchase of the home is taken at closing then 1 percent of your home’s value is paid for many years for this insurance”.
There is no direct benefit of PMI to the borrower; this insurance is specifically for the lending institution. However, if a borrower is in an emergency situation, there are financial institutions including the Federal Housing Authority, the Veterans Administration and the Department of Agriculture that assist qualified applicants to purchase a home. These organizations will typically require a much lower down payment than a traditional lending institution such as the bank. The FHA has been known to accept as little as 3.5 percent of the purchase price. Some building companies even boast that they can get their customers in a house for zero down. Every borrower is unique and different down payments are feasible for different borrowers’ financial situations. However, as a general rule, paying at least the standard 20 percent down payment is ideal, and is more likely to incur less additional costs for the borrower.
Knowing what to expect throughout the loan application process, the different types of loan choices available, and what the recommended down payment typically is should help potential home buyers feel much more knowledgeable and at ease when making one of the most important financial decisions of all- buying a home. So take your slice of the American Dream with confidence, and enjoy the fact that with the necessary knowledge, you have made the best decision for you and your family.