How do you prepare for the one of the biggest purchases of your life?
I have been in the mortgage industry for over 10 years now, and I have worked with many people who did not know how to prepare for buying a home. Some were purchasing their very first house, some were downsizing in their retirement years, and others were buying second homes or investment properties.
No matter who I worked with, very few fully understand the mortgage requirements for buying a home, whether it be credit score, debt to income, or reserves.
So I thought I would share a few pointers if you are thinking about purchasing a home, especially in the current climate.
Credit Score – Why is it different?
This one is a big question mark for many of the customers I have worked with. They think their credit score is 790 but when it is pulled for a mortgage application it is 755. Why the difference? Their credit card app says one thing, and the mortgage score says another. There are several reasons for this.
One is that FICO has many different score variations. The mortgage industry uses different variations than self-monitoring apps typically use. Credit card variations are the most common scores looked at by customers. So there is often a discrepancy when their credit is pulled with a mortgage lender.
The other big reason for the discrepancy is that credit scores change monthly. This is mainly due to credit card use. Many people, including myself, pay almost everything with a credit card, and then pay the card balance completely off when it is due each month. What a lot of people don’t know is that even if you pay it off each month and do not carryover a balance from month to month, the credit card companies report your balance to the credit reporting agencies, not the zero balance. The credit reporting agencies give a credit score based on credit used compared to credit available when it comes to revolving accounts (credit cards). So if you charge 50% or more of your credit limit in a month, your score is going drop. The best rule is to keep your charges under 10% of the credit limit if you do not want it affecting your credit score negatively.
Debt to Income – What does this mean?
This one can make it hard for people to purchase. If you have too many monthly liabilities (what you owe monthly), you may not qualify for a mortgage. Debt to income is calculated by looking at the following monthly liabilities:
- Any monthly payment that shows up on your credit report – this can include car payments, student loan payments, credit card payments, personal loans, and mortgage payments (for current home if you own one already or second home/investment properties
- Estimated mortgage payment for the new home you are purchasing – this includes the principal and interest, homeowner’s insurance, taxes, and HOA dues (if there are HOA dues for the property)
- If you own other properties already and they are not escrowed, then taxes, insurance, and HOA dues are included
- Federal tax payments if you are making monthly installment payments on taxes owed
Income is calculated by taking your gross monthly pay for your employment. Debt to income is calculated by taking the sum of all monthly liability payments and dividing by your gross monthly income.
The maximum debt to income ratio allowed for a mortgage loan varies depending on which loan you are doing. But in general they range from 43-50%.
Down Payment – How much is needed?
Down payment is the money you are required to put down for the mortgage loan. The required down payment depends on the loan program you are doing. Generally down payment requirements will range from 0%-20% for primary homes. If you want to avoid private mortgage insurance (PMI), you would need to put 20% down.
Also depending on the loan program, some or all of the down payment can be gifted by a family member. There are also employers who offer down payment assistance. Down payment assistance programs are available from other sources, as well. Those programs are usually for individuals or families who fall in a lower income bracket. Many people also use funds received from their tax return refund in the springtime to put towards a down payment.
One of the biggest issues I have seen when it comes to down payment is what we in the industry call “mattress money.” Cash is not good when it comes to getting a mortgage. If you have cash at home, it will not be acceptable to use in purchasing a home if you are getting a mortgage. Because of federal requirements, all funds used in getting a mortgage must be sourced. This means you have to provide a paper trail through bank statements showing where the money has come from. In general, you have to provide your most recent two months of bank statements. Any large deposits must be sourced. If cash is deposited and shows on the statement, it will not be able to be used. If you have a large amount of cash you want to use to purchase a home, you would want to deposit it into a checking or savings account and let it sit for at least two months so that when you provide the required account statements when you apply for pre-approval or start the process, the deposit will not show up. This is referred to as “seasoning” the funds.
Closing Costs – What are these for?
There are closing costs involved with purchasing a home. The amount of closing costs depends a lot on the state you are purchasing in. I live in South Carolina, and the closing costs are much lower than states like New York and New Jersey. Generally, you can expect closing costs to be anywhere from 3-5% of the purchase price amount. Closing costs are funds needed on top of down payment requirements.
When I first started in the mortgage industry, it was a buyer’s market so I regularly saw seller’s assisting with closing costs. Currently, I do not see that happening much in the current market. With the existing home shortage, it is still more of a seller’s market even with the higher interest rates. If a seller does agree to assist with closing costs, usually they can give a credit up to 3% of the purchase price.
Closing costs include the lender fees, attorney/title company fees, title search, title insurance, appraisal, and city/county transfer taxes.
Reserves – When is this needed?
Reserves are funds required that you have in liquid assets (example would be a checking or savings account). These funds are in addition to what is needed for down payment and closing costs. A lot of the time you do not need reserves if you are purchasing a primary home, but some loan programs do require it for primary homes. The reserves requirement is usually to show that you have at least a 2-3 months of the estimated payment (principal, interest, taxes, insurance, and HOA dues).
For second homes and investment homes, reserve requirements are very common.
Sometimes a percentage of the balances in retirement accounts can be used for reserves if you can show through the terms and conditions of withdrawal that you could pull from the account if you needed to.
Final Thoughts
My advice if you are thinking of purchasing a home in the future is to find a mortgage loan officer you trust and speak with them. They will be able to help you know what loan program will be the best fit for you and if you would qualify for any first time homebuyer loans or assistance. They would also be able to give you an idea of down payment and closing costs for your particular situation.
I would also highly recommend finding a realtor to work with once you are ready to start your home search. A realtor will help you negotiate the purchase price with the seller and walk you through all of the details involved with making offers and getting them accepted. They also will guide you through the home inspection process once you are under contract and assist in negotiating items that might need to be fixed in the home prior to closing on the purchase. Currently, the seller pays the buyer’s realtor fees so having a realtor is no extra cost to you.
I always encourage people to find a mortgage loan officer and realtor through recommendations from trusted family and friends.
Owning a home is a wonderful and life changing thing, and it is part of the “American Dream” that I think everyone should have the opportunity to experience.
