Your house is the largest single investment most people will make in their lifetime. And yet, the vast majority of people have absolutely no idea how this whole thing works. If you were paying attention, you probably know that the 2008 recession had something to do with housing and something or something, but that’s a topic for a whole different time and another sub. People’s knowledge generally stops at making payments on time and everyone got screwed on their interest rate. So let’s try to learn something about the way this whole thing works.
So you want to buy a house. Congratulations! There’s a LOT of stuff that you need to be thinking about and every single person you talk to is going to have an opinion or a way to help. But no matter who you talk to, the first question you’ll get is always “What’s your rate?” Gonna be honest, as an MLO, I absolutely hate that question. I could tell you the rate is 3.5%, I could tell you it’s 7.5%, but what does that actually mean for you? Most people don’t really have a point of reference for it. I understand why everyone cares, but there’s a TON of stuff that goes into it. We’ll get to rates later. Yes, it’s a fair question, but it’s not at all the most important thing.
The first thing you should actually be asking is this: How can I get a pre-qualification letter? The vast majority of the time, to actually make an offer on a house, they’ll ask you for some sort of evidence that you actually have the money to buy the house. If you don’t happen to have $250,000 lying around somewhere, you’ll probably need to borrow it, so they want to see proof that you’re actually qualified to borrow that much money. That’s what the pre-qualification is for. It also helps you with figuring out exactly what your price range is.
So, we’re trying to get you pre-qualified, that’s fantastic! A couple of very important steps are coming into play here. How much of a down payment do you have saved up? The “traditional” wisdom is 20% of the house, but… That’s a ton of money and a lot of people just aren’t able to get that much saved up very easily. If that’s you, there are other options available. If you’re a veteran or active duty in the military, you can actually finance 100% of the house. The same is also true if you live in a metropolitan statistical area of under 20,000 people. Financing 100% of the house isn’t exactly ideal and it’ll bring your payment up quite a bit, but we can do it. If you don’t fall in to one of those two categories, like most people, you must bring at least 3.5% as a down payment, no matter what. Gifts are allowed, but if it’s a gift, you have to have a notarized letter saying that there’s no expectation of it to be repaid. Otherwise, you have to be able to prove that you’ve had the money for at least two months. So, to summarize: How much should you bring for a down payment? As much as possible, but at least 3.5%. The more, the better.
Okay, awesome, you have a down payment! The next thing we’re going to do is get you credit qualified. That’s easy, right? Eh…. Not quite. It’s not quite as simple as just checking your credit score, although that is a part of it. As long as you’re above ~650, there won’t be a problem with the score. But just to make it more complicated, your Credit Karma score isn’t going to really help you. It’s been tossed around a little bit, but mortgage companies use a different scoring equation. So it’s fantastic if Credit Karma tells you that you have a 750, but if I pull your credit and see a 550, I can’t help you. That’s an extreme example, but I’ve seen differences of up to 100 points between the calculation methods. Beyond just the credit score, there are also things on the credit report that we need to see. No bankruptcies discharged in the last two years. (Side note, if you’re in the middle of a chapter 13, we can still help you. It might be worth looking into.) We don’t like collections, but those are case-by-case and we usually ignore medical collections (mostly). As far as late payments go, all we really care about is late payments on the mortgage. If you have a mortgage right now, you have to be current on it. But if you’ve been late more than twice in the last 12 months, our investors don’t want us to take that risk. If your credit score is below 650, it just means you need to shop around a little bit. My last company, for example, was able to lend down to 620 or even 600 with some circumstances. Your local bank might be able to lend on even lower credit scores. It just depends.
And while we’re on the topic of credit, time for a second about credit pulls. The CFPB has actually put a rule in place stating that after a mortgage company makes a credit pull, you can have every other mortgage company in the country pull your credit and after 45 days, it’ll all only count as 1 credit pull. You have a 45 day window for free pulls, you may as well use it and shop around while you can.
Okay, great, so you have a down payment and you have your credit qualification. Next step, income! You do have an income, right? Yes, I have actually run into problems with this one before… You HAVE to have an income that reports to the government. If the federal government doesn’t know about it, we can’t use it. So you 1099 folks, be careful how much you’re writing off for business expenses. That can affect how much income we’re allowed to use to qualify you. Now, how much do you need? So conventional budget-building recommends that you should keep your housing expenses right about 30% of your budget. Fun fact, when it comes to the mortgage, that’s the actual rule. It depends on the mortgage program, but your housing expenses aren’t allowed to be more than ~28-36% of your monthly income, although some exceptions occur. In addition, your TOTAL debt-to-income ratio has to be under 45%. Your income is one of the limiting factors for your monthly payment.
Okay, so we’ve already got a lot of the stuff we need to know. Your down payment, your credit qualification, and your income gives us benchmarks for what your payment limits are. There are 6 pieces of information that we need to give you an accurate rate. If anyone is trying to quote you a rate before getting all six pieces of information, be very skeptical of it. It probably won’t be accurate. Those six pieces of information: The loan vs the value of the house (LTV), the amount of the loan, the income you’re able to use, your credit score, the loan program you’re using, and what the purpose of the loan is (in this case, a purchase). Right now, rates are typically in the 4-5% range, mostly on the lower end of that. Obviously, though, your mileage may vary.
Okay, now for my mini-rant about why rate doesn’t actually matter. On a $100,000 loan, a 10 year note at 10% is $1,321 per month. A 30 year note for the same amount at 3.5% is $449 per month. Over the lifetime of the loan, though, the 10 year costs about $158,000 while the 30 year costs $161,000. A .125% change in interest rate on the same 30 year note is a difference of $8/month and about $2500 over the life of the loan. It’s not nearly as important as people think it is. Not saying it doesn’t matter at all, but that 4% vs that 4.125% isn’t quite as big a difference as people think. The difference maker is actually the term of the loan.
A $100,000 loan at 4% for 10 years costs you $1,012 per month with a total lifetime repayment of $121,494. The same loan over 30 years is only $477 per month, but you’ll end up paying $171,870 before the house is paid off. Extending the loan out 20 years saves you about $750 every month but costs you $50,000 over the life of the loan (spoiler alert, you end up ahead by about 20 years’ of payments on the 30 year). What I recommend to people, for the most part is this: Go with the 30 year note, then make extra payments. Why? Because no mortgage since 2008 has prepayment penalties (unless you have a really shady bank) and mortgage interest is simple interest, instead of compounding. That’s right, mortgage interest does not earn interest on itself. Your mortgage interest for the year is calculated at the beginning of the year and scheduled out throughout the year. Every penny you pay over your minimum payment is money paying down the principal of the loan. This makes mortgages one of the easiest loans to pay ahead on. That’s why I personally tend to recommend going with a 30-year, then paying ahead when you can. That way, you have the lowest possible payment if something were to happen, but you can afford to throw a ton of extra money at it while you’re able to.
Okay, so we have your credit, we have your rate, we have the program, all the structures of the loan, all that fun stuff, we’re almost done right? Kinda… Next step is the appraisal. If we’re going to lend you money on your house, we need to know how much your house is actually worth. I’ve seen a lot of people really not understand what the appraisal is about. It has nothing to do with how recently you put your roof on, how recently you painted, if you recently replaced a door, none of that stuff. The appraisal is based on the prices of houses in the neighborhood and what they actually sold for. The appraiser will do some adjustments because not all houses are identical, but it all depends on what your neighbors are selling their houses for. (There are other ways to do appraisals, this is the most common.) And this is where you start to get into all the fees associated with buying a house. Title work, inspections, origination fees, surveys, HOA fees, all that fun stuff. There’s a lot of it, but I’ll save that for another post because this one is already getting long. Just… Be prepared to need anywhere from $2-5000 dollars to cover the “closing costs” of buying a house. I promise, the fees all make sense and none of them are meaningless, it’s just expensive.
So congratulations! You now own a home and owe on a debt for 15-30 years of your life. I’ll put up another post about the closing costs and what all goes into that at a later date. Until then, be an educated consumer.