Planning on taking out a loan to buy a home? Here some ways to make sure you get the best mortgage on the best terms.
1. Get a copy of your credit report. Any lender you approach will want to see a copy of it as well, and you could be unpleasantly surprised by what's on it. Credit reporting agencies must give you a free copy of your credit report once every 12 months, if you request it. To get your free report from any or all three major credit reporting agencies (Experian, Equifax, and TransUnion), go to www.annualcreditreport.com.
After you get the report, review it and take steps to correct any mistakes or outdated information and add positive information. This isn't just a case of wanting a lender to give a "thumbs up" rather than "thumbs down" on your loan. Lenders use your credit report to determine whether you should be charged a higher interest rate, too.) (Learn more about how to correct errors on your credit report and how to add positive information to your credit report.)
2. Check your credit score. This is a separate numerical calculation, designed to indicate your creditworthiness. While there are different types of credit scores (FICO, VantageScore), creditors often look at the FICO score. A basic FICO score ranges from 300 to 850, the closer to 850, the better. Your FICO score, however, isn't free for the asking from the credit reporting companies. You can, however, find reliable sources for it online, such as from Credit Karma, Discover or Capital One. Nevertheless, your lender might use a different FICO score than the versions you receive (because there lots of different types of FICO scores). Still, you’ll get an idea of where you fall in terms of credit risk.
4. Decide whether you'd prefer a fixed rate or adjustable rate loan. If you select a fixed-rate mortgage, the amount you’ll pay in total for principal and interest remains the same over the entire mortgage term, because the interest rate stays the same. Although you slowly pay off the principal, your payment will likely be set at the same amount each month, based on a mathematical process called "amortization." The total payment could go up, however, if there is an increase in your property taxes or homeowners' insurance and those items are escrowed and paid as part of your mortgage payment.
With an adjustable rate mortgage (ARM), the rate will change from time to time based on the interest rates in the economy. Your monthly payment will increase if rates go up and go down if rates fall.
Another option might be a hybrid ARM, which has a fixed rate for a certain period (say three, five, seven, or ten years). After the fixed-rate period ends, the interest rate switches to an adjustable one and remains variable for the rest of the loan term.
5. Determine how long you want your mortgage to last. A mortgage term is typically 15 or 30 years, though it could vary. If you take out a 15-year mortgage, you’ll pay it off much quicker than with a 30-year loan, but the monthly payment will be higher. The advantage to choosing a 15-year mortgage is that you save thousands of dollars in total interest over the life of the loan.
7. Calculate whether lenders will approve of your housing debt-to-income ratio. Mortgage lenders often look at this "front-end ratio" when reviewing applications for a mortgage. It's the percentage of gross (pre-tax) monthly income that goes towards a mortgage payment. According to many lenders, your housing payment should not exceed about 28% of your gross monthly income.
8. Calculate whether lenders will approve of your total debt-to-income ratio. This "back-end ratio" is a comparison of all your debts (such as monthly mortgage payments, car payments, credit card payments, and student loan payments) to your income. A high debt ratio indicates that your monthly expenses might be getting unmanageable. Most mortgage lenders prefer that your back-end ratio not exceed around 36% of your gross (pre-tax) monthly income.
9. Consider using a mortgage broker. Unlike a "loan officer," who works for one bank or lender, mortgage brokers work with many lending institutions to try to find the best lender and mortgage for your particular situation. However, the broker won’t look at every available mortgage on the market. Instead he or she will likely find you the best option from a lender that he or she has a relationship with. The broker will work with you to get preapproved for a mortgage (after you decide which loan you want) and help you complete your loan application and prepare confirmation of employment and wages, financial information, credit report, and other documentation the lender needs.
As for compensation, mortgage brokers make most of their money by marking up the costs on the loan the wholesale lender offers. This might get passed on to you in the form of points (one point is 1% of the loan value), processing fees, or a higher interest rate on the mortgage you’re getting.
10. Shop around and compare products. Even after careful shopping, many people have a hard time comparing loan terms and deciding whether to pay more points for a lower interest rate. Nolo's free mortgage comparison calculator can help. It allows you to enter the loan terms (rates, points, fees), as well as your estimate on how long you will stay in the house, and compare the performance of the various loans: total payments made over the course of the loan, taxes saved, and APRs.