If you are planning on taking out a loan to buy a home sometime in the near future, here are ten preparatory tasks that will be of great help in getting you the best mortgage on the best terms.
1. Get a copy of your credit report. This tops the list, because any lender you approach will want to see a copy of it as well -- and you could be unpleasantly surprised by what they see there. Fortunately, 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 towww.annualcreditreport.com.
After you get the report, review it for errors and then take steps to correct any mistakes or outdated information and add positive information. (Remember, 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. Review your credit score. It’s also a good idea to find out your credit score before you shop for a mortgage. (Your credit score is a numerical calculation that is 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 your score is to 850, the better you’ll look in the eyes of the lender. (FICO offers a variety of scoring formulas that emphasize different aspects of your credit, so you'll likely have more than one FICO score. For more information about FICO credit scores, go to www.myfico.com and click on “Learn about scores.”)
Your FICO score, however, isn't free. You can pay to find out your FICO scores at www.myfico.com/default.aspx. You can also contact Experian, Equifax, and TransUnion, but these companies may not give you the actual credit score that creditors will use to evaluate you. (Instead, they'll sell you an “educational” score.) Also, your lender may use a different FICO score than the versions you receive from FICO's website (remember, there a lots of different types of FICO scores), or another type of credit score altogether. Still, you’ll get an idea of where you fall in terms of credit risk if you get your scores from FICO or from the credit reporting agencies.
3. Gather up relevant financial and employment documents. When you apply for a mortgage loan, you’ll be required to provide the lender with financial and employment documentation, as well as information about your assets and liabilities. You’ll probably need to provide pay stubs, bank statements, and tax returns, among other things. Getting this information together ahead of time will give you a better understanding about your own finances, and the process will move ahead much more quickly when you eventually apply for a loan.
4. Learn about different types of mortgages. It's worth getting educated about the different types of mortgages (such as conventional, FHA, VA, and others) that are available before you start shopping for a loan. A conventional home loan is not insured or guaranteed by the federal government, while FHA and VA loans are government backed. Learn more about the difference between a conventional FHA, and VA loan and some of the features of these loans.
5. Figure out whether you want a fixed rate or an adjustable rate. 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 monthly payment will normally be set at the same amount each month, based on a mathematical process called "amortization." This 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. (Learn more in Fixed Rate vs. Adjustable Rate Mortgages.)
Another option is a hybrid ARM, which has a fixed rate for a certain period of time (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 remainder of the loan term.
6. Determine what mortgage term you want. A mortgage term (that is, how long it takes to pay off the loan) is typically 15 or 30 years, though it could vary. If you take out a 15-year mortgage, you’ll pay off the loan much quicker (half the time) as with a 30-year loan, but the monthly payment is higher. The advantage to choosing a 15-year mortgage is that you will save thousands of dollars in interest, but the higher monthly payment is not affordable for many borrowers.
7. Understand your housing debt-to-income ratio. Mortgage lenders often look at debt-to-income ratios to qualify you for a mortgage. A housing debt-to-income ratio (also called a front-end ratio) is the percentage of your 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. Understand your total debt-to-income ratio. The total debt-to-income ratio (called a 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. Don’t apply for new credit around the time you’re trying to get a mortgage. It’s generally not a good idea to try to get other credit (such as a new car loan or a new credit card) around the same time you’re taking out a mortgage. This is because the lender may consider you to be a greater credit risk if you apply for additional credit at this time, and it might kill the deal.
10. Think about where you want to shop for a mortgage. There are different options when it comes to shopping for a mortgage. You may choose to use a mortgage broker to help you, go directly to your local bank or credit union, and/or shop online. (Get more information about where to shop for a mortgage.)