If you’ve been following the housing market, you know that the last couple of years have been great for home buyers finally taking the plunge. According to Freddie Mac, the average rate on a 30-year fixed rate mortgage was 3.47% in October 2016. By contrast, the average rate in 2000 topped 8%! These low financing rates continue to fuel the American dream of owning a home.
Whether you’re just starting out to think about homeownership, or have been contributing towards a down payment for years, let’s review the key steps to finally signing on your dream home.
3-5 years before: Build up your credit score
Having a good FICO score isn’t just important for a mortgage - it’ll help you qualify for or get better rates on credit cards, auto loans, and other financing; it may also help with everything from renting an apartment to getting a job. If you want to learn more about FICO scores in general, check out this primer. Here are four tips for building a healthy credit score:
- Avoid missed payments. Your payment history makes up 35% of your credit score. Set up automatic payments to avoid accidentally missing one, and if you close a checking account, make sure you’ve changed any automatic payments drawing from that account. If you do happen to miss a payment, contact the lender to ask if they’ll take it off your score (here’s a sample letter).
- Keep a low balance on your revolving loans. The amount of money you owe accounts for 30% of your FICO score. The most important factor in this is how much you owe on revolving loans like credit cards - owing $50,000 in credit card debt is considered a higher risk factor than that same amount in student loan debt. Most experts recommend that you keep your debt-to-credit ratio (that is, the percent of your credit line you’re currently using) below 30% on your credit cards.
- Monitor your credit report for irregularities. Identity theft and honest mistakes are an unfortunate part of life, and the day before you apply for a mortgage isn’t the best time to find out about them. You’re entitled to one free report from each of the three main credit reporting bureaus every year, and some banks or third parties offer free credit score monitoring. In addition to regular checkups on your credit report, you can also consider signing up for a service like Mint that will alert you to unusual spending.
- Keep no-fee credit cards open. Having more credit cards helps your FICO score in a number of ways: It increases the total credit available (thus improving your debt-to-credit ratio), the number of accounts open, and the average age of your accounts. Keep your no annual fee credit card accounts open, even if you’re not actively using them, and your score will be better for it. If your card does have an annual fee, consider downgrading to a no-fee version rather than closing the account altogether.
1-3 years before: Save enough for a down payment
A substantial down payment not only decreases the amount you’ll have to pay in interest, it also helps compensate for a lower credit score. For example, if you get a Federal Housing Authority (FHA) loan, you’ll need a down payment of at least 10% if your FICO score is below 580. Scores above 580, on the other hand, require down payments as low as 3.5%. In fact, many housing experts recommend a down payment of as much as 20%.
If you're looking in to using a "hardship withdrawal" to use your 401(k) funds towards your home purchase, read this post and be sure to ask your 401(k) administrator or HR representative what the terms of such a withdrawal would be, so you can plan your contributions in advance if you do decide to go this route.
Start saving up (or increasing your contributions!) to improve your chances of closing on that loan. Like saving for retirement, putting aside money for a down payment is best done sooner rather than later.
Here’s another reason to save up. When your loan-to-value (LTV) ratio is above 80% on conventional mortgages or 90% for FHA loans (that’s less than 20% or 10% down, respectively), the lender is legally allowed to charge you private mortgage insurance (PMI). You’ll have to pay PMI until the LTV ratio falls to 78%. This is protection for the lender in case you were to default on the loan, and it can add substantially to the cost of a mortgage.
Depending on your credit score, down payment, loan terms, and other factors, PMI can range from 0.25% to 2% annually. On the average 2015 U.S. mortgage - $172,341 - that’s $431 to $3,447 a year. The greater your down payment, the less you’ll have to pay in PMI.
Before loan shopping: Understand your mortgage options
There are three main types of mortgages:
- Conventional mortgages: These “plain vanilla” home loans offer the best interest rates, have fewer requirements than other types of mortgages, and take generally less time to process. However, you need to have a very good credit score, a low debt-to-income ratio, and a large down payment.
- FHA loans: These are available for those with credit scores of at least 580 and down payments of at least 3.5% of the total purchase price. However, FHA loans have higher insurance premiums than conventional mortgages do.
- VA loans: Veterans Affairs mortgages are available to qualifying active-duty military personnel and veterans. Unlike conventional and FHA loans, VA loans can provide up to 100% financing to eligible applicants. However, these loans require an upfront VA funding fee and have a ceiling on how much you can borrow.
Unless you’re currently serving or have served in a branch of the U.S. armed forces, you’ll only have access to either conventional or FHA mortgage. Building up your credit score is critical - a score of 680 is a minimum threshold to access many of the best financing options.
Just before applying for mortgages: Give your credit score a last-minute boost
Hopefully, you’ve spent the past few years building up your credit score. But before you apply for home loans, you’ll want to give it one last spit-shine. This means:
- Pay down the balance on your credit cards. Your lender will look at the total amount on your credit card (not just the last statement balance), so you’ll want to pay off the entire balance on the cards before you apply.
- Don’t apply for new loans. Applying for too many new credit cards, auto loans, etc. in a short period of time is a huge red flag to lenders. Avoid opening new loans right before you apply for a mortgage.
- Check your own credit score. When you ask for a loan, the lender will make an inquiry into your FICO score, which has a small but negative impact on your credit score. However, doing your own credit inquiry doesn’t hurt - in fact, it can help quite a bit if it reveals mistakes or fraud.
- Do your loan shopping in a short window. A lender will be suspicious if you apply for five new credit cards in a week, but it’s expected that you’ll apply for a number of different mortgages so that you can compare rates. Lender credit checks for a mortgage made within a 45-day window will appear as just one credit check, minimizing the impact on your FICO score. Rate shopping is a good strategy for lowering your costs, but you’ll want to do it within the 45-day period.
After all the work you’ve done to build up your credit score, these last few steps will make sure you appear as creditworthy as possible.
Before closing: Prepare for potentially higher expenses
Besides your down payment and loan closing costs, you may have to face last-minute or soon-to-come expenses. Here are some examples:
- Rate increases: Take the deadlines from your financial institution very seriously. If you take too long submitting necessary paperwork, then you may face a higher interest rate.
- Lower appraisal: If your bank hires a third-party appraiser who finds that your home is under the market value your seller quoted, you’ll have to come up with the difference on your own, request a seller’s credit, or bargain with your agents to lower their commission.
- More “broken-downer” than fixer-upper: As part of the home buying process, you’ll receive a report from a licensed home inspector informing you about any potential issues. While no home is perfect, make sure that you understand what you’re getting yourself into so you don’t have unpleasant and costly surprises.
- Upcoming increase in homeowner’s association (HOA) fees: Your new HOA board may be reviewing (or have already approved) large projects that considerably increase your monthly HOA dues. Depending on the cost of the project, a board could consider charging you your entire portion of the project upfront, or offer you financing options to pay it over time.
It’s always a good idea to budget for such expenses to avoid reducing the size of your down payment and potentially limiting your financing options. As a last resort, you may be able to use your individual retirement account (IRA) funds to finance a home purchase.You won’t incur the typical 10% early distribution penalty when you use your IRA funds for a qualified first-time home purchase.
The most you can take from your IRA to qualify for a first-time homebuyer exemption is $10,000. If your spouse or child also has an IRA, you could both take out up to $10,000 and pool your funds. Just remember that you’re still liable for applicable income taxes on the distribution.
In a perfect world, you’ll never want to tap into your nest egg until retirement. However, if doing so reduces the cost of a 30-year debt and sets you on the path to homeownership, it’s worth considering.
After the loan: Minimize PMI payments
As we mentioned above, your best course of action is to avoid PMI altogether with a sufficient down payment. However, if you’re stuck paying PMI, you can take steps to minimize the cost. You can request in writing to your lender to cancel your PMI when your loan reaches an 80% LTV (rather than the 78% standard), as long as you’ve been current on your monthly payments for the last two years, your credit score is solid, and your house hasn’t dramatically dropped in market value.
Additionally, if your property has greatly appreciated from its original value due to market conditions or a substantial renovation, you can request a new appraisal and submit it to your lender for an LTV recalculation. An appraisal averages between $400 and $500, but can cost about $1,000 for large, complex homes. Still, investing a couple of hundred dollars could help you save several thousands over the life of your mortgage.
The bottom line: Keep an eye on the housing market
By improving your credit score, saving up for a substantial down payment, minimizing costs, and budgeting well, you’ll be able to land the home of your dreams. Remember that as much as you can plan in advance, sometimes you’ll have to make a purchase earlier than expected. In September 2016, properties typically stayed on the market for 39 days, 10 fewer than the year prior. If your target dream home is suddenly available, you’ll have to act fast. Still, by following these guidelines, you have a much better chance of finding your home sweet home at an affordable price.
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