Buying a home is one of the biggest purchases you will ever make. Although many of us are on the path to FI, most of us don't have enough cash to buy a house without taking out a mortgage.
From pre-qualification to paperwork to credit scores, this in-depth guide will walk you through how to apply for a mortgage while keeping in mind the philosophies of FI.
How Much Can You Afford?
Before applying for a mortgage, you'll want to determine how much you want to spend on a home. Much to the chagrin of your real estate agent, you won't be stretching your budget to buy the largest McMansion on the block.
Remember, the last thing you want is to become “house poor.” This term means that so much of your paycheck is going towards a mortgage that you don't have any money left over to enjoy life or work towards your other goals.
Conventional Vs. FIRE Standards
There are conventional standards of how much home you can afford. Then there is the FIRE method.
Conventional wisdom says that you should buy as much home as you can get approved for as your income will grow over time, allowing for more financial flexibility.
The FIRE community thinks about how to apply for a mortgage differently. I asked the ChooseFI community their opinions on how to apply for a mortgage. As you can guess, they had strong opinions. One commenter from the Facebook group suggested that your mortgage should not exceed one week's pay (or 25% of your monthly salary).
Instead of stretching to fit into a bigger home, rethink your home search and see how much house you really need. The “tiny home” movement is popular these days as people realize they don't need a huge house to fill with stuff they don't need or use.
How Many Times Your Income Can You Borrow For A Mortgage?
When you buy a smaller home than your real estate agent may be pushing, you're able to reduce that number.
Conventional standards have increased over the years with consumers and banks becoming more comfortable with household debt. Today, banks are willing to let you have a mortgage payment that is up to 33% of your gross income. Additionally, your total debt-to-income ratio factoring in your other debts (i.e., credit cards, student loans, auto payments) can be as high as 43%.
Following the conventional formulas can put you in a tough situation financially. Even if you have a side hustle, you probably won't have much money left over to invest, pay down debt, or accelerate the payoff of your mortgage.
Ideally, you'll keep your mortgage payment under 25% of your gross income and your total debt load under 33%. Remember, just because you're approved for it, doesn't mean that you should borrow that much.
How Much Should You Save For A Down Payment?
When searching for homes, the two biggest factors in determining how much you can pay is:
- your down payment
- the size of your mortgage
To stay on the path to financial independence, you want to keep your mortgage payment low as we discussed above. The other factor is the size of your down payment.
There are many mortgage programs that offer low down payment options, such as FHA and VA loans. Conventional loans with less than 20% down come with PMI (private mortgage insurance) payments that are added to your monthly mortgage, taxes, and insurance payment.
Most commenters agreed that you should have a down payment of at least 20%. For example, if you're buying a $100,000 home, you'll need to put $20,000 down. This avoids PMI and provides an equity cushion in case home values decline. Many in the FIRE community suggest a down payment of 50% or more to accelerate the payoff of your mortgage.
Should You Get A Mortgage From Your Bank?
There are many places where you can get a mortgage. Your bank, a credit union, or a mortgage broker are your primary options. When researching your options, it is a good idea to get multiple mortgage quotes.
Many loan officers will request to run your credit before they will provide a mortgage estimate. Don't go overboard with inquiries, but it is OK to have multiple credit inquiries when shopping around. The credit bureaus understand the need to speak with multiple banks, and it will not harm your credit score when several mortgage companies pull your credit within a short time frame.
All mortgage inquiries within 45 days will have the same impact as a single credit inquiry.
The good thing about applying for a mortgage with your primary bank is that they know you. The loan process can be easier because they already have access to your bank statements and much of the required personal information. They may also offer you a discount based upon the size of your relationship.
In other words, the higher your deposit and investment balances are with them, the lower the rates are that they will offer you.
Keep in mind that they may not have the best interest rates and terms. The loan officer you speak with can only offer you mortgage options from your bank.
Credit unions are a popular place to apply for loans because they often have better rates and terms. Their clients are their shareholders so they return their profits in the form of higher deposit rates and lower rates when borrowing. Also, because they are more relationship-focused, they are most likely to have wiggle room when underwriting their loans.
Mortgage brokers are independent salespeople who work with banks and credit unions. They can offer multiple loan solutions that match your profile rather than a bank employee who tries to shoehorn you into a limited number of available options.
Unfortunately, because they act as a middleman, this also means that you won't deal directly with the decision-makers throughout the loan process.
What Types Of Mortgages Are Available?
Mortgages come in many flavors, but the most common are:
- Nonconforming or jumbo
Conforming mortgages are smaller loans that fall below limits set by the Federal Housing Finance Agency (FHFA). In 2019, the limit is $484,350 but loan limits may be more in higher-cost areas.
Nonconforming mortgages, also known as “jumbo mortgages” in the lending world, are for borrowers with good credit. However, the loan amount exceeds the FHFA guidelines.
Subprime mortgages are for borrowers who have lower credit scores and are unable to qualify for a conforming mortgage.
FHA mortgages are government-insured and offer borrowers the ability to buy a home with a down payment as low as 3.5%.
VA mortgages are guaranteed by the Department of Veteran Affairs. These loans are designed for active military and veterans and allow them to purchase a home with no down payment
How To Apply For A Mortgage That Will Work For You
There are two primary factors to consider thinking about how to apply for a mortgage–the length of the loan and the type of interest rate.
Length Of Mortgage
The two most common mortgage lengths are 15 and 30 years. A 15-year mortgage carries a higher payment because the loan balance is spread across a smaller number of years. The 30-year mortgage usually carries a higher interest rate to reward the lender for lending for a longer period of time.
Should You Get A 15 Or 30-Year Mortgage?
Personally, I prefer having a 30-year mortgage. By having a lower payment, I can choose to pay down the mortgage faster when I have extra money while only paying the minimum when I don't.
When applying for a mortgage, you will have either a “fixed” or “variable” loan. A fixed-rate mortgage has an interest rate that does not change throughout the term of your loan, whereas a variable-rate loan adjusts periodically.
Interest rates on variable-rate mortgages will change before the term ends. Some variable-rate mortgage offer interest rates that are fixed for a specific time frame, while others will adjust almost immediately after your loan is funded. For example, a 2/28 variable mortgage has a fixed interest rate for two years with the interest rate open to change for the remaining 28 years.
When variable-rate mortgages change interest rates, their rates can go up or down based on the underlying rate index. With today's historically low-interest rates, there's a greater possibility of rates going up versus down over the next 30 years.
Each time that your interest changes, there's a maximum adjustment amount. And there is a cap to how high your interest rate can increase over the life of your loan. Your mortgage documents will spell all of this out for you.
Should You Get A Fixed Or Variable Mortgage?
I like the safety and security of a fixed-rate mortgage. When interest rates are low and stay low, as they have been over the last decade, you'll end up paying more with a fixed-rate mortgage.
However, the fixed-rate mortgage payment will not increase. With a variable-rate mortgage, the interest rate could increase dramatically over the course of a few years. This could put major pressure on your budget to the point where your mortgage is no longer affordable.
During the financial crisis, many people lost their homes because of increasing mortgage payments on variable-rate mortgages.
What Credit Score Do You Need To Buy A House?
Just like any other loan application, the higher your credit score, the better rates and terms you will receive. When you apply for your mortgage, the bank will pull all three credit scores and use the middle score to grade you. For example, if you have a 719 Experian, 725 Equifax, and 780 Transunion, your application will be based on the 725 credit score.
Ideally, you will have a credit score of 720 or higher to be approved for most mortgage programs. Some options provide better pricing or terms if your credit score is 740 or 760. However, scores higher than that will not provide any additional benefits.
If your credit scores are lower, you can still get approved for a mortgage. However, the terms and interest rates may not be as favorable.
Tips To Increase Your Credit Score
In the months leading up to buying a home, you should pull your credit reports and scores yourself. Pulling this information yourself will not affect your credit score. However, it will give you an idea of where you stand so you can figure out how to improve your score (if you need to).
- Review your credit report: request to remove accounts that are not yours and dispute any incorrect information, such as late payments, collections, or liens.
- Pay down revolving debt: credit utilization is the proportion of balances to credit limits. The lower you can reduce balances, the more you can improve your score.
- Stop using your credit cards: if you can't pay off your balances, at least stop adding to them. By switching to a cash budget, you can maintain control of your money and stop increasing your debt.
- Do not apply for new credit: when you apply for new credit, two things happen. Your credit score will go down based on a new inquiry and the average age of accounts will be reduced with the new account.
Before taking any drastic measures like closing an account, make sure you speak with a loan officer. They have tools that can perform simulations to estimate the impact to your credit score based on moves you may make.
How Long Does It Take To Be Approved For A Mortgage?
Today, the mortgage process typically takes 45 days from start to finish. However, I've seen some banks complete loans in as little as 15 to 20 days.
The biggest thing to remember is that you can help speed up this process. Start by having all of your paperwork ready when you apply, and always respond to any requests as soon as possible.
Do I Need To Pre-Qualify Before Submitting An Offer?
Although it is not a written rule, many real estate agents will not accept an offer on a home without a pre-qualification or pre-approval letter from your mortgage company.
Being pre-qualified shows the seller that you are serious about buying the home. This letter lets the seller know that you have the required down payment and income to be approved.
Should You Apply For A Credit Card During The Mortgage Process?
As tempting as it is to start buying accessories for your new home, you should not apply for any credit during the mortgage process. Your credit report will be pulled when you apply for a mortgage and again before the loan closes.
Banks want to be sure that you haven't taken on any new debt during the mortgage process that would affect your ability to make the new mortgage payment.
What Documents Do You Need To Get A Mortgage?
Applying for a mortgage is a very document-intensive process. You will share more financial information than just about any other time in your life. And when you provide some documents, it may trigger more questions and document requests from the lender.
The document requests will vary somewhat depending upon your personal situation, but these are the most common documents requested:
- Pay stubs for the last 60 days. Be prepared to provide the latest pay stubs as you get paid during the mortgage process.
- Two years' worth of tax returns. You'll also need to sign Form 4506-T, which allows the mortgage company to verify that the returns you provided are accurate.
- Three months' bank and investment statements. These statements document your assets and the deposits related to your income. This includes both taxable and retirement accounts. If there are large deposits or withdrawals, the lender may request more information about them.
- HOA documents. If your home is part of an HOA, they will want a copy of the agreement and terms.
- Property tax records. Most loans include property taxes in the payment, so the mortgage company needs to calculate the annual amount.
- Home insurance bill. This insurance is also included in your monthly payment.
Unique Situations Require Additional Documents
If you are self-employed, the lender will ask for additional documentation about your income. These documents include 1099s, a year-to-date profit & loss statement, and business bank statements.
For owners of rental properties, you'll need to provide details of each property. This includes current value, loan amount, property taxes, insurance, and a copy of the tenant lease. It is a good idea to have current mortgage statements, property tax bills, and insurance statements handy.
Other situations that can affect your finances, such as alimony, child support, or lawsuits, will also generate questions. Be prepared to answer questions about these arrangements during the loan process.
Should You Pay Off Your Home Early Or Invest?
Once you have your mortgage, the next question is “how will you pay your new loan?” Many people in the FI community advocate for becoming debt-free as soon as possible. Others, however, focus on the interest rate arbitrage available by borrowing at a lower rate while investing for higher returns.
Both sides have valid arguments about why their strategy is the better approach. Paying down your mortgage is a guaranteed return because you are avoiding interest charges on those balances. But you have to keep in mind that, if you need the money, you won't be able to access it without selling your home or refinancing it.
For a more in-depth discussion, read this article on the debate on paying off your home early or investing the money.
Ready To Apply For Your Mortgage?
With these tips on how to apply for a mortgage, the process will go much more smoothly.
You've identified a home that fits your budget and your goals. The down payment has been seasoning in an account for at least two to three months. All of your documentation is gathered and is available digitally to upload to your mortgage officer. And you're avoiding making any moves that could harm your credit, such as applying for credit or spending on your existing credit cards.
Have you applied for a mortgage recently? Were there any surprises along the way? Share your experiences in the comment section below.