Homeownership is still the American dream for millions, but with mortgage rate increases and property values on the rise, the affordability question looms large.
After all, it’s hard to shop for the home of your dreams if you aren’t sure of the size and type of mortgage you’ll qualify for, nor can you take steps if you haven’t determined if you’ll qualify for a mortgage in the first place.
The more knowledge you’ve got under your belt, the smoother the home-buying process will be. Knowing how much you can borrow is the first step to navigate the yellow brick road to homeownership.
Qualifying for a Mortgage
A new home is the largest purchase you may make during your lifetime, and unless you’ve amassed a sizeable nest egg, you’ll require a loan to bankroll the process. As it stands, the average home costs $395,000, up 44% from $274,000 a decade ago.
A mortgage can be your answer to homeownership. Mortgage loans, which last 30 years on average, are backed by your property and come with lower interest rates than a credit card. Several government programs can help you on your path to homeownership, including a Federal Housing Administrative (FHA) loan.
How to Determine Your Mortgage Rate
Both private and government-backed lenders will determine if you’re credit-worthy or in a suitable financial position to pay back the money you’re loaned. Lenders apply a stringent underwriting process that scrutinizes your past financial behavior. The last thing lenders want is a borrower to default on the loan so they get stuck with the property and have to pay expenses such as homeowners insurance.
Based on these results, they’ll assign an interest rate for the loan. The better you do during the underwriting process, the lower your interest rate. According to FICO, the credit scoring data company, the average interest rate on a 30-year fixed-rate mortgage is based on credit score:
|Credit Score||Average Mortgage Rate|
Factor 1: Credit Score
To determine the interest rate you’ll pay, lenders rely heavily on your credit score. This is the score given to you by the three credit scoring companies: TransUnion, Equifax and Experian, and is based on your past financial performance. To calculate the score, the firms look at your open lines of credit, instances when you applied for credit, your payment history and how long you have had a credit history. The credit scoring agencies assign different weights to each category to come up with your overall score.
For instance, according to FICO, the biggest factor is payment history, which accounts for 35% of your score. A close second, at 30%, is accounts owed. New credit and the mix of credit each make up 10% of the score and the length of your credit history accounts for 15%.
The credit score is an indicator of what type of mortgage you are eligible for, so know your credit score before you start getting quotes. Everyone is entitled to a free credit report from all three credit scoring firms on an annual basis. Keep in mind that while your credit score is an important component, it’s not the only factor in determining your mortgage rate.
Factor 2: Down Payment
One of the biggest roadblocks to homeownership is the down payment. In order to avoid paying private mortgage insurance, which can add 0.5% to 2% of the original mortgage loan to your payments each year, you’ll need to come up with 20% down, but the down payment doesn’t only lower the amount you have to pay back, it can also play a big role in the interest rate you pay.
The more skin in the game you have, the more confidence the lender has that you’ll make your payments. If you’re thinking about putting more down, consider the long-term implications. Will it save you enough money over the life of the loan to make it worthwhile to direct cash away from a $10,000 investment that has the potential to grow, for example?
Factor 3: Interest Rate Type
When it comes to the type of interest you pay on your mortgage, buyers have two options: fixed and variable. With a fixed-rate mortgage, the interest rate is locked in during the life of the loan. With an adjustable, or sometimes knows as a variable-rate mortgage, borrowers lock in an interest rate for a period of time and then it adjusts to the prevailing rate in the market.
An adjustable-rate loan tends to have a lower fixed rate, but when it resets, the rate can be much higher, depending on economic conditions at the time. Adjustable-rate mortgages vary; the most common is the five-year, but lenders also offer adjustable-rate mortgages that reset after three, seven and 10 years.
A fixed-rate mortgage tends to have a higher interest rate, but with it comes peace of mind that it won’t automatically reset and send your monthly payment higher.
Factor 4: Loan Terms
Lenders want to lend homeowners money but also prefer that it isn’t locked up for decades. As a result, they will entice buyers who choose shorter-term mortgages with a better interest rate. In general, the shorter the term of the loan, the less interest you’ll face because you pay off the mortgage more quickly. For example, a Freddie Mac 15-year fixed-rate mortgage has an average interest rate of 3.89%, compared to a 30-year fixed-rate loan from a government agency, which currently carries an average interest rate of 4.45%.
Factor 5: Location
In some areas of the country (California and New York, for example) home prices are skyrocketing, which requires borrowers to take out what is known as a jumbo mortgage. These are home loans for properties that cost more than $484,350, the limit for conventional mortgages. The larger the purchase price, the more risk to the lender, which leads to higher mortgage rates. A Fannie Mae jumbo loan, for example, typically carries interest rates that are 0.25% to 0.50% higher.
Where to Get a Quote
Start your search for a quote with banks, credit unions and mortgage companies. Various lenders will quote you different rates, so it’s important to contact several.
Time-strapped homebuyers can also work with a mortgage broker to get a quote. Brokers act as a middleman and contract with several lenders to provide you with a wider selection of terms from which to choose. Keep in mind they may not have your best interest in mind and could steer you toward a loan product that may not be the most advantageous. Consider contacting more than one mortgage broker to expand your net if you are going this route.
You can also complete the quote process through the internet. There are a handful of online lenders that will give you a detailed quote in as little as two minutes. Marketplaces also exist on the internet where lenders can compete for your business. The top rates may not always be the best, so make sure to shop around.
How to Get a Better Mortgage Rate
Getting mortgage quotes could leave you less than satisfied with the rate you’ll have to pay to purchase a home. If you fall into that category, there are steps you can take to improve your mortgage terms.
For starters, you can set aside your buying aspirations for a few months to a year and work on improving your credit. Pay down debt, keep balances low and make several on-time payments in a row to boost your credit score and lower your mortgage rate. You can also opt to increase your down payment or go with a lower-priced property.
Shopping for a home can be an exhilarating (and daunting!) process, especially for first time buyers. Understanding how much of a mortgage you qualify for can be immensely advantageous.