Buying a home can be a long, complicated experience because you are unfamiliar with the process and procedures. There are realtor terms to understand when shopping for a home and lending practices to navigate when working with an underwriter. You must choose the right loan, at the best possible rate. Each decision can have a financial impact for decades to come.
When you understand the loan approval process, you can make better financial decisions.
The Four Elements of The Loan Approval Process
Lenders analyze every loan application focused on four key areas of your financial life, which include: income, assets, credit, and debt.
Income can include salary, hourly wages, bonuses, side jobs, or any other form of regular payment you receive. It is not necessary to include every source of income, but the lender will only consider what you disclose. In some cases, the lender will not include an income source if they deem the amount to be irregular. Commissions and bonuses are an example.
The amount of income needed to purchase a home varies based on where you want to buy. In general, cities are more expensive than the country, and certain neighborhoods can double the asking price of a home. For instance, buying in San Francisco will cost a median of 1.5 million, where $137,000 is the median price for a home in Cleveland.
Regardless of location, borrowers who spend less than 28% of monthly income towards the mortgage payment have stronger finances.
Assets: Lenders want to review checking, savings, and investment accounts to establish your financial strength. Available assets also play a part in the down payment. You do not need a 20% down payment, although paying a lower amount will typically raise the cost of the loan and could require mortgage insurance, which can add $100 or more to the monthly payment.
Credit: Lenders seek to understand how you manage credit. Loan approval typically requires a credit score above 620. Although, lenders reserve the best rate and terms to borrowers with credit scores above 700. A larger down payment or more assets could allow borrowers with weaker credit scores to receive an approval.
Debt: Along with a review of how you manage current debt obligations, lenders use current debt levels to calculate the debt to income ratio. This calculation compares your monthly income with the minimum debt payments found on your credit report. This ratio plays a major role in setting the upper limit on a home loan.
Mortgage Terms and Interest Rates
The type and term of the loan you choose will directly impact the rate you receive. The most common loan terms are 15 and 30-year loans. The 15-year mortgage will have a lower interest rate and a higher payment than a 30-year loan and is best if you want the lowest overall loan costs.
The ARM (Adjustable Rate Mortgage) offers the lowest rate and lowest monthly payment, but potentially the highest overall loan costs. An ARM provides an initial fixed rate, which then adjusts every year after the fixed rate term ends. The loans last for 30-years and typically come with a five or seven-year initial fixed term, before converting to an annually adjusted loan.
A fixed rate locks in the same interest for the duration of the loan. Therefore, a 15-year fixed rate offers the same payment for 15 years.
|Cost of A $200,000 Loan||Interest Rate||Monthly Payment|
|15 Year Fixed||4.125%||$1,492|
|30 Year Fixed||4.5%||$1,013|
|5/1 ARM 5 Year Fixed, 30 Year Term||4.250%||$ 984|
|7/1 ARM 7 Year Fixed, 30 Year Term||4.375%||$ 999|
A 30-year mortgage has a lower monthly payment than the 15-year. However, you pay significantly more over time by choosing the longer term. The 30-year loan reduced the payment by $479. However, the total interest on the 15-year loan is $68,548.33, compared to $164,813.42 on the 30-year loan. You pay nearly 2.5 times the interest for the longer term. The interest rate and payment are not the only factors to consider when choosing a loan.
The Adjustable Rate Mortgage ARM may be the best choice if you plan to live in the home for a short time. Typically, there are interest rate caps on ARM loans that have a maximum limit on increases. The rate caps affect the annual increase as well as a maximum over the life of the loan. For instance, the rate may only increase a maximum of 2% per year.
Refinance Versus Buying
Refinancing a loan will require paying closing costs again, which typically range from 1 to 5% of the loan amount. Many people refinance their home to secure a lower interest rate or eliminate the mortgage insurance. You can also use a refinance to reduce the term or get cash out for other needs. The rate offered will depend on the type of refinance, you plan to complete.
As you lower the mortgage, you gain equity in the home. Appreciation and home improvements can increase home equity faster. The difference between the value of your home and how much you owe on your home is known as equity. For example, if your home has a value of $250,000 and you owe $100,000, you have $150,000 of equity. Lenders do not typically allow you to get a loan at 100% equity. Taking out a loan for more than 80% of the value could result in paying mortgage insurance, just as with the original loan.
A cash-out refinance, can reclaim some of the equity in the form of a cash payment. However, you will reduce existing equity, increase the time it takes to pay off the loan and raise the amount you pay in interest. In many cases, it will result in a mortgage payment in retirement, which could impact your ability to retire comfortably.
If you are burdened with high amounts of credit card debt and are struggling to make your payments, or you’re just not seeing your balances go down, call Timberline Financial today for a free financial analysis.
Our team of highly skilled professionals will evaluate your current situation to see if you may qualify for one of our debt relief programs. You don’t have to struggle with high-interest credit card debt any longer.