Finding the perfect home for you is a dream come true, but you could be in for a rude awakening if you're not ready to pounce when you find it. Before you go looking for that home, you have to do some work in advance in order to be ready to lock in the deal.
What does that mean? It means saving up an adequate down payment, identifying the right mortgage lender, checking your credit rating, minimizing your debts, setting aside cash for closing costs, and getting pre-approval for a mortgage in advance.
All before you go to your first open house.
Key Takeaways
- Make sure you have an adequate down payment; 20% of the purchase price is standard.
- Do your research in advance to target the best lender for you.
- Check your credit rating and improve it if necessary to get the best mortgage rate.
- Add up your total outstanding debt and trim as possible.
- Stash away 2% to 5% of your planned purchase price to cover closing costs.
- Get pre-approval from your chosen lender.
Requirements to Buy a House
A growing number of homebuyers are skipping the mortgage process and paying all cash. Nearly 32% paid cash for a home in 2022, according to the real estate site Redfin. That's a considerable increase from only two years before, at the height of the pandemic, when it was about 20%.
That's nice for them. An all-cash buyer has an edge over others if there are multiple parties interested in the home.
However, two-thirds of the homebuying marketdoesn't have that kind of cash. These buyers may be homebuyers in their 20s, just starting in the career world, or other first-time homebuyers. Their need for advance preparation becomes all the more urgent.
The six steps below can help equal the playing field for you. Especially the last step: Get a mortgage pre-approval in advance. It's not a binding document, but it alerts the seller that a lender has reviewed your financial circ*mstances and is ready and willing to grant you a mortgage up to a certain level.
6 Boxes to Check
The process can differ among lenders but in every case, there are six boxes to check off when applying for a home loan: Get your down payment together; pick a lender, check your credit score, check your debt-to-income ratio, set aside closing costs, and apply for pre-approval of a mortgage.
You might add a good real estate agent to this list. Eighty-six percent of people who bought a home in 2022 said they found a real estate agent to be useful in the process.
Important
When choosing a real estate agent, consider the person's background, credentials, and experience. Asking friends and family for referrals can help you find the right professional to work with.
Requirement #1: Collect the Down Payment
The first requirement to buy a home is a down payment. This is the money you pay upfront to offset the amount you need to borrow.
“Lenders have tightened the requirements since the economic crisis in 2008,” says Karen R. Jenkins, president and CEO of KRJ Consulting. “As a result, prospective borrowers seeking to purchase a home must have some ‘skin in the game’ to qualify for a home.”
To get the best rate available, you should have 20% to put down. That also will allow you to skip private mortgage insurance, which adds to your monthly costs down the road.
If you don't have that kind of money, consider checking your eligibility for a Federal Housing Administration (FHA) loan. The agency requires only a 3.5% down payment. With FHA approval, you can get a loan from a bank with the federal agency acting as your mortgage insurer.
If you are a veteran of the U.S. Armed Forces, you may be eligible for a Veterans Administration-backed loan. Up to 100% financing is available.
The U.S. Department of Agriculture (USDA) has its own home loan program that assists lower and moderate-income people to obtain decent homes in rural areas. It offers up to 100% financing.
If you're having trouble getting the down payment together, there are other options. The federal Housing and Urban Development (HUD) has a down payment assistance program for first-time homebuyers. The money is distributed through the states, and each has its own rules.
You could also ask for a down payment gift from a family member. Keep in mind that there may be limits on down payment gifts and you'll need a properly documented down payment gift letter.
Requirement #2: Choose a Lender
It's important to shop around for a lender. Every bank sets its own loan rates, and a fractional difference adds up to a lot of bucks over 15 or 30 years.
You can start off by checking with your own bank. It might offer you a competitive rate because you already do business with them.
Don't rule out credit unions, small community banks, and online lenders. The more lenders you check, the more likely it is that you'll get a really good rate.
A great tool for researching and comparing interest rates is a mortgage calculator. It will give you an idea of your real costs at various rates before you meet with a mortgage broker or a lender.
Getting pre-approved for a home loan could give you an edge when making an offer on a property. It shows the seller that you're qualified and you're serious.
Requirement #3: Check Your Credit Score
Mortgage lenders consider your entire financial situation when you apply for a loan but your FICO score is a critical piece of information.
Your score indicates to lenders how likely you are to repay the money you borrow. The higher your credit score, the better the interest rate you will be offered. If you have a bad score or, even worse, no credit history at all, it will be very difficult to qualify at all.
It would be a challenge to find a lender who'll work with a borrower who has a credit score below 620 or 640. The FHA will back mortgages for qualified buyers with a credit score as low as 500.
Checking your credit scores before applying can give you a better idea of whether you meet the lender's requirements to buy a house. This can also give you a feel for what kind of interest rates you're likely to pay for a mortgage.
If you find that your credit score is too low for you to qualify for a mortgage, don't despair. Start working on paying off bad debts and paying down credit card debt. Keep checking your score from month to month. You should see real progress within a few months.
Requirement #4: Know Your Debt-to-Income Ratio
Debt-to-income ratio (DTI) represents the percentage of your gross income that goes toward paying off debt and interest each month. The lower this number is, the better for meeting the mortgage requirements.
Banks use your DTI to determine whether you can afford to add the burden of a mortgage payment to your existing debts. The Consumer Financial Protection Bureau has rules stating that the debt-to-income ratio, including the mortgage and associated costs, cannot exceed 43% of gross income. If your DTI exceeds this amount, you will have a harder time getting a mortgage.
So how can you reduce your DTI to meet the requirements for a mortgage? Paying down some of your debt is an obvious choice. You could also improve your debt-to-income ratio by finding ways to boost your earnings.
But consider whether that higher income is sustainable. Otherwise, you may not be able to afford mortgage payments over the long term.
Requirement #5: Set Aside Closing Costs
Closing costs are fees and charges you must pay to various parties at closing.
Your lender will provide you with a detailed estimate of what you'll have to pay. On average, closing costs run from 2% to 5% of the home's purchase price. So, if you're buying a $300,000 home you might pay anywhere from $6,000 to $15,000 at closing.
Typical closing costs can include:
- Credit report fees
- Application fees
- Recording fees
- Title insurance fees
- Underwriting or processing fees
- Closing fees
- Escrow fees
- Origination fees
- Prepaid interest
- Survey fees
Some of the same sources that offer down payment assistance programs also offer help with closing costs. For example, the Florida Housing Finance Corporation has a housing costs program for some first-time homebuyers.
Requirement #6: Apply for a Mortgage Pre-Approval
If you're going to apply for a mortgage, you need to gather together your financial documents. And once you have that done, you're ready to apply to a lender for a mortgage pre-approval. This will speed the process and save you work down the road when you've actually found the home you want.
Your lender can give you a checklist of the required documentation. Generally, it includes proof of your income, debts, assets, and employment. Pay stubs, tax returns, bank statements, W2 forms, and employment verifications are all proof of your ability to pay off a mortgage.
Pre-approval is a fairly speedy process. Since it's not a binding document, the bank doesn't have to verify every piece of paper.
The actual mortgage approval process is a more exhaustive process and can be grueling. Just grit your teeth and give them the extra pieces of paper they want.
What Credit Score Is Needed to Buy a House?
An applicant who gets approval for Federal Housing Administration (FHA) loan can qualify for a mortgage with a credit score as low as 500. Most banks and other lenders require a credit score of 640 or above. The best interest rates are available only to those with high credit ratings.
How Much Money Do I Need to Put Down on a Home?
You'll need to put down at least 20% on a conventional home loan. That is the minimum that most lenders want to see, and it also allows the buyer to avoid paying for private mortgage insurance (PMI) until they build up some equity.
FHA loans have a down payment requirement as low as 3.5%, while programs from the VA and the USDA will finance up to 100% of a mortgage.
What Documents Do I Need To Apply for a Mortgage?
When you choose a lender, ask for its checklist. The documents you need can include pay stubs, tax returns, bank statements, and investment account statements. The lender will ask for consent to pull your credit reports and credit scores as well. Basically, you need to prove that you have a steady income, a habit of paying your bills, a reasonable amount of debt, and some cash in the bank.
How Much Money Will I Need for Closing Costs?
Closing costs for a home purchase typically range from 2% to 5% of the home's purchase price. The more expensive the home, the more money you'll likely need to finalize the closing. This varies greatly by location. Check for state and city transfer taxes.
The Bottom Line
Before you can think about buying your dream home, you need to be sure that your finances are in order and that you're thoroughly prepared for the mortgage approval process. You'll really have your ducks in a row if you get a mortgage pre-approval. You'll be ready to apply for a mortgage quickly and the seller will know your intentions are serious.
