Those advertised super low interest rates are really attractive. So what do you need to actually get them?
Do you want to buy a home now or in the future, but fear that it's too expensive? Well, there may be ways to make it more affordable.
And while you may not be able to do much more than haggle over the asking price of your dream home, there are things you can do to make your mortgage cheaper.
"It's all about showing the lender that you are financially solvent and a low risk to loan a large amount of money," says Ellen Davis, a senior mortgage banker with Corridor Mortgage Group in Columbia, MD. In short, your lender wants to feel confident that you'll pay them back.
So, keep reading for three things you'll need to get the best deal on your mortgage.
1. A High Credit Score
You may feel that you are more than just a number, but according to Davis, your credit score is one of the first things a potential lender checks when going over your loan application. Most lenders use the FICO credit score, she says which ranges from a low of 300 to a high of 850.
To qualify for a mortgage at all you'll probably need a credit score of at least 620, maybe even 640, says Ken Lin, CEO of CreditKarma.com, a site where consumers can access their free credit reports.
But to qualify for those great rates that are splashed all over lenders' ads, in addition to other requirements, you'll probably need a score somewhere above 720 and possibly as high as 740, says Davis.
In other words, the higher your score is the lower your interest rate and the cheaper your mortgage.
And the difference between a poor and strong credit score and your resulting interest rate could mean a lot over the course of your mortgage. In fact, according to an example provided by Credit.com, a website that educates people about credit, it could be enough to pay for your kid’s education or a nice new car.
Their example looked at the difference between interest rates offered to borrowers in three different credit ranges for a 30-year, fixed-rate mortgage of $200,000 in May 2014. Here's what they found:
Credit Score Interest Rate Monthly Payment
(Principal & Interest) Lifetime Cost Total Savings with Great Credit
740 and above 4.025% $958 $344,778
680-699 4.974% $1,070 $385,368 $40,591
620-639 5.481% $1,133 $407,950 $63,173
As you can see, having good or excellent credit could save you tens of thousands of dollars over the life of your mortgage.
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To attain that great credit score, Lin says you'll want a few things. One is to have a few credit cards.
"You are not born with good credit - you have to earn it," says Lin. People sometimes believe that because they don't have any debt or have never used credit that they must have great credit. Not true, says Lin. "You have to use credit to get good credit," he says.
Next, in addition to never being late on your payments, keep your outstanding balance to 30 percent or less of your available credit limit, he says. So, if you have two credit cards with an available credit limit of $5,000 each, keep the outstanding balance on each below $1,500.
Finally, check your credit and correct any mistakes. Lin says 25 percent of all credit reports have a meaningful error on them, which could range from inaccurate late payment records to identity theft.
Lin also suggests checking your score at least six months before you apply for a mortgage, so you have time to work on improving it by doing a few of the things listed above.
He says that while a few late payments or a delinquency can lower your credit score fast, it takes time to raise your score more than a few points. He adds that six months before applying for a mortgage is not the time to close cards or get new ones - both can lower your score.
2. A Big Down Payment
A big down payment may sound like the opposite of “saving money,” but putting a lot of money down on your home could save you a bunch in interest and reduce your monthly costs.
First, it’s merely a math equation to see that a bigger down payment - and therefore, borrowing less - saves money. That’s because you will pay 30 years of interest on every dollar you borrow.
A larger down payment also helps with the interest rate you'll be offered, says Jim Duffy, a senior loan officer with Primary Residential Mortgage, Inc. Just like with credit scores, the percentage you put down could affect the amount of risk the lender sees in you, he says.
The numbers are not as straightforward as with FICO scores, but a good rule of thumb for most loans is to shoot for 20 percent down. If your other factors hold up - good credit report and score, good income, etc. - Duffy says this is the magic number to get the best rates.
That's because your down payment is the lender's "cushion" against you defaulting on your mortgage, says Duffy.
Finally, putting 20 percent down gets you out of having to pay private mortgage insurance (PMI), for exactly the same reasons as outlined above: under 20 percent down and lenders begin to get nervous about you defaulting on your mortgage.
Calculating PMI is complicated and varies widely based on the amount you borrow, the amount you put down, as well as other factors, says Duffy, but it can really add up. In fact, it can range from .5 percent to 1 percent of the amount of the mortgage per year, he says.
Run those numbers for a $300,000 mortgage, and PMI could ding you for $1,500 to $3,000 a year, or $125 to $250 per month.
To see how much all this could cost, let's look at a simple example of two 30-year mortgages. We'll keep the sales price of the home ($300,000) and the interest rate the same (4.20 percent*), but change the amount of down payment.
Mortgage A Mortgage B
Down Payment Percentage: 20 10
Down Payment Amount: $60,000 $30,000
Total PMI (@.75 percent/year):* $0 $11,981 ($168.75 for 71 months)
Monthly Mortgage Payment: $1,174 $1,320
Total Cost of Interest and PMI: $182,511 $217,306
Total Cost of Home: $482,511 $517,306
Bottom Line: As this example clearly shows, that 10 percent extra in down payment pays off overtime to the tune of savings of nearly $35,000.
3. A Low Debt-to-Income Ratio
The amount of debt you have compared to the amount of income you have is another key area of interest for any lender. Remember, the thinner you are stretched financially, the more risky you are perceived to be by lenders.
One way lenders assess this is by calculating your debt-to-income ratio (DTI), which is simply the percentage of your gross monthly income that goes toward paying your debt.
"Any monthly payments on credit cards, student loans, car loans, personal loans, etcetera, is used in the underwriting process to help calculate the debt-to-income ratio," says Davis. In addition, the mortgage payments, taxes, and PMI on the home you are trying to buy will also factor in.
When all that is calculated, you'll want your DTI to be 40 to 43 percent or lower to qualify for a mortgage, depending on the institution, says Davis.
However, for the best rates, you'll want your DTI to be in the mid 30s or below, all else being equal, says Duffy.
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So, say your total debt obligations for credit cards, car and personal loans, and the mortgage for which you're applying came to $1,500 a month. Your gross monthly income would have to be at least $4,286 to be considered for the best rates. That would be a DTI of 35 percent. Again, it's not exact, but it's a good start.
*According to Freddie Mac, one of the nation's largest mortgage holders, for the week of September 25, 2014. In the PMI example, this figure is based on the fact that with most mortgages, you can stop paying PMI once you reach 20 percent equity in your home. Make all scheduled payments in the above example, and that happens after 71 payments.
