Lenders will examine your credit history, capacity, and collateral. Lenders will verify your employment for the past two years and try to predict how likely it is that you will keep your job. If you’re weak in one area, strength in the other two areas or in a spouse’s bona fides may compensate. Or you may need to improve your credit score and establish a more stable income history or save for a bigger down payment. How much house can you afford depends on the monthly mortgage payment for which you qualify. Lenders apply payment-to-income ratios that you can also use for a ballpark estimate. Under the rules set by Fannie Mae and Freddie Mac, your monthly mortgage payment shouldn’t exceed 28% of your monthly gross income before taxes and other deductions. That includes principal and interest, real estate taxes, homeowners insurance, and homeowners’ association dues. Recurring monthly payments for all debts including mortgage, car loans, credit cards and student loans, shouldn’t exceed 36% of your monthly gross income. The Federal Housing Administration, another loan guarantor, allows ratios for mortgage and all debts of 31% and 43%, respectively. The higher your credit score, the bigger your down payment and the lower the risk of default you pose to the lender, the better the interest rate you’ll get. Fannie Mae and Freddie Mac require a minimum 5% down payment.
If you put down less than 20%, you’ll have to pay private mortgage insurance to protect the lender if you default. PMI costs about 0.5% to 1.5% of your loan amount per year, and the monthly cost factors into the debt-payment-to-income ratio. The FHA sets the bar at 3.5% down but requires an upfront mortgage-insurance premium, which is often rolled into the loan amount. You can use part of your down-payment money for an earnest-money deposit, which you’ll give to the seller with your purchase offer to show that you are a serious buyer. The amount required varies by location but typically runs 1% to 2% of the purchase price. The seller’s agent will hold the money in escrow until the sale closes, when you’ll receive credit for it. You may lose all or part of that money if you back out of the contract. You’ll also need money for closing costs usually 3% to 6% of the home’s purchase price. Sellers of entry-level homes often cover at least some of your closing costs, but loan guarantors limit how much they can help. If your down payment is 10% or less, the seller can pay up to 3% of the closing costs, and with 10% to 25% down, 6%. You can use a gift for your earnest money, down payment, closing costs or reserves.
The lender will require a gift letter from the donor stating that no repayment is expected. You can also borrow money from your 401(k) or IRA. You may qualify for down-payment and closing assistance from your city, county or state. You will not know for sure how much money you can borrow until you talk with a loan officer, who will review your financial profile and require you to document your resources with pay stubs, Form W-2s, tax returns, and bank and investment statements. Agents prefer that you be preapproved before they start showing you homes. That avoids wasted time and frustration looking at houses you can’t afford. Your real estate agent may urge you to meet with a “preferred” lender, whether it’s a favorite loan officer or a lender that’s affiliated with the real estate brokerage company. As a first-time borrower, you may feel more secure working with a local loan officer who can provide hand-holding. When you’re ready to make an offer, the lender will write an up-to-date preapproval letter for the specific property and the specific price you want to pay. The letter will show sellers you can afford their house, but it won’t reveal whether you can afford more than you’re offering. Agents receive a commission and the national average is 5.4% of the home sale price. The money is divided between the seller’s agent, your agent, and the real estate brokerage companies that employ them. As a buyer, you’re not responsible for payment because the sellers pay the entire commission from the proceeds of the sale. Protect yourself as best you can by hiring an agent who represents your interest only, a buyer’s agent, with whom you sign a “buyer’s agency agreement.” The agent pledges to protect your interest, and you agree to work only with that agent for a period of time. Include an inspection contingency in the contract so that you can renege without penalty if the house doesn’t meet up to standards. If your state provides a rescission period, you can organize for an inspection before the deadline. If there’s no rescission period, you should also incorporate financing and appraisal contingencies.