Buying a home is one of the biggest purchases you can make in your lifetime. Here’s the Smart MNE guide to mortgages as a first-time buyer.
This is the run-down for all you sophisticated adults wanting this to be a less sophisticated decision than your TI-80 calculator computing the mortgage amortization schedule. First you need to ask yourself: Am I ready to take on a long-term commitment in order to stop spending close to $4,000 a month on rent?
Buying a condo or home has a lot of upfront expenses, like closing costs and a down payment, but the long-term benefits are equity growth and the freedom to customize your home to your liking. If this is your cup of tea, you need to figure out how much you can afford to spend on a house.
The rule of thumb is that your mortgage payment shouldn’t be more than 28% of your monthly pre-tax income and 36% of your total debt, otherwise known as the debt-to-income (DTI) ratio. For example, a salary of $150,000 would afford a mortgage payment of up to $3,500 a month. But that doesn’t take into account other housing costs like homeowners insurance or property taxes. At the end of the day, you want to find your breakeven point between the rent you’re paying now and the total monthly costs to own.
Buy your first house without breaking the bank
I’m writing to you from the other side of this financial transaction and can say with confidence, buying a house is easier than you think—with the right amount of planning. I can also say that your first condo or home purchase doesn’t have to cost you that fantastic vacation to the Mediterranean next year. Understanding the incentives and rules for a first-time home purchase can be done without selling your kidneys.
The upside of being a first-timer is that you can put as little as 3% down. But before we jump straight to the 3% down payment option, I want to lay out the most common types of mortgages.
1. Conventional mortgages
Conventional mortgages are conventional for a reason; it’s the loan that’s most often offered by lenders. This type of loan is so common that it was used to fund 78.5% of new home sales in Q1 of 2022. Conventional mortgages have the benefit of a less stringent property standard when it comes time for appraisal. This type of loan can also be used on rental properties which is a big plus over FHA loans. The conventional route requires a higher credit score and good personal balance sheet. This means small amounts of debts and plenty of liquid assets (aka cash) stowed away for the homebuying process.
Typically, lenders will want to see a credit score higher than 600. Buyers with scores of 740 or more usually get the best interest rates. Banks and mortgage lenders will allow consumers with higher credit scores to put less than 20% down.
The reason conventional loan qualifications are more stringent is because they’re not backed by any government agency. Without the backing of these agencies, lenders need you to be in a stronger financial position to take on this long-term debt. This type of loan is most commonly offered as a 30-year term, and the better your credit, the less interest you will pay over time. Additionally, if you put down less than 20%, lenders will require you to pay for private mortgage insurance (PMI) to further protect themselves from a default.
Frequently asked questions about conventional mortgages
Do conventional loans offer the lowest down payment of all types of mortgage loans?
The short answer is yes, but that’s only if you’re the perfect borrower by their standards—meaning you have a decent level of income and savings, and an excellent credit score.
The lowest down payment possible with a conventional loan is 3%. Qualifying for that is rare, especially in this economy, simply because the risk is entirely on you. It’s more common to get a lower down payment with a government-backed loan like an FHA (3.5%) or a VA (0%).
Where does private mortgage insurance come into play?
In the world of conventional loans, PMI seems like a pestering extra expense on your monthly payment, but it’s really your get out of “20% down” jail card. Any loan that is funded with less than 20% requires private mortgage insurance. This little caveat protects the lender from a huge default on the books and allows you to have more money on hand for other expenses.
With a conventional loan, the PMI cost varies based on your loan amount. Once your equity reaches 22% of the original purchase price, you no longer have to pay private mortgage insurance.
2. Federal housing administration (FHA) mortgages
When the bankers say, “You’re not qualified yet,” Fannie Mae and Freddie Mac are here to assist. You may not be considering these names for your firstborn child, but having them back your mortgage makes qualifying easier. If your credit score hovers around 580, consider yourself a top recruit for the 3.5% down, FHA loan. Credit scores as low as 500 can get an FHA loan but will require a higher down payment. The real beauty of these loans is that the government is on your team and will allow a more favorable DTI ratio of 50% or less.
Frequently asked questions about FHA mortgages
What is the loan dollar limit for FHA loans?
The 2022 FHA loan limit is $420,680 in low-cost areas and $970,800 in expensive markets. So if you’re looking at that $4 million high-rise mansion, you’re instead going to need a jumbo loan, which I suggest you read more about here.
Can I refinance an FHA loan?
Yes, indeed. In fact, FHA loans are the easiest of all mortgages to refinance. There are no income verifications or credit checks and more often than not you can skip the home appraisal. Another great benefit to refinancing your FHA loan to a conventional loan would be to eliminate the mortgage insurance costs. Once you reach 20% equity on the home, you can refinance and break free.
3. VA loans
This type of mortgage loan was established by the Department of Veteran Affairs (VA). It was created to offer active veterans and their surviving spouses a dedicated avenue for purchasing a home. If you qualify for this type of loan, the benefits are very generous. VA loan terms can be written with no down payment, mortgage insurance, or prepayment penalties. The VA department sets the terms and conditions on these loans but does not actually write the loan. It is another government-backed loan but is issued through private lenders after a borrower has proven their qualifications.
What property restrictions do VA loans have?
First and foremost, you can only use this type of loan for your primary residence. Additionally, the property you are purchasing needs to be in “move-in ready” condition to get approved. So that fixer-upper or working farm will not suffice.
What are the financial requirements of the borrower for a VA loan?
The great thing with this type of loan is that the borrower can receive financing for up to 100% of the purchase price. In other words, there’s no down payment requirement. However, if the borrower has a history of bankruptcy or foreclosure they will not be denied a loan. This type of loan does not require mortgage insurance no matter how small the down payment may be.
Fixed vs. variable mortgages
Mortgages can either have a fixed interest rate or an adjustable interest rate.
Whether you choose a 15-, 20-, or 30-year mortgage, a fixed interest rate is locked in and will never change or be affected by market conditions.
An adjustable-rate mortgage, or ARM, is going to have a fixed interest rate period that lasts usually five or seven years. Once your fixed period has ended, your rate will fluctuate based on a set schedule as market rates change. That means your monthly payment can go up or down. This arrangement can be complicated and is best for a specific type of buyer.
Frequently asked questions about ARMs
What is the best case scenario to consider an ARM mortgage?
If the thought of a shifting mortgage payment makes you queasy, let me give you the antacid pro to ARM mortgages. These types of mortgages are going to give an initial interest rate considerably below any fixed interest rate offer. This can be a good strategy for someone who is not planning to stay in their home for more than five to seven years. Before the rate is set to “float,” you can sell.
Are the current housing market and interest rate conditions ideal today?
The Federal Reserve is expected to continue raising interest rates until we have a hold on inflation. That means potentially down the road when interest rates are no longer being hiked, we could see rates go down—but that’s all speculation.
Dive in to home equity
Owning a home is a rite of passage. With it comes new responsibilities and challenges. If you’re ready for never-ending home improvement projects and dealing with absentee home repairmen—plus all the other, actual true delights that come with homeownership—review your budget and talk to your local mortgage broker about the best financing options for your situation.