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By Gabriella Cruz-Martínez
December 7, 2020
Rangely García / Money

A mortgage is a loan used to finance the purchase of a home or other real estate. Unlike credit cards or personal loans, mortgages are secured against the property they are used to buy, so if the borrower fails to pay, the lender may repossess the home.

What You Should Know:

  • The most popular loan in America is a 30-year fixed-rate mortgage. With this type of loan, borrowers agree to pay back their lender with identical monthly installments. After paying for 30-years — or 360-months — they will own the home outright.
  • Lenders also offer fixed-rate loans with 15-year terms. Some offer custom terms. A shorter loan term on the same house would mean paying more each month, but getting out of debt sooner and paying less interest over time.
  • An alternative to a fixed-rate loan is an adjustable-rate mortgage. These loans often have lower interest rates at first, but rates start to adjust to market conditions after five to ten years. ARMs are risky unless you know you will sell or refinance to a fixed loan before the fixed period ends.
  • Although you will apply for a mortgage with a bank or specialized lender, many loans in the United States are eventually purchased by Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs) that buy loans on the secondary market. Loans that meet Fannie and Freddie’s standards for purchasing loans are therefore called conforming loans. Loans that do not meet these standards, such as jumbo loans that exceed the GSEs loan size limits, are called non-conforming.
  • The U.S. Department of Agriculture, the Department of Veterans Affairs, or the Federal Housing Administration also guarantee mortgages for those who qualify.
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A home is the most expensive purchase most people will ever make. Chances are you don’t have enough cash to purchase a house out-of-pocket, which is why more than 80% of homeowners in the United States use a mortgage.

While eligibility requirements vary by lender and loan type, someone with a stable income, a high credit score, and a good credit history will be more likely to qualify for a home loan. In general, borrowers must meet a minimum credit score requirement of 580 for FHA loans and 620 for conventional loans. Most lenders will also require a debt-to-income ratio below 50%, which is calculated by dividing your monthly debt payments by your gross monthly income.

Types of Mortgages

Conventional vs. Conforming Loans

Conventional loans — not to be confused with conforming loans — are those which are not secured by the federal government. According to mortgage technology company Ellie Mae, conventional loans made up 80% of all mortgage applications in September 2020.

On the other hand, a conforming loan is a type of conventional loan which meets the loan limits set by the Federal Housing Finance Agency as well as the standards to be purchased by government-sponsored enterprises Fannie Mae and Freddie Mac.

As of 2020, the maximum conforming loan limit for one-unit properties to be acquired by Fannie Mae and Freddie Mac is $510,400 across most of the country. The loan limit for 2021 will be $548,250 or up to $822,375 in the most expensive housing markets.

Other Fannie Mae and Freddie Mac borrower eligibility guidelines for conforming loans include:

  • A minimum credit score of 620
  • A debt-to-income ratio of 43%
  • A down payment of 3% (or 20% in order to avoid paying for private mortgage insurance, which protects the lender, not the borrower)

Conforming mortgages are ideal for borrowers with a strong credit history, a stable source of income, and who can afford a larger down payment.

Non-Conforming Loans

A non-conforming loan is one that doesn’t meet the eligibility requirements set by Freddie and Fannie. There are two types of non-conforming loans: jumbo loans and government-backed mortgages.

Jumbo loans are used to finance expensive properties that exceed FHFA borrowing limits. For 2020 loans that exceed $510,400 are considered jumbo in most areas. The limit goes up to $765,600 in certain high-cost markets, yet actual limits vary by state and county. Lenders typically charge higher interest rates on jumbo loans and have stricter qualification requirements.

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Government-Backed Loans

Government-backed mortgages are those which are insured by the federal government through one of three agencies: the Federal Housing Administration (FHA), the US Department of Agriculture (USDA), or the Department of Veteran Affairs (VA).

These mortgages tend to have better interest rates and can provide relief options and protections in case of financial hardship. If you can’t get a conventional loan, you might be able to get a government-backed loan, as standards are different and sometimes less strict for these types of loans.

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Government-Backed Loans
U.S. Department of Veteran Affairs
(VA loans)
While VA loans are backed by the federal government, they are issued through private lenders. You don’t need to have excellent credit to be eligible for a VA loan; most lenders accept a credit score of 620. But you do need to meet military service requirements.
U.S. Department of Agriculture
(USDA loans)
USDA loans are designed to assist low-income homebuyers in rural or suburban areas. This loan is intended for the purchase, renovation, or construction of a single-family home, and the borrower must reside in the property. Most lenders accept credit scores starting at 640.
Federal Housing Administration
(FHA loans)
FHA loans allow you to purchase a home with as little as 3.5% down, a credit score as low as 580, and a low debt to income ratio. If your credit score is lower, a 10% down payment may be required.

Fixed vs. Adjustable-Rate Mortgage

The main difference between an adjustable-rate mortgage and a fixed-rate mortgage is that fixed-rate mortgages feature the same interest rate for the entire loan duration or term, while rates on adjustable-rate mortgages adjust at predetermined intervals after an initial fixed-rate period.

Mortgage lenders express the frequency at which ARM rates reset following a particular structure – 5/1, 7/1, or 10/1, for example – where the first number represents how long the rate will remain fixed and the second number the frequency with which the rate will adjust. So a 5/1 ARM mortgage will feature a fixed rate for the first five years, after which it will adjust annually based on an index.

Starting rates for ARMs are typically lower than those of fixed-rate mortgages but can increase over time, making your monthly mortgage payments unaffordable. However, according to the Consumer Financial Protection Bureau, some adjustable-rate mortgages have a cap on how high interest rates can go.

Fixed-Rate Mortgage Adjustable-Rate Mortgage
A fixed-rate mortgage charges the same amount of interest throughout the life of your loan. An adjustable-rate mortgage is variable, meaning that it will be subject to market conditions and your monthly payments could go up over time.
Main Advantages
You’re protected from market conditions influencing your monthly payments. A variable-rate often has an initial lower payment (or rate) than a fixed-rate mortgage, which can keep your monthly payments lower for a time.
Experts Recommend
An ARM is only worth considering if you plan to move out of your home before the fixed-rate period is up.

How to Qualify for a Mortgage

Before getting started on your journey to homeownership, take a look at your financial situation, gather the necessary paperwork, and crunch the numbers to have a better idea of what you can expect.

Check Your Credit

Start by going through your credit history and work on improving your credit score.

According to Equifax, your credit score will narrow down the interest rate, amount of money you can qualify for, and the payment terms of your mortgage loan. You’ll qualify for lower rates if your credit score is good to excellent. If your credit is considered bad or fair, your options will be limited.

“The most common reason why lenders may deny a mortgage is not having good credit,” said Jason Sharon, owner, and broker of Home Loans Inc. “For example, while VA loans don’t require a minimum credit score most lenders implement one as an overlay. They will also take a look into your credit history; if you have multiple missed payments, you’re not going to get a loan.”

Type of Loan Credit Score
Conventional loans A minimum of 620, while some require 660 or more.
Jumbo Loans Because they are at higher risk, they may require a credit score of 700 or more.
FHA Loans A minimum credit score of 500, but you’ll need a down payment of 10%, 0r 580 if you put down 3.5%
VA Loans No minimum credit score, but generally accept a credit score of 620.
USDA Loans A minimum of 580, but may have exceptions in some cases.
Source: Experian

Checking your credit reports regularly can give you an idea of your financial health and help you manage your financial obligations effectively. It can also help you identify fraud or incorrect items that could be lowering your credit score.

“Due to Covid-19 and general economic uncertainty, some lenders are still more conservative when it comes to credit score requirements,” warns Josh Lewis, owner, and broker at Buy Wise Mortgage.

Lewis states that while FHA and VA credit requirements have not changed, many lenders have implemented minimum credit scores of 620-640, which he describes as “a massive change” considering that credit scores for government-backed loans were lower.

“While some lenders will still do government loans with scores down into the 500’s, interest rates are much higher,” adds Lewis.

By a higher interest rate, Lewis means rates of 4% and above or paying 2-3 points to get the same rate as someone with a 680 FICO.

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Get Pre-Approved

A mortgage pre-approval letter is an essential part of the home buying process, as many sellers and agents won’t entertain an offer from a borrower that isn’t pre-approved — especially when demand and competition are high. To get pre-approved, you’ll need to verify your income, employment, assets, and debt. If you’re self-employed, you may have to share more information regarding your income.

Pre-qualification, on the other hand, gives you a general idea of how much house you can afford using basic information from your bank account and credit.

To get the best possible rates, shop around and get pre-approved with different lenders. Pre-approval letters are generally valid for up to 90 days, which gives you sufficient time to compare offers.

If you’re worried that your credit score will suffer after getting pre-approved by several lenders, there’s no need. While getting pre-approved for a loan does result in a hard credit inquiry, multiple hard credit inquiries for auto or home loans within a certain period (usually 14-45 days) are counted as one inquiry.

Common documents required to get pre-approved include:

  • Pay stubs and employment documents, such as tax returns, W-2s, and 1099s
  • Asset statements on bank, retirement, and investments
  • Debt-to-income ratio: monthly debt obligations (auto, student, or real-estate loans)
  • Bankruptcy and foreclosure records
  • Evidence of divorce, if applicable
  • Copy of former rental payments

Calculate Your Payment

You can calculate your mortgage payments using our simple mortgage calculator.

Don’t Forget About Closing Costs

Closing costs vary depending on your state, loan type, and mortgage lender. You can expect to pay up between 2% to 5% of the home’s purchase price in closing costs.

Closing generally includes:
Appraisal fee The appraisal determines the value of the home. Can cost between $300 – $500.
Home inspection costs Inspections ensure the property is structurally sound and habitable. Can cost from $300 to over $500.
Escrow fees An escrow account is set up to hold your good faith deposit until closing. After closing, you may be required to add funds to the account to cover property taxes and home insurance.
Property tax fees The city or county may charge a fee for certifying you have paid your property taxes.
Flood certification Charged to determine whether the property is located in a flood hazard area.
Application fee Charged for processing and underwriting the loan. This is a non-refundable fee.
Origination fee Charged by the lender for setting up a new loan. This can cost from 0.5% – 1% of the loan amount.
Mortgage points Also known as discount points, these allow you to pay more up front to get a lower interest rate. One point costs 1% of the total loan amount.
Private Mortgage Insurance Insurance to protect the lender from losses, typically required from borrowers whose down payment is less than 20% of the value of the home.
Credit Report The cost of a credit report detailing your credit history. Generally $30 to $50.
Document Preparation The cost of preparing legal closing documents.
Homeowners Insurance Protects the lender and the borrower against physical damage to the home. Homeowners insurance costs vary by property type, location, and the coverage amount.
Title search report Charged by a title company that goes over the property history to ensure the title is clear of liens.
Prepaid interest Interest that accrues from the time the loan is closed to the first mortgage payment.

The Right Mortgage For You

To find the best mortgage lender and interest rate, take your time, and compare offers from several lenders. The three credit reporting agencies, TransUnion, Equifax, and Experian, allow exceptions on hard inquiries if you’re shopping rates for a new auto or mortgage loan.

Remember that should you request several pre-approval letters, those multiple inquiries will count as one inquiry for a given period of time, typically 14 to 45 days. This gives you time to shop for lenders and find the best loan terms for you.

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