Key number 1: Assess your strengths and weaknessesFor the purpose of obtaining a mortgage, your financial position consists of three components:
- Your income, which gives you the ability to make your monthly payments
- Your savings, which allow you to make a down payment, cover closing costs, and keep some cash reserves to cover unexpected expenses
- Your management of other credit, such as car loans and credit card balances
- Your strengths and weaknesses can be gauged by looking at these components relative to one another.
A. Savings relative to income
The first relationship to look at as is your savings relative to your income. Add up all of the savings that you have available for a down payment, including savings accounts, mutual fund shares that you plan to redeem, and gifts from relatives that will go toward a down payment. Then take this as a percent of your annual income, as in the calculator below:
If your savings amount to less than 25 percent of your income, then your savings are relatively deficient. For the maximum purchasing power, you probably will require a loan with a down payment of less than 5 percent, such as those offered by the Veterans Administration (VA) or the Federal Housing Authority (FHA). Alternatively, if you believe that you have the capacity to add to your savings in the next year or two, then it may pay to wait before buying a home.
If your savings amount to more than 25 percent of your income but less than 75 percent of your income, then your savings are adequate. You probably can put down at least 5 percent of the purchase price of your home. However, for the maximum purchasing power, you probably will require a loan with Private Mortgage Insurance (PMI), which adds to the cost of a mortgage.
If your savings amount to more than 75 percent of your income, then you probably can make a down payment of 20 percent of the purchase price of your home. This will allow you to avoid paying the cost of PMI.
B. Debt relative to income
One way to assess your management of credit is to look at the ratio of debt payments to income. Debt payments consist of car payments, student loan payments, alimony, required payments on installment loans, required payments on credit cards where you are paying interest, and other obligations. They do not include rent, utility bills, the mortgage payment on a house that you are selling to buy a new home, or payments on credit card balances where you pay at the end of the month without owing interest.
You want to look at your monthly debt payments as a percent of monthly income, which means taking your annual income and dividing it by 12, as in the calculator below.
If your monthly debt payments are more than 10 percent of your income, then debt is an area of concern. If along with this high debt ratio you have a history of sometimes missing your monthly payments, then you may have difficulty qualifying for the best mortgage rates. Even if your payment history is clean, you might benefit by paying down some of your debts before you take on the additional burden of a mortgage.
If your monthly debt payments are between 5 and 10 percent of your income, then this should not prevent you from obtaining a standard mortgage. However, you probably could benefit from reducing your debt payments, and you might be able to reduce your interest costs by taking out a larger mortgage and paying off some of your other debt. If your monthly payments are less than 5 percent of your income, then your debts should not cause a problem with respect to obtaining a mortgage.
Key number 2: Choose a standard product to fit your time horizon
When you look for a mortgage, you might encounter a lender who offers a “unique” mortgage product. When this happens, you should be wary.
It is difficult, if not impossible, to invent a new mortgage product that is clearly better than the standard products that exist. Typically, there is a trade-off. For example, you may find that a mortgage with a prepayment penalty offers a lower interest rate. However, if interest rates tumble after you take out the mortgage, the prepayment penalty will make it more difficult for you to realize the potential savings from refinancing.
My concern with “unique” products is that they take away your bargaining power. If the product truly is unique to that lender, then you cannot obtain a comparable quote from another lender, which weakens your bargaining power. For that reason, I recommend that you stick with mortgage products where you can get competing quotes from different lenders. That is what I mean by a standard product.
It is important to realize that the 30-year fixed-rate mortgage is not the only standard mortgage product. You can obtain quotes from many different lenders on 5-year and 7-year balloons, 1-year, 3-year, and 5-year adjustable rate mortgages (ARMs) tied to the one-year Treasury index, and 6-month and one-year ARMs tied to the COFI index (these latter loans are more prevalent in California than elsewhere).