Ready to buy a house? Great! Before you start shopping online or waltzing through open houses, you’ll want to line up financing first.
To make that happen, you’ll need to do a little prep work when applying for a mortgage.
REVIEW YOUR BUDGET
Figure out the maximum payment you can afford to take on each month for your future home. This figure should ensure that you’re still able to pay all your bills, cover your lifestyle and keep working toward other financial goals. You don’t want to take on such a huge loan that it leaves you house poor.
CHECK YOUR CREDIT SCORE
Mortgage lenders will look at your credit score (most likely your FICO score) to gauge your level of financial responsibility. A better score typically means you’ll pay less in interest, which can save you thousands of dollars over the life of your loan.
While a perfect credit score is 850, scores 800 and above are considered exceptional, according to Experian, one of the credit reporting agencies. For comparison: a very good score is 740 to 799, a good credit score is 670 to 739, a fair score is 580 to 669, and a poor score is 300 to 579.
You’re entitled to a free copy of your credit report once a year from each of the three major credit bureaus (Equifax, Experian and TransUnion) at AnnualCreditReport.com. The credit report doesn’t include your actual score — for that, you’ll have to pay a small fee — but it shows your credit history, including any blemishes like missed credit card payments. (Note: Some credit card companies or other financial institutions will show your credit score for free on your monthly statements or on request.)
So, why check your credit report before applying for a home loan? Because there might be errors that are damaging your score. In a 2013 Federal Trade Commission survey, one in four Americans said they spotted errors on their reports. If you find an error, report it.
If your credit is in bad shape because of something you did — like missing payments — it may take you several months to boost your score. If you’re in this situation, you may want to wait until your score goes up before applying for a loan.
Credit score requirements depend on what type of loan you’re getting. For most conventional loans, you need at least a 620. Some alternative loans will accept a lower score.
COMPILE THE NECESSARY PAPERWORK
To apply for a home loan, you’ll need to provide the mortgage lender with a number of documents. For the typical home buyer, this includes:
- Pay stubs from the past 30 days showing your year-to-date income
- Two years of federal tax returns
- Two years of W-2 forms
- 60 days or a quarterly statement of all your accounts, including your checking, savings and any investment accounts
- Residential history for the past two years, including landlord contact information if you rented
- Proof of funds for the down payment, such as a bank statement. If the cash is from a gift, you may also need to provide a gift letter from the person who gave the gift to prove the money isn’t a loan.
DETERMINE YOUR DOWN PAYMENT AMOUNT
For a conventional loan, there are a couple main benefits to making the widely recommended 20 percent down payment. The obvious one is that a larger down payment means a smaller monthly mortgage payment — and, consequently, less money you’ll pay in interest over the life of the loan. The other perk of putting 20 percent down? It enables you to avoid paying private mortgage insurance (PMI) — a premium that protects the mortgage lender in case you can’t pay the loan back. PMI ranges from about 0.5 to 1 percent of your home loan and is usually paid in monthly installments or an upfront premium. Once you have around 20 percent equity in your home, you can usually get rid of PMI.
If you don’t have a conventional loan but rather a Federal Housing Administration (FHA) loan, you’ll typically have to pay an upfront and monthly insurance premium (MIP) no matter how big your down payment is. The timing for when or if the MIP is canceled depends on your loan terms.
BUDGET FOR CLOSING COSTS
In addition to the cash that you’ll need for the down payment, you’ll also have to cover your share of the closing costs, which are one-time fees.
Closing costs typically run from 2 to 5 percent of the home’s purchase price. For example, on a $300,000 home, your closing costs might be between $6,000 and $15,000. While that’s a wide range, your mortgage lender will provide you with a “Loan Estimate,” a document that spells out the terms of the mortgage, including the loan amount, interest rate and approximated closing costs. This estimate — sometimes referred to as a “Good-Faith Estimate” — will be provided to you by the lender within three business days of receiving your loan application.
A better score typically means you’ll pay less in interest, which can save you thousands of dollars over the life of your loan.