Editor's note: This article originally ran on the personal finance blog Len Penzo dot com. It has been reprinted here with permission.
A mortgage is often the single biggest loan someone obtains in his or her lifetime, typically costing tens of thousands of dollars in interest alone. Therefore it’s especially important to avoid some of the key mistakes that many home buyers make throughout the process of finding a lender and acquiring a home loan.
Here are five of the biggest errors home buyers make when obtaining a mortgage:
Having Unreasonable Expectations
Home buyers often look at only the mortgage payments for their dream homes and think they’re affordable. But it’s important to calculate the mortgage payments, as well as the taxes and insurance. Many lenders want these total housing costs to not exceed 30 percent of a borrower’s gross income. Home buyers should get preapproved for a loan before they start shopping to understand how much house they can afford.
Not Shopping Around
While 1 or 2 percent may not sound like a large amount, when it comes to a mortgage, the difference adds up. Consider: Home buyers who get a $300,000, 30-year mortgageat a 4 percent interest rate pay about $215,000 in interest over the life of the loan; home buyers who get a mortgage for the same amount but at a 5 percent rate pay about $64,000 more in interest over the life of the loan, despite only having an interest rate that’s 1 percentage point higher. It’s important for home buyers to shop around for reputable lenders offering low interest rates and low closing costs. Borrowers typically pay between 2 and 5 percent of the purchase price of the home in closing costs.
Not Reviewing — and Improving — Credit Scores Before Applying for a Loan
Lenders look at home buyers’ credit scores to help determine what interest rate they’ll charge. Home buyers should be aware of and, if necessary, improve their credit scores before securing a loan. Go to AnnualCreditReport.com to get credit scores from all three credit bureaus. Credit scores range from 300 (poor) to 850 (excellent) and are calculated by looking at a person’s past payment history (35 percent), amount owed (30 percent), length of time he or she has had credit (15 percent), new credit (10 percent) and types of credit (10 percent). Lenders typically offer borrowers with credit scores of 720 and higher the lowest rates. Consumers who have less-than-ideal scores should pay their bills on time, pay down big debts such as credit cards and avoid taking out multiple new credit lines at once. Plus, they should correct any errors on their credit reports that are bringing down their scores.
Not Being Financially PreparedComment on this story
When applying for a mortgage, lenders ask home buyers for financial records such as their past two years’ tax returns, proof of assets, proof of income, bank and brokerage accounts and other financial documents. It’s important that buyers understand not only which documents they’ll be asked to provide, but also how lenders are reviewing their financials. Lenders generally check that borrowers have a steady job history of two or more years at the same company or in the same field, sufficient income to pay housing costs and a debt-to-income ratio less than 40 percent. The debt-to-income ratio is the amount of monthly debt a person has compared to his or her monthly income. So, a home buyer who pays $1,000 per month for debts (including the new estimated housing expense) and brings in $4,000 per month in gross income would have a debt-to-income ratio of 25 percent (1,000/4,000). Lenders also review a home buyer’s bank accounts for multiple overdraft fees, which may be a red flag for lenders that the buyer can’t manage his or her money well. Note that buyers can often get a lower interest rate not only by having solid financials and a good credit score, but also by paying a down payment greater than 20 percent of the cost of the home.
Not Sourcing All Funds
Many home buyers think they have all their financials in order only to have a lender ask for a paper trail or source for their funds. Lenders get nervous when they see large cash deposits, gift money and regular transfers of money, and often ask buyers to show documentation for the source of the money, be it a side job or a gift. If the money is a gift, home buyers need to show where the money came from and get a signed letter stating that the money is a gift and not a loan.
In summary, it’s not difficult to avoid the major mortgage mistakes commonly made by home buyers. A well-prepared buyer should fully understand how much home he or she can afford before shopping for a mortgage, shop around for reputable but low-cost lenders, review credit scores and financials before applying for the loan, and have a paper trail for all funds.