Affordability Planning : what you need to apply for a mortgage
The first step to acquiring financing is to get pre-approved. This means the bank has done it’s due diligence on your income and has provided you a soft commitment to finance your mortgage. Below is an overview what it takes to get pre-approved and here is how to calculate your own affordability.
The obvious goal is to secure financing at an attractive interest rate. The interest rate reflects the level of risk that you represent as a borrower to the bank. Factors that affect the interest rate include your credit rating, income, down payment, cash on hand, and the type and use of the home which you are purchasing (investment properties and condos, for example, can carry higher interest rates due to taking on more risk of having tenants and sharing walls with neighbors).
The first thing any lender will do is run a credit check to review your credit history and score. It is wise to know your credit score and many credit cards and websites available today can provide that information to you at little to no cost. It’s worth checking in on your score prior to heading to the bank. While those with credit scores in the 600s can certainly qualify for a mortgage, scores above 720 will benefit from lower rates.
Traditionally, buyers put down 20% of the home purchase price in cash in the form of a down payment. This money is different than closing costs and can be thought of as your initial equity in your home.
Down Payment + Mortgage = Home Purchase Price
Down Payment + Closing Costs = Cash To Close
The more money you put down, the less amount of money you need to borrow from the bank, and hence the more likely you are to benefit from a lower rate. Generally, banks work in 5% increments, meaning your interest rate rises as you move from 20% to 15% down, then may be higher if you put only 10% down.
We discuss in more detail here the different types of mortgage loans and their down payment requirements. FHA loans, for example, require as little as 3.5% down, but carry additional insurance the buyer pays throughout the life of the loan, making the total payment potentially higher. The best bet is to put as much down as you can reasonably afford, ensuring you retain enough for an emergency fund.
Cash on Hand
In addition to the down payment, banks will want to see you are retaining enough cash to cover emergencies, closing costs, moving expenses, and more. A good rule of thumb is to retain at least three months of living expenses (new home cost + other monthly debt payments + other spending).
Down Payment + Closing Costs + Emergency Fund = Cash To Buy
The more stable your income and job, the better. Most lenders require two years of tax returns to use as your baseline income. Critically, when applying for financing and throughout the home buying process, staying at your job is a necessity. Changing jobs will often require the bank to re-review your credit worthiness and could interfere with your ability to obtain a mortgage.
The Required Documents
Before you apply for a mortgage, ensure you have these documents ready to hand over:
Social Security numbers and birthdates for all borrowers
Two year employment history
Two year residency history
Last two to four paystubs
Last two years of Tax Returns (W-2’s if applicable)
All bank account and investment account balances