Life Events, Mortgage

Open Credit Report Disputes Can Sabotage Your Chance For a Mortgage

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Purchase agreement for house

After months of searching through listings, you’ve finally found your dream home. Your offer has been accepted and you’ve started daydreaming about future dinner parties, contemporary light fixtures, and planting a backyard herb garden. Just one problem — the financing hasn’t been approved.

The mortgage underwriting process can seemingly last a lifetime when it’s standing between you and your dream home. However, the timeline hasn’t always been such a nail-biter for prospective homebuyers.

The housing bubble leading up to The Great Recession created a hunger from investors for mortgage-backed securities. As a result, borrowing costs were lowered, lending standards were loosened, and many homebuyers were approved for loans they couldn’t afford. When the housing market collapsed, many Americans were in trouble. These predatory lending practices contributed to both the financial crisis and The Great Recession.

A direct response to The Great Recession, the Dodd-Frank Wall Street Reform and Consumer Protection Act or “Dodd-Frank” was signed into law in 2010. This financial reform legislation included the creation of the Consumer Financial Protection Bureau who established the Ability to Repay and Qualified Mortgage Standards Under the Truth in Lending Act.

These new standards include a much more comprehensive financial verification process for mortgages including a closer look at an applicant’s credit history.

Why Do Credit Scores Matter?

Before you begin the home buying process, it’s smart to review your credit report and have a copy of your FICO score handy. Your FICO score is assigned by the credit reporting agencies based on the information within your credit report. A FICO score also factors into your Ability to Repay qualifications.

Tip: You can request a free credit report once a year from AnnualCreditReport.com.

Credit scores aren’t the only thing mortgage loan officers worry about, but a FICO score can heavily influence the interest rate you are able to secure. The highest scores qualify consumers for the best possible mortgage rates.

It’s critical to arm yourself with this information in advance. Plus, it gives you the opportunity to dispute any inaccuracies you’ve discovered and clean up your report.

What is a Credit Report Dispute?

Credit report inaccuracies are relatively common. Inaccurate information can happen for a variety of reasons — a clerical error, a shared name, or even identity theft. And inaccurate information in your credit report can harm your score. That’s why it’s important to regularly keep track of what’s happening.

Under the Fair Credit Reporting Act (FCRA), consumers have the right to dispute inaccurate information. Fortunately, it’s easier than ever to file a dispute with all three credit reporting agencies online.

The problem is, many disputes can go unresolved for long periods of time. An unresolved dispute can be particularly troublesome for consumers applying for a mortgage. Many applicants don’t realize an open credit report dispute can raise a red flag to lenders, and may even prevent mortgage approval.

[Learn more about Fannie Mae’s Frequently Asked Underwriting Questions here.]

How Open Credit Report Disputes Hurt a Mortgage Application

If open credit report disputes are relatively common, how can they hurt a mortgage application?

When a dispute is filed, credit reporting agencies are required to label the item as “in dispute.” An item being actively disputed can not harm your FICO score. In fact, your score will be temporarily inflated while harmful items are being investigated.

Lenders know credit reports with disputed items are not the most accurate picture of a consumer’s history and many require for this status to be removed before approving a mortgage application. This leaves some consumers with a difficult decision to make — accept costly credit report errors or delay applying for a loan until disputes have been resolved.

Fannie Mae & Freddie Mac

Fannie Mae’s automated underwriting system, Desktop Underwriter (DU), automatically issues the warning message “consumer disputed” when a credit report reveals a 30-day or more delinquency reported within 2 years of the inquiry. The lender must confirm the accuracy and completeness of the borrower’s credit report by obtaining a new report without the dispute or manually underwrite the loan.

Loan Prospector, Freddie Mac’s automated underwriting system, follows a similar process. Gaining access to a new credit report with updated information is not an option for the borrower if the creditor won’t correct the information. And when a consumer files a complaint with the credit reporting agencies (TransUnion, Equifax, and Experian), the agencies will often defer to the creditor.

Last fall, the National Consumer Law Center wrote a letter to the Federal Housing Finance Agency, urging reform for the treatment of consumers with credit report disputes. They believe lenders who reject applicants because they don’t want to manually underwrite the loan are in violation of the Equal Credit Opportunity Act (ECOA).

FHA Approved Mortgages

FHA approved mortgages will approve an application with a disputed credit report, however, the process may still be time consuming.

A couple of years ago, the U.S. Department of Housing and Urban Development decided to look more closely at open disputes and provided new instructions for lenders in a Mortgagee Letter (ML). This ML addresses both derogatory and non-derogatory disputes and requires lenders to more carefully evaluate the risk associated with a consumer.

What To Do if You’re Still Struggling

Dealing with an unresolved credit report dispute can turn into a consumer nightmare. Even if you’ve followed best practices, like submitting credit report disputes both in writing and online, you may still be unhappy with the results.

Fortunately, you can still submit a complaint to the Consumer Financial Protection Bureau. They will forward your complaint directly to the company in dispute and work to get a response from them. Another option is to seek guidance from a consumer advocate or an attorney. The National Foundation for Credit Counseling may be a helpful place to start.

Because a credit report and FICO score have such a strong influence on lifelong financial health, the best defense is to be proactive. Regularly monitoring your credit report and working to fix inaccuracies before applying for a mortgage is the best way to prevent major problems.

Kate Dore
Kate Dore |

Kate Dore is a writer at MagnifyMoney. You can email Kate at kate@magnifymoney.com

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Mortgage

Risks to Consider Before Co-signing Your Kid’s Mortgage

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Homeownership is a cornerstone of the American Dream for most, but many millennials are finding it difficult to afford to buy in.

Overall, millennials are still far behind in homeownership compared to previous generations were at their age. Only 39.1% of millennials lived in a home they owned in 2016 compared with 63.2% of Gen Xers, according to an analysis by Trulia Economist Felipe Chacón.

Student debt and stagnant incomes could share some of the blame. Millennials earn 78.2 cents for every dollar a Gen Xer earned at their age, Chacón found. Nearly half of millennial homebuyers report carrying student loan debt, according to the 2016 National Association of Realtors Home Buyer and Seller Generational Trends survey. They carry a median loan balance of $25,000.

Loan officers have to take a borrower’s total debt picture into account when running their application, and it’s become increasingly hard to qualify for a mortgage with a vast amount of student debt.

When they can’t get approved for a mortgage, it’s common for homebuyers to seek out a co-signer for their loan. Often, that person is a parent.

Co-signing a child’s mortgage loan is a serious decision, and parents should weigh all of the risks before making any promises. We asked financial experts what risks are worth worrying about to help clear out the noise.

1. You’re on the hook if your kid stops making mortgage payments

When you co-sign a loan, you agree to be responsible for payments if the primary borrower defaults. If you’re expecting to retire during the life of the mortgage loan, co-signing is an even larger risk, as you may be living on fixed income.

Dublin, Ohio-based certified financial planner Mark Beaver says he’d be wary of a parent co-signing a mortgage for their adult child. “If they need a co-signer, it likely means they cannot afford the house, otherwise the bank wouldn’t require the co-signer,” says Beaver.

By co-signing, you effectively take on a risk the bank doesn’t want. And the list of potential scenarios in which your child may no longer be able to afford their house payments can be vast.

“What if your daughter marries a jerk and they get divorced, or he/she starts a business and loses money, or doesn’t pay their taxes. The risk is ‘what can happen that can make this blow up,’” says Troy, Mich.- based lawyer and Certified Financial Planner, Leon LaBrecque.

Bottom line: If you wouldn’t be able to comfortably afford the payments in case that happens, don’t co-sign.

2. You’re putting your credit at risk

A default isn’t the only event that could negatively affect your finances. The mortgage will show up on your credit report, too, even if you haven’t taken over payments. So, if your child so much as misses one payment, your credit score could take a hit.

This may not be the end of the world for an older parent who doesn’t anticipate needing any new lines of credit in the future, Beaver says, but it’s still wise to be cautious.

You might think your child is ready to become a homeowner, but a closer look at their finances may reveal they aren’t yet that financially mature. Don’t be afraid to ask about their income and spending habits. You should have a good idea of how your child handles their own finances before you agree to help them.

“Sure, we don’t want to meddle and pry into our children’s business; however, you are putting yourself financially on the line. They need to understand that and be open about their own habits,” says Andover, Mass.-based Certified Financial Planner John Barnes.

3. Your relationship with your child could change

Co-signing you child’s mortgage is bound to change the dynamics of your relationship. Your financial futures will be entangled for 15 to 30 years, depending on how long it takes them to pay off the loan.

Seal Beach, Calif.-based certified financial planner Howard Erman says not to let your feelings get in the way of making the correct decision for your budget. Think of how often you communicate and the depth and strength of your relationship with your child. If saying no might create serious tension in your relationship, you likely dodged a bullet.

“If your child conditions their love on getting money, then the parent has a much bigger problem,” says Erman.

Similarly, you should consider how your relationship would be affected if somehow your child ends up defaulting on the mortgage, leaving you to make payments to the bank.

4. You might need to let go of future borrowing plans

Co-signing adds the mortgage to the debts on your credit report, making it tougher for you to qualify for additional credit. If you dreamed of one day owning a vacation home, just know that a lender will have to consider your child’s mortgage as part of your overall debt-to-income ratio as well.

Although co-signing a large loan such as a mortgage generally puts a temporary crimp in your ability to borrow, keep in mind you may be affected differently based on the dollar amount of the mortgage loan and your own credit history and financial situation.

How to Say “No” to Co-signing Your Child’s Mortgage

There is a chance you’ll need to deny your child’s request to co-sign the loan. If you feel pressured to say yes, but really want to say no, Barnes suggests you say no and place the blame on a financial adviser.

“Having [someone like] me say no is like a doctor telling a patient he or she can’t run the marathon until that ankle is healed. It is the same principle,” says Barnes.

He advises parents facing the decision to co-sign a loan for a family member to meet with a financial planner to analyze the situation and give a recommendation for action.

If you choose to take the blame yourself, you may want to take the time to explain your reasoning to your child if you feel it’s warranted. If you said no based on something they can change, give them a plan to follow to get a “yes” from you instead.

LaBrecque suggests that parents who want to help out but don’t want to take on the risks of co-signing instead give the child a down payment and treat it as an advance in the estate plan. So if you “gift” your kid $30,000 to make the down payment, you would reduce their inheritance by $30,000.

The “gift the down payment” method grants you some additional benefits too.

“[The] method has a more positive parent/child relationship than the potential awkwardness of Thanksgiving with the kid(s) and late payments on the mortgage. Also, the ‘down payment gift’ is a quick victory. The kid’s now made their bed with the mortgage; let them sleep in it,” says LaBrecque.

Similarly, you could choose to help your child pay down their debts, so they’ll be in a better position to get approved on their own.

If you must say no, try to do so in a way that will motivate them toward the goal rather than deflate them. Erman recommends lovingly explaining to your child how important it is for them to be able to achieve this success on their own.

How to Protect Yourself as Co-signer

The best way to protect yourself against the risks of co-signing is to have a backup plan.

“If a child is responsible with money, then I generally do not see a problem with co-signing a loan, provided insurance is in place to protect the co-signer (the parent),” says Barnes.

He adds parents should make sure the child, the primary borrower, has life insurance and disability insurance in case the widowed son or daughter-in-law still needs to live in the home, or your child becomes disabled and is unable to work.

The insurance payments will also help to protect your own credit history and future borrowing power in case your child dies or becomes disabled. But these protections would be useless in the event your child loses their job.

If that happens, “insurance will not pay your bill unfortunately, so even if you are well insured, budgeting is vitally important,” Beaver says.

If you choose to take on the risk and co-sign, Barnes says to make sure you and your child have a plan in place that details payment, when to sell, and what would happen if your child is unable to make payments for any reason.

Additionally, LaBrecque recommends you get your name on the deed. Don’t forget to address present or future spouses. Ask your lawyer about having both kids sign back a quit-claim deed to the parent. If you get one, he says, you’ll be protected in case the marriage goes south, or payments are made late, because you would be able to remove a potential ex off the note.

Brittney Laryea
Brittney Laryea |

Brittney Laryea is a writer at MagnifyMoney. You can email Brittney at brittney@magnifymoney.com

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Life Events, Mortgage

The Hidden Costs of Selling A Home

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With home values picking back up, many homeowners may be already dreaming of the money they’d make selling their home. Although the aim is to make money on a home sale, or at least break even, it’s easy to forget one important thing: selling a house costs money, too.

A joint analysis by online real estate and rental marketplace Zillow and freelance site Thumbtack found American homeowners spend upward of $15,000 on extra or hidden costs associated with a home sale.

Most of those expenses come before homeowners see any returns on their home sale. Most of the money is spent in three categories: closing costs, home preparation, and location.

Here are a few hidden costs to prepare for when you sell your home.

Pre-sale repairs and renovations

Zillow’s analysis shows sellers should plan to spend a median $2,658 on things like staging, repairs, and carpet cleaning to get the property ready.

Buyers are generally expected to pay their own inspection costs; however, if you’ve lived in the home for a number of years and want to avoid any surprises, you might also consider spending about $200 to $400 on a home inspection before listing the property for sale. That way, you can get ahead of surprise repairs that may decrease your home’s value.

Staging is another unavoidable cost for any sellers. Staging, which involves giving your home’s interior design a facelift and removing clutter and personal items from the home, is often encouraged because it can help make properties more appealing to interested buyers. Not only will you need to stage the home for viewing, but sellers often need to have great photos and construct strong descriptions of the property online to help maximize exposure of the property to potential buyers. If your agent is handling the staging and online listing, keep an eye on the “wow” factors they add on. Yes, a 3-D video walk-through of your house looks really cool, but it might place extra pressure on you budget.

You could save a large chunk on home preparation costs if you decide to DIY, but if you outsource, expect a bill.

ZIP code

Location drove home-selling costs up for many respondents in ZIllow’s analysis, as many extra costs were influenced by regional differences — like whether or not sellers are required to pay state or transfer taxes.

With a median cost of $55,000 for closing and maintenance expenses, San Francisco ranked highest among the most-expensive places to sell a home. At the other extreme, sellers in Cleveland, Ohio, pay little more than a median $10,100 to cover their selling costs.

Generally, selling costs correlate with the cost of the property, so expect to pay a little more if you live in an area with higher-than-average living costs or have a lot of land to groom for sale. Take a look at Zillow’s rankings below.

Closing costs

Closing costs are the single largest added expense of the home-selling process, coming in at a median cost of $12,532, according to Zillow. Closing costs include real estate agent commissions and state sales and/or transfer taxes. There may be other closing costs such as title insurance or escrow fees to pay, too.

Real Trends, a research and advisory company that monitors realty brokerage firms and compiles data on sales and commission rates of sales agents across the country, reported the national average was 5.26% in 2015.

Real Trends says rates are being weighed down by:

  • an increasing number of agents working for companies like Re/Max that give them flexibility to set commission rates without a minimum requirement
  • more competition from discount brokers like Redfin, an online brokerage service that charges sellers as low as 1%
  • an overall shortage of homes for sale pressuring agents to negotiate commission rates

The firm’s president, Steve Murray, told The Washington Post he predicts agent commissions will fall below 5% in the coming years.

Luckily, some closing costs are negotiable.

To save on real estate agent commissions, you can either negotiate their fee down or find a flat-fee brokerage firm like Denver-based Trelora, which advertises a flat $2,500 fee to list a house regardless of its selling price. Larger companies like Re/Max give their agents full control over their commission rates, so you may have better luck negotiating with them.

If you have the time on your hands, you could also list the home for-sale-by-owner to save on closing costs. Selling your home on your own is a more complicated and time-intensive approach to home selling and can be more difficult for those with little or no experience.

Other costs to consider:

Utilities on the empty home

If you’re moving out prior to the sale, you should budget to keep utilities on at your old place until the property is sold.

It will help you sell your home since potential buyers won’t fumble through your cold, dark home looking around. It may also prevent your home from facing other issues like mold in the humid summertime. Be sure to have all of your utilities running on the buyer’s final walk through the home, then turn everything off on closing day and handle your bills.

Make room in your household’s budget to pay for double utilities until the home is sold.

Insurance during vacancy

Again, prepare to pay double for insurance if you are moving out before your home sells. You’ll still need homeowner’s insurance to ensure coverage of your old property until the sale is finalized. Check the terms first, as your homeowner’s insurance policy might not apply to a vacant home. If that’s the case, you can ask to pay for a rider — an add-on to your basic insurance policy — for the vacancy period.

Capital gains tax

If you could make more than $250,000 on the home’s sale (or $500,000 if you’re married and filing jointly), you’ll want to take a look at the rules on capital gains tax. If your proceeds come up to less than $250,000 after subtracting selling costs, you’ll avoid the tax. However, if you don’t qualify for any of the exceptions, the gains above those thresholds could be subject to a 25% to 28% capital gains tax.

The Key Takeaway

Selling a home will cost you some money up front, but there are many ways you can plan for and reduce the largest costs. If you’re planning to sell your home this year, do your research and keep in mind falling commission costs when you negotiate.

List all of the costs you’re expecting and calculate how they might affect the profit you’d make on the sale and your household’s overall financial picture. If you’re unsure of your costs, you can use a sale proceeds calculator from sites like Redfin or Zillow to get a ballpark estimate of your potential selling costs, or consult a real estate agent.

Brittney Laryea
Brittney Laryea |

Brittney Laryea is a writer at MagnifyMoney. You can email Brittney at brittney@magnifymoney.com

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Mortgage, Pay Down My Debt

Should You Use a Mortgage to Refinance Student Loans?

Editorial Disclaimer: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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Fannie Mae, the largest backer of mortgage credit in America, recently made it a little easier for homeowners to refinance their student loans. In an update to its Selling Guide, the mortgage giant introduced a student loan cash-out refinance feature, permitting originators that sell loans to Fannie Mae to offer a new refinance option for paying off one or more student loans.

That means you could potentially use a mortgage refi to consolidate your student loan debt. Student loan mortgage refis are relatively new. Fannie Mae and SoFi, an alternative lender that offers both student loans and mortgages, announced a pilot program for cash-out refinancing of student loans in November 2016. This new program is an expansion of that option, which was previously available only to SoFi customers.

Amy Jurek, a Realtor at RE/MAX Advantage Plus in Minneapolis/St. Paul, Minn., says people with home equity have always had a cash-out option, but it typically came with extra fees and higher interest rates. Jurek says the new program eliminates the extra fees and allows borrowers to refinance at lower mortgage interest rates. The policy change could allow homeowners to save a significant amount of money because interest rates on mortgages are typically much lower than those for student loans, especially private student loans and PLUS loans.

But is it a good idea?

Your student debt isn’t eliminated; it’s added to your mortgage loan.

This may be stating the obvious, but swapping mortgage debt for student loan debt doesn’t reduce your debt; it just trades one form of debt (student loan) for another (mortgage).

Brian Benham, president of Benham Advisory Group in Indianapolis, Ind., says refinancing student loans with a mortgage could be more appealing to borrowers with private student loans rather than federal student loans.

Although mortgage rates are on the rise, they are still at near-historic lows, hovering around 4%. Federal student loans are near the same levels. But private student loans can range anywhere from 3.9% up to near 13%. “If you’re at the upper end of the spectrum, refinancing may help you lower your rate and your monthly payments,” Benham says.

So, the first thing anyone considering using a mortgage to refinance student loans should consider is whether you will, in fact, get a lower interest rate. Even with a lower rate, it’s wise to consider whether you’ll save money over the long term. You may pay a lower rate but over a longer term. The standard student loan repayment plan is 10 years, and most mortgages are 30-year loans. Refinancing could save you money today, but result in more interest paid over time, so keep the big picture in mind.

You need to actually have equity in your home.

To be eligible for the cash-out refinance option, you must have a loan-to-value ratio of no more than 80%, and the cash-out must entirely pay off one or more of your student loans. That means you’ve got to have enough equity in your home to cover your entire student loan balance and still leave 20% of your home’s value that isn’t being borrowed against. That can be tough for newer homeowners who haven’t owned the home long enough to build up substantial equity.

To illustrate, say your home is valued at $100,000, your current mortgage balance is $60,000, and you have one student loan with a balance of $20,000. When you refinance your existing mortgage and student loan, the new loan amount would be $80,000. That scenario meets the 80% loan-to-value ratio, but if your existing mortgage or student loan balances were higher, you would not be eligible.

You’ll lose certain options.

Depending on the type of student loan you have, you could end up losing valuable benefits if you refinance student loans with a mortgage.

Income-driven repayment options

Federal student loan borrowers may be eligible for income-driven repayment plans that can help keep loan payments affordable with payment caps based on income and family size. Income-based repayment plans also forgive remaining debt, if any, after 25 years of qualifying payments. These programs can help borrowers avoid default – and preserve their credit – during periods of unemployment or other financial hardships.

Student loan forgiveness

In certain situations, employees in public service jobs can have their student loans forgiven. A percentage of the student loan is forgiven or discharged for each year of service completed, depending on the type of work performed. Private student loans don’t offer forgiveness, but if you have federal student loans and work as a teacher or in public service, including a military, nonprofit, or government job, you may be eligible for a variety of government programs that are not available when your student loan has been refinanced with a mortgage.

Economic hardship deferments and forbearances

Some federal student loan borrowers may be eligible for deferment or forbearance, allowing them to temporarily stop making student loan payments or temporarily reduce the amount they must pay. These programs can help avoid loan default in the event of job loss or other financial hardships and during service in the Peace Corps or military.

Borrowers may also be eligible for deferment if they decide to go back to school. Enrollment in a college or career school could qualify a student loan for deferment. Some mortgage lenders have loss mitigation programs to assist you if you experience a temporary reduction in income or other financial hardship, but eligibility varies by lender and is typically not available for homeowners returning to school.

You could lose out on tax benefits.

Traditional wisdom favors mortgage debt over other kinds of debt because mortgage debt is tax deductible. But to take advantage of that mortgage interest deduction on your taxes, you must itemize. In today’s low-interest rate environment, most taxpayers receive greater benefits from the standard deduction. As a reminder, taxpayers can choose to itemize deductions or take the standard deduction. According to the Tax Foundation, 68.5% of households choose to take the standard deduction, which means they receive no tax benefit from paying mortgage interest.

On the other hand, the student loan interest deduction allows taxpayers to deduct up to $2,500 in interest on federal and private student loans. Because it’s an “above-the-line” deduction, you can claim it even if you don’t itemize. It also reduces your Adjusted Gross Income (AGI), which could expand the availability of other tax benefits.

You could lose your home.

Unlike student debt, a mortgage is secured by collateral: your home. If you default on the mortgage, your lender ultimately has the right to foreclose on your home. Defaulting on student loans may ruin your credit, but at least you won’t lose the roof over your head.

Refinancing student loans with a mortgage could be an attractive option for homeowners with a stable career and secure income, but anyone with financial concerns should be careful about putting their home at risk. “Your home is a valuable asset,” Benham says, “so be sure to factor that in before cashing it out.” Cashing out your home equity puts you at risk of carrying a mortgage into retirement. If you do take this option, set up a plan and a budget so you can pay off your mortgage before you retire.

Janet Berry-Johnson
Janet Berry-Johnson |

Janet Berry-Johnson is a writer at MagnifyMoney. You can email Janet here

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Mortgage

2 Times an Adjustable-Rate Mortgage Makes Perfect Sense

Editorial Disclaimer: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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The interest rate on your loans determines how expensive it is to borrow money. The higher the interest rate, the more expensive the loan.

With a conventional, 30-year fixed-rate mortgage, borrowers with the best credit can expect to receive a 4.23% interest rate on that loan. The average homebuyer borrows about $222,000 when they take out a mortgage, which means paying a staggering $168,690 in interest over the term of the loan.

When you need to repay balances in the hundreds of thousands of dollars, even half a point of interest can make a huge difference in how expensive your mortgage is. If you borrowed the same amount but had a rate of 4.73% rate, you’d pay $192,190 in interest — or almost $24,000 more for the same loan.

Given that interest rates make such a big impact on how much your mortgage costs, it makes sense to do what you can to get the lowest rate possible. And this is where adjustable-rate mortgages can start to look appealing. In two cases especially, it makes perfect sense to go with an ARM: when you plan to pay off your mortgage quickly, or you plan to move out of the home within a few years.

Adjustable-Rate Mortgages Can Allow You to Borrow at Lower Rates

An adjustable-rate mortgage, also known as an ARM, is a home loan with a variable interest rate. That means the rate will change over the life of the loan.

ARMs are usually set up as 3/1, 5/1, 7/1, or 10/1. The first number indicates the length of the fixed rate period. If you look at a 3/1 ARM, the initial fixed rate period lasts 3 years. The second shows how often the interest rate will adjust after the initial period.

Some ARMs come with interest rate caps, meaning there’s a limit to how high the rate can adjust. And their initial rate is often much lower than traditional fixed-rate loans.

This can help you buy a home and start paying your mortgage at a lower monthly cost than you could manage with a fixed-rate mortgage. Borrowers with the best credit scores can access a 5/1 ARM with an interest rate of 3.24% right now.

The Risks ARMs Pose to Average Homebuyers

“The main advantage of an ARM is the low, initial interest rate,” explains Meg Bartelt, CFP, MSFP, and founder of Flow Financial Planning. “But the primary risk is that the interest rate can rise to an unknown amount after the initial, fixed period of just a few years expires.”

Homebuyers can enjoy extremely low interest rates for a month, a quarter, or 1, 5, 7, or 10 years, depending on the term of their adjustable-rate mortgage. But borrowers have no control over the interest rate after that.

The rate can rise to levels that make your mortgage unaffordable. Remember our earlier example, where just half a point of interest could mean making the entire mortgage $24,000 more expensive?

ARMs adjust their rates periodically, and the new rate is partly determined by a broad measure of interest rates known as an index. When the index rises, so does your own interest rate — and your monthly mortgage payment goes up with it.

The variable nature of the interest rate makes it difficult to plan ahead as your mortgage payment won’t be static or stable.

“Imagine at the end of year 5, rates start going up and your mortgage payment is suddenly much higher than it used to be,” says Mark Struthers, a CFA and CFP who runs Sona Financial. “What if your partner loses their job and you need both incomes to pay the mortgage?” he asks. In this situation, you could be stuck if you don’t have the credit score to refinance and get away from the higher rate, or the cash flow to handle the extra cost.

“Once you get in this spiral, it is tough to get out,” says Struthers. “The spiral just gets tighter.”

And yes, adjustable-rate mortgages can go down. While that’s possible, it’s more likely that the rate will rise. And some ARMs will limit how high and how low your rate can go.

Struthers puts it plainly: “ARMs are higher-risk loans. If you can handle the risk, you can benefit. If you can’t, it can crush you. Most people do not put themselves in a position to handle the risk.”

Who Can Make an ARM Work in Their Favor?

That doesn’t mean no one can benefit from adjustable-rate mortgages. They do come with the benefit of the lower initial interest rate. “If you plan to pay off the mortgage during that initial fixed period, you eliminate the risk [of getting stuck with a rising interest rate],” says Bartelt.

That’s exactly what she and her husband did when they bought their own home.

“In my situation, we had enough savings to buy our house with cash. But the cash was largely in investments, and selling all the investments would push our income into significantly higher tax brackets due to the gains, with all the cascading unpleasant tax effects,” Bartelt explains.

“By taking an ARM, we can spread the sale of those investments out over 5 years, minimizing the income increase in each year. That keeps our tax bracket lower,” she says. “We avoided increasing our marginal tax rate by double digits in the year of the purchase of our home.”

She notes that another benefit of taking the ARM in her situation was the fact that she and her husband could continue to pay the mortgage past that initial 5 years if they chose to do so. “The interest rate won’t be as favorable as if we’d initially locked in a fixed rate,” she admits. “But that option still exists, and having options is power.”

Planning for a Quick Sale? An ARM Might Work for You

Another way ARMs can provide benefits to homeowners? If you won’t live in the home for long. Buying the home and also selling it before the initial rate period expires could provide you with a way to access the lowest possible rate without having to deal with the eventual rise in mortgage payment when the rate increases.

“ARMs are typically best for those who are fairly certain they won’t be in the house for a long period of time,” says Cary Cates, CFP and founder of Cates Tax Advisory. “An example would be a person who has to move every two to four years for their job.”

He says you could view taking out an ARM as a way to pay “tax-deductible rent” if you already know you don’t want to stay in the house for more than a few years. “This is an aggressive strategy,” he explains, “but as long as the house appreciates enough in value to cover the initial costs of buying, then you could walk away only paying tax-deductible interest, which I am comparing to rent in this situation.”

Cates says you’re obviously not actually paying rent, but you can mentally frame your mortgage payment that way. But you need to know the risk is owing on your mortgage if you go to sell and the home hasn’t realized enough appreciation to cover what you spent to buy.
He also reminds potential homebuyers that you take on the risk of staying in the home longer than you expected to. You could end up dealing with the rising interest rate if you can’t sell or refinance.

What You Need to Know Before Taking an ARM

Before applying for an adjustable-rate mortgage, make sure you ask questions like:

  • What is the initial fixed-interest rate? How does that compare to another mortgage option, and is it worth taking on a riskier mortgage to get the initial fixed rate?
  • How long is the initial fixed rate period?
  • How often will the ARM adjust after the initial rate period?
  • Are there limits to how much your ARM’s rate can drop?
  • How high can the ARM’s rate go? How high can your monthly mortgage payment go?
  • If the mortgage’s interest hit the maximum rate, could you afford the monthly payment?
  • Do you have a plan for selling the home within the initial rate period if you want to sell before paying the adjusted rate?
  • Could you pay off the mortgage without selling if you did not want to pay the adjusted rate?

Do your due diligence and understand the risks and potential pitfalls before making a final decision. But depending on your specific situation, your finances, and your plans for the next 5 years, you could make an ARM work for you.

Kali Hawlk
Kali Hawlk |

Kali Hawlk is a writer at MagnifyMoney. You can email Kali at Kali@magnifymoney.com

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Mortgage

Buying a House When You Have Student Loan Debt

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Buying a House When You Have Student Loan Debt

Student loan debt is a reality for many people wishing to buy homes. Fortunately, it does not have to be a deal-breaker. But there’s no getting around the fact that a large amount of student loan debt will certainly influence how much financing a lender will be willing to offer you.

In the past, mortgage lenders were able to give people with student loans a bit of a break by disregarding the monthly payment from a student loan if that loan was to be deferred for at least one year after closing on the home purchase. But that all changed in 2015 when the Federal Housing Authority, Fannie Mae, and Freddie Mac began requiring lenders to factor student debt payments into the equation, regardless of whether the loans were in forbearance or deferment. Today by law, mortgage lenders across the country must consider a prospective homebuyer’s student loan obligations when calculating their ability to repay their mortgage.

The reason for the regulation change is simple: with a $1.3 million student loan crisis on our hands, there is concern homebuyers with student loans will have trouble making either their mortgage payments, student loan payments, or both once the student loans become due.

So, how are student loans factored into a homebuyer’s mortgage application?

Anytime you apply for a mortgage loan, the lender must calculate your all-important debt-to-income ratio. This is the ratio of your total monthly debt payments versus your total monthly income.

In most cases, mortgage lenders now must include 1% of your total student loan balance reflected on the applicant’s credit report as part of your monthly debt obligation.

Here is an example:

Let’s say you have outstanding student loans totaling $40,000.

The lender will take 1% of that total to calculate your estimated monthly student loan payment. In this case, that number would be $400.

That $400 loan payment has to be included as part of the mortgage applicant’s monthly debt expenses, even if the loan is deferred or in forbearance.

Are Student Loans a Mortgage Deal Breaker? Not Always.

If you are applying for a “conventional” mortgage, you must meet the lending standards published by Fannie Mae or Freddie Mac. What Fannie and Freddie say goes because these are the two government-backed companies that make it possible for thousands of banks and mortgage lenders to offer home financing.

In order for these banks and mortgage lenders to get their hands on Fannie and Freddie funding for their mortgage loans, they have to adhere to Fannie and Freddie’s rules when it comes to vetting mortgage loan applicants. And that means making sure borrowers have a reasonable ability to repay the loans that they are offered.

To find out how much borrowers can afford, Fannie and Freddie require that a borrower’s monthly housing expenses (that includes the new mortgage, property taxes, and any applicable mortgage insurance) to be no more than 43% of their gross monthly income.

On top of that, they will also look at other debt reported on your credit report, such as credit cards, car loans, and, yes, those student loans. You cannot go over 49% of your gross income once you factor in all of your monthly debt obligations.

For example, if you earn $5,000 per month, your monthly housing expense cannot go above $2,150 per month (that’s 43% of $5,000). And your total monthly expenses can’t go above $2,450/month (that’s 49% of $5,000). Let’s put together a hypothetical scenario:

Monthly gross income = $5,000/month

Estimated housing expenses: $2,150
Monthly student loan payment: $400
Monthly credit card payments: $200
Monthly car payment: $200

Total monthly housing expenses = $2,150

$2,150/$5,000 = 43%

Total monthly housing expenses AND debt payments = $2,950

$2,950/$5,000 = 59%

So what do you think? Does this applicant appear to qualify for that mortgage?

At first glance, yes! The housing expense is at or below the 43% limit, right?

However, once you factor in the rest of this person’s debt obligations, it jumps to 59% of the income — way above the threshold. And these other monthly obligations are not beyond the norm of a typical household.

What Can I Do to Qualify for a Mortgage Loan If I Have Student Debt?

So what can this person do to qualify? If they want to get that $325,000 mortgage, the key will be lowering their monthly debt obligations by at least $500. That would put them under the 49% debt-to-income threshold they would need to qualify. But that’s easier said than done.

Option 1: You can purchase a lower priced home.

This borrower could simply take the loan they can qualify for and find a home in their price range. In some higher priced real estate markets it may be simply impossible to find a home in a lower price range. To see how much mortgage you could qualify for, try out MagnifyMoney’s home affordability calculator.

Option 2: Try to refinance your student loans to get a lower monthly payment.

Let’s say you have a federal student loan in which the balance is $30,000 at a rate of 7.5% assuming a 10-year payback. The total monthly payment would be $356 per month. What if you refinanced the same student loan, dropped the rate to 6%, and extended the term to 20 years? The new monthly payment would drop to $214.93 per month. That’s a $142 dollar per month savings.

You could potentially look at student loan refinance options that would allow you to reduce your loan rate or extend the repayment period. If you have a credit score over 740, the savings can be even higher because you may qualify for a lower rate refi loan. Companies like SoFi, Purefy, and LendKey offer the best rates for student loans, and MagnifyMoney has a full list of great student loan refi companies.

There are, of course, pros and cons when it comes to refinancing student loans. If you have federal loan debt and you refinance with a private lender, you’re losing all the federal repayment protections that come with federal student loans. On the other hand, your options to refinance to a lower rate by consolidating federal loans aren’t that great. Student debt consolidation loan rates are rarely much better, as they are simply an average of your existing loan rates.

Option 3: Move aggressively to eliminate your credit card and auto loan debt.

To pay down credit debt, consider a balance transfer. Many credit card issuers offer 0% introductory balance transfers. This means they will charge you 0% interest for an advertised period of time (up to 18 months) on any balances you transfer from other credit cards. That buys you additional time to pay down your principal debt without interest accumulating the whole time and dragging you down.

Apply for one or two of these credit cards simultaneously. If approved for a balance transfer, transfer the balance of your highest rate card immediately. Then commit to paying it off. Make the minimum payments on the other cards in the meantime. Focus on paying off one credit card at a time. You will pay a fee of 3% in some cases on the total balance of the transfer. But the cost can be well worth it if the strategy is executed properly.

Third, if the car note is a finance and not a lease, there’s a mortgage lending “loophole” you can take advantage of. A mortgage lender is allowed to omit any installment loan that has less than 10 payments remaining. A car is an installment loan. So if your car loan has less than 10 payments left, the mortgage lender will remove these from your monthly obligations. In our hypothetical case above, that will give this applicant an additional $200 per month of purchasing power. Maybe you can reallocate the funds from the down payment and put it toward reducing the car note.

If the car is a lease, you can ask mom or dad to refinance the lease out of your name.

Option 4: Ask your parents to co-sign on your mortgage loan.

Some might not like this idea, but you can ask mom or dad to co-sign for you on the purchase of the house. But there are a few things you want to make sure of before moving forward with this scenario.

For one, do your parents intend to purchase their own home in the near future? If so, make sure you speak with a mortgage lender prior to moving forward with this idea to make sure they would still qualify for both home purchases. Another detail to keep in mind is that the only way to get your parents off the loan would be to refinance that mortgage. There will be costs associated with the refinance of a few thousand dollars, so budget accordingly.

With one or a combination of these theories there is no doubt you will be able to reduce the monthly expenses to be able to qualify for a mortgage and buy a home.

The best piece of advice when planning to buy a home is to start preparing for the process at least a year ahead of time. Fail to plan, plan to fail. Don’t be afraid to allow a mortgage lender to run your credit and do a thorough mortgage analysis.

The only way a mortgage lender can give you factual advice on what you need to do to qualify is to run your credit. Most applicants don’t want their credit run because they fear the inquiry will make their credit score drop. In many cases, the score does not drop at all. In fact, credit inquiries account for only 10% of your overall credit score.

In the unlikely event your credit score drops a few points, it’s a worthy exchange. You have a year to make those points go up. You also have a year to make the adjustments necessary to make your purchase process a smooth one. Do keep in mind that it is best to shop for mortgage lenders and perform credit inquiries within a week of each other.

You should also compare rates on the same day if at all possible. Mortgage rates are driven by the 10-year treasury note traded on Wall Street. It goes up and down with the markets, and we’ve all seen some pretty dramatic swings in the markets from time to time. The only way to make an “apples-to-apples” comparison is to compare rates from each lender on the same day. Always request an itemization of the fees to go along with the rate quote.

Rafael Reyes
Rafael Reyes |

Rafael Reyes is a writer at MagnifyMoney. You can email Rafael here

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Featured, Mortgage, News

4 Reasons You Should Make Biweekly Mortgage Payments

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4 Reasons You Should Make Biweekly Mortgage Payments

The vast majority of people make monthly payments on their mortgage either until they sell their property or the mortgage balance has been repaid. Like the beige paint on the walls in your apartment, monthly payments are fine, but maybe there’s a more appealing alternative. One choice is to split your mortgage payment in half, paying every two weeks instead of making one lump-sum payment each month.

Biweekly mortgage payments could actually save you more in the long term, says Jim Lestitian, senior loan officer at Federated Mortgage Corp.: “This is a great and easy way to prepay your loan (shorter term) and reduce the amount of interest paid over the term of the loan.”

When you pay off the principal more quickly, less interest accrues, and you also reduce the amount of time it will take you to pay back the loan. When biweekly mortgage payments are set up properly, it’s possible to accomplish just that.

In this post, we’ll break down the pros of making biweekly mortgage payments and show how this strategy differs from making additional mortgage payments.

4 Benefits of Biweekly Payments

  1. You’ll gain equity in your home a lot faster

Arguably the most valuable benefit of biweekly payment is that you can gain more equity in your home. Equity accumulates more quickly when you pay twice monthly, because the money you borrowed from the bank has less time to accrue interest.

Why does equity matter?

When you buy a house, the ultimate goal is to live in your home without owing the bank any more money. The amount of ownership you have in a home also fluctuates constantly with the current market value. The difference between the current market value of your home and your mortgage is called equity. Therefore, when your mortgage is completely repaid, the total value, or equity, in the house belongs to you. If you sell your house before your mortgage is repaid, some or all of the proceeds from your sale are used to repay the outstanding mortgage balance.

  1. You’ll pay less interest over time

When you first take out a mortgage, the bank gives you a fixed or variable interest rate. This is the “rent” the bank will charge, and it is typically applied to your balance daily. Since your “rent” is charged daily, you want to spend as few days as possible “renting” the bank’s money. In other words, pay back the principal of the mortgage as quickly as possible to reduce your overall interest expense.

Biweekly mortgage payments help to reduce your interest expense because instead of making one payment against interest and principal each month, you’re making two. While the two separate payments are individually smaller, they both have a more significant impact, because each payment slightly reduces the amount of principal. So, if less principal means the bank can charge less “rent,” then the total “cost” of your mortgage will be reduced with biweekly payments.

  1. You’ll pay off your mortgage faster

The third rider on this tandem bicycle of home financing is duration, or the length, of your mortgage. Most often, mortgages are based on 15- or 30-year terms. However, when biweekly payments are made, your mortgage’s principal is reduced more quickly, so less interest is charged. As a result, you simply won’t need the full term of your loan to pay back the balance.

  1. The secret extra payments

Why the emphasis on biweekly payments, rather than twice-monthly payments?

What is 52 divided by 2? OK, what is 12 times 2? These two problems produce two different numbers, don’t they? By making a payment on your mortgage every two weeks, you’ll make an additional two payments over the course of a year.

The inherent benefits of the secret extra payments compound the three perks listed above: you’re going to have a lower interest expense, by chipping away at your principal more quickly, thereby shortening the amount of time you will need to pay off the balance.

Though, just as there’s more than one way to build a house, there’s a second approach to the 13th payment: additional payments toward principal.

Biweekly Payments vs. Additional Payments

Biweekly payments are not your only option for a shorter, more inexpensive mortgage. Additional payments are a great alternative and applicable to any loan. An additional payment is entirely separate from your total monthly payment and then applied directly to principal. An additional payment can also be any amount you wish, made with any frequency that suits your budget.

Additional payments are totally within your control. In the event that biweekly payments are unavailable or not in your best interest, nothing is stopping you from saving one or more months of mortgage payments (a good idea regardless) and then contributing that balance directly to principal. This approach will simulate the secret extra payments created by biweekly payments, but without the need to adopt a biweekly structure.

Similar to biweekly payments, additional payments will reduce your total interest expense and loan duration. When you’re devoting additional cash to accelerate the repayment of a loan, however, you must consider if this is the best use for your money. For instance, the amount of your additional payment could be used to pay other debts, grow more liquid investment accounts, or increase your emergency fund. These are important considerations because you don’t want to find yourself in a position where you need money that is inaccessible due to being tied up in your home.

When you make an additional payment, be sure to call your lender and tell them to apply it to the principal. You would never want to find yourself in a position where you’ve sacrificed the benefits of an additional payment due to a clerical error by a bank employee.

4 Questions You Must Ask Before Signing Up for Biweekly Mortgage Payments

  1. Are biweekly payments available with my lender?

Just as every landlord won’t offer the same amenities, all lenders won’t offer the option to make your mortgage payments on a biweekly schedule rather than monthly installments. Since interest rates do not vary significantly from one lender to the next, most often this payment structure is used as an additional selling point to entice a potential borrower. So why would a lender not offer a biweekly payment structure to its borrowers?

Biweekly payments are more complicated to administer, feasibly doubling the amount of work on the part of the lender. In addition to being more labor intensive, biweekly payments also generate less income for the lender over the lifetime of the loan. Remember, a mortgage is just another product offered by a lender, so when you make biweekly payments, you’re essentially receiving a discount on the total price of your mortgage.

If your lender does not offer the option of a biweekly payment structure, third-party vendors do exist to fill the gap. These companies simulate biweekly payments by coordinating with your lender to fulfill your monthly mortgage payment on your behalf. Then, you make biweekly payments to the third-party vendor, most often with the addition of an initial and/or ongoing fee.

  1. Are there additional fees associated with a biweekly payment structure?

Since a biweekly payment structure means more work for the lender, many lenders charge fees to enroll. Lestitian often sees lenders or third-party vendors apply a $200 to $400 fee to establish a biweekly payment structure and/or charge an ongoing monthly transaction fee. Therefore, unless you are going to save more in interest by making biweekly payments than you’ll pay in fees, it probably doesn’t make sense to pay biweekly.

  1. When will my lender apply my second payment to my mortgage balance?

Lenders don’t always treat biweekly mortgage payments the same. Some lenders will apply your biweekly payments to your mortgage balance as soon as your payments are received. Other lenders will simply hold your first payment until your total payment has been received.

If your lender is not applying your biweekly payments immediately, there is no point in signing up for biweekly payments. Stick to the usual monthly payment or consider refinancing with a lender who will honor extra payments. The benefit of biweekly payments is only realized if the payments are applied to your mortgage balance immediately.

  1. How does my lender calculate interest?

Your bank will calculate the interest due on a daily, weekly, or monthly basis. This detail is important to note because it dictates how much value you will be able to derive from making biweekly mortgage payments.

If interest is calculated daily, then you will save 14 days of interest expense with every biweekly payment. Similarly, if interest is calculated weekly, you will save two weeks of interest expense, with every biweekly payment. The lynchpin for biweekly payments is if interest is calculated monthly, which is very rare. If this is the case, however, you will not realize any additional benefit by making biweekly instead of monthly payments. So you’re better off sticking to once-a-month payments.

The Bottom Line

Biweekly payments, when structured properly, are a great way to shorten the duration and lower the interest expense of your mortgage, all while enabling you to build equity in your home more quickly. Though remember that the devil is in the details.

Before signing on the dotted line, make sure that your biweekly payments are applied to your balance immediately and not held until the end of the month. You also need to be cognizant of how interest accrues on your mortgage and any associated fees, because both components play a major role in how much additional value you will gain from making biweekly payments.

Another point to consider is whether or not biweekly payments are even the best option for you. Your alternative option is to make additional payments toward principal, which can help to produce the same benefits as biweekly payments but without the lengthy commitment. Though whether or not biweekly payments are appropriate for you, your mindset is a prudent one. To be focused on strategies for building equity and reducing expenses as quickly as possible is likely to pay dividends for years to come.

Aaron Kahn |

Aaron Kahn is a writer at MagnifyMoney. You can email Aaron here

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Mortgage

How to Speed Up Your Mortgage Refinance

Editorial Disclaimer: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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Clock time deadline

When you’re refinancing your mortgage, timing is everything.

Once a lender offers you a rate, they only give you a certain amount of time in which to take advantage of it — a period called a “lock.” Locks come in 15-day increments. The shortest is 15 days, followed by 30 days, followed by 45 days, and so on. Shorter locks generally mean better rates, while longer locks mean higher rates.

If you’ve found an amazing interest rate with a short lock period, you’ll want to make sure things go as quickly and smoothly as possible so you don’t lose that fantastic deal. Here are the best ways to speed up the mortgage refinance process so you can take advantage of lower interest rates.

Related Article: Guide to Refinancing Your Mortgage

Be Honest on Your Application

You may be tempted to omit some debt on your application in order to get approved for a larger loan. Don’t do it. Lenders will find out if you’re withholding information about debts, and the ensuing paperwork will slow down the process. Avoid the headache now and be forthright about all of your finances.

You do not, however, need to disclose all of your assets. In fact, Casey Fleming, mortgage adviser and author of The Loan Guide: How to Get the Best Possible Mortgage, cautions against it if you want the process to go quickly.

“Typically, [you only need to disclose] enough to pay for all closing costs, plus a little more than three months of reserves,” Fleming advises. One month of reserves is the sum of the principal, interest, taxes, insurance, mortgage insurance, and any HOA dues you may incur with your new property.

“Providing more assets than this just gives the underwriters more paperwork to plow through and more opportunities for more questions,” Fleming says. “It is not considered fraudulent to understate your assets.”

Know How to Access Your Paperwork and Return Documents Quickly

Because each individual’s situation is different, it’s very hard for borrowers to know what paperwork they will need to include in their application before applying. Fleming does, however, recommend knowing how to get necessary paperwork should it be requested. This includes knowing how to print out e-statements from financial accounts and obtaining copies of pay stubs and deposited checks.

Throughout the process, you will be asked to submit additional supporting documentation, along with signing and returning new documents issued by the financial institution. This is one of the biggest things that slows down mortgage refinances, and it’s completely in your hands. Return all requested paperwork expediently.

Stay at Your Current Job

If you’re thinking of making a career move, hold off until you close. Stability is a big deal when lenders are making their decisions, and switching employers before closing could negate the entire deal.

Don’t Take on New Debt

If you’re looking for a fast refinance, it is wise to stop taking on new debts 60 days before you apply. It can take this long for lenders to report new loans to the credit bureaus. If your new loan doesn’t appear on your credit report, the financial institution issuing the mortgage refinance will have to get in touch with the credit bureaus directly, which costs both additional time and money.

Note: Taking on new debt, even prior to 60 days before your application, can temporarily reduce your credit score. This can affect the interest rates you are offered or even keep you from qualifying.

You may think you’re golden after you have been approved, but that simply isn’t true. Your lender will pull your credit report on the day of closing, enabling them to see any new debt you’ve taken on since they approved your application. Don’t do anything that would change your debt-to-income ratio.

Find a Lender Who Uses Appraisal Waivers

In the past, common industry advice instructed borrowers to schedule their appraisal as soon as possible, and to keep their own schedule flexible so they could accommodate that of the appraiser. Because physical property appraisals take a long time, this was one of the best things you could do to speed up the process.

However, technology is now offering better and quicker options both for the lender and the borrower.

“More and more automated approvals are requiring only an automated valuation — a software-generated estimate of value,” says Fleming. These valuations are similar to Zillow Zestimates, but they are more accurate as they are based on more data points. “This is commonly known as an appraisal waiver. It is faster and, of course, cheaper than a real appraisal.”

Fleming says that the cost of a typical home appraisal would likely run somewhere between $400 and $500, though he notes these numbers can vary depending on region.

“Appraisal waivers used to be $75,” says Fleming, “but I understand that Fannie [Mae] is experimenting with waiving the appraisal waiver fee.” That means that the appraisal waiver is potentially free to your financial institution.

Not all lenders use appraisal waivers equally. Before applying, you can ask different lenders what percentage of their loans were approved with appraisal waivers in the past 12 months. This can help you identify lenders who will save you a lot of time during the appraisal process.

If you can’t find a lender with competitive rates who also uses appraisal waivers, stick to the old advice and book your appraisal as early as possible.

Refinances Will Move Faster This Year

If you applied for a mortgage refinance in 2016, you probably noticed that the process took a long time. There was a reason for that.

“Interest rates stayed much lower than expected,” Fleming explains. “The purchase market is not highly sensitive to interest rates, but the refi market is. Purchase applications were about as predicted [in 2016], but the refi market was much larger than anticipated.”

Because interest rates stayed so low, more people applied for mortgage refinances. Financial institutions weren’t expecting the increased demand, so many found themselves severely understaffed.

In 2017, Fleming doesn’t predict the same problem. In fact, he anticipates that mortgage refinances will close much more quickly.

“With rates up about 0.5% or more from the lows of last year, it is estimated that 25% to 50% of the refi market is no longer viable,” says Fleming. “It no longer makes sense for [many homeowners] to refinance. So, in 2017 the purchase market will stay about steady, while the refi market will drop precipitously.”

That means staffing should not be an issue and lenders will be eager for your business. The entire process is anticipated to move very quickly in the new year, which is good news for those securing competitive interest rates with short lock periods.

Brynne Conroy
Brynne Conroy |

Brynne Conroy is a writer at MagnifyMoney. You can email Brynne at brynne@magnifymoney.com

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Mortgage

Guide to Getting a Mortgage When You’re Self-Employed

Editorial Disclaimer: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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For some Americans, self-employment is the ultimate dream. Roughly 15 million people (10.1% of the total U.S. workforce) were self-employed in 2015, according to the U.S. Bureau of Labor Statistics. Self-employment offers workers the kind of flexibility that can be hard to find in a traditional 9-to-5 job, not to mention the potential for higher earnings.

However, self-employment does come with its own challenges, and, unfortunately, one of these difficulties can be homeownership. Despite earning a solid income, self-employed borrowers face a unique set of hurdles when it comes to determining whether they are eligible for a mortgage. In this guide, we will cover a number of requirements borrowers should begin preparing for as early as possible into their home-buying journey.

The Self-Employed Challenge

In order to gain a deeper understanding of what it takes to be approved for a mortgage as a self-employed borrower, it’s helpful to know how mortgages work in the U.S. For starters, most banks bundle up mortgages and sell them to Fannie Mae, Freddie Mac, or private investors.

To make those investments as safe as possible, Fannie Mae and Freddie Mac have a strict set of guidelines for lenders to follow when deciding which borrowers qualify for a mortgage. Because self-employed borrowers’ income can be unpredictable, they are considered higher-risk borrowers than W-2 workers. That means these guidelines are especially strict for self-employed borrowers.

Requirements for Self-Employed Borrowers: Fannie and Freddie

Although there are a variety of options for mortgages available, we are going to focus on eligibility requirements for self-employed borrowers seeking financing through Fannie Mae and Freddie Mac. Why? If you’re eligible for these loans, you will have access to the lowest interest rates and safest mortgages.

Fannie Mae

Fannie Mae’s Selling Guide outlines a strict set of rules about income for self-employed borrowers. Fannie Mae notes your business income (from a partnership or S corporation) reported on IRS Form 1040 may not necessarily represent the income that has been distributed to you. They point out it’s important to review business income distributions that have been made or could have been made while determining the viability of your business.

Eligibility for Fannie Mae

First and foremost, all borrowers (whether self-employed or not) need to meet Fannie Mae’s normal eligibility requirements:

  • You must be a natural person (living human being) who has reached the age at which a mortgage is legal in the area where the property is located. There is no maximum age limit for the borrower.
  • You must have a valid Social Security number or Individual Taxpayer Identification Number.
  • Per Fannie Mae’s Eligibility Matrix, credit scores must meet the following criteria:
    • Manually underwritten loans – 620 for fixed-rate loans, 640 for adjustable-rate mortgages (ARMs)
    • Desktop Underwriter loans – 620 for both fixed-rate and ARMs
    • Mortgages insured or guaranteed by a federal government agency (HUD, FHA, VA, and RD) – 620
  • The purchase of a single unit principal residence must have a loan-to-value (LTV) of no higher than 97%. If your loan-to-value ratio is less than 75%, a credit score as low as 620 is allowed.
  • Your debt-to-income (DTI) ratio should be no greater than 36%. If your DTI ratio falls between 36% and 45%, a credit score above 680 is required.
  • Fannie Mae now offers a 3% down payment option.

In addition to these requirements, self-employed borrowers have some additional hoops to jump through.

Verification of Income

In order to verify your employment and income, a lender will ask for a copy of your signed income tax returns (individual and sometimes business, as well) from the past two years. This paperwork must include all applicable forms.

A lender may also use IRS-issued transcripts from your individual and business federal income tax returns from the past two years. If you are using these, the information must be complete and legible.

If you use two years of signed individual federal tax returns, the lender may waive the need to see your business tax returns if:

  • you are using your own personal funds to fund the down payment and closing costs and can satisfy the reserve requirements;
  • you have been self-employed in the same business for at least five years; and
  • your individual tax returns show an increase in self-employment income over the past two years.

In certain situations, Desktop Underwriter, Fannie Mae’s automated underwriting system, will only require one year of personal and/or business tax returns if lenders document your income by:

  • obtaining signed individual and business federal income tax returns for the most recent year,
  • confirming the tax returns reflect at least 12 months of self-employment income, and
  • completing Fannie Mae’s Cash Flow Analysis (Form 1084) or any other type of cash flow analysis form that applies the same principles.

Analysis of Your Personal Income

Your lender will prepare a written evaluation of your personal income, including your business’s profit or loss, as reported on your income tax returns. This will help them determine how much stable and continuous income you have. It’s important to note this step isn’t required if you qualified using income you didn’t receive from self-employment. Examples include qualifying for the loan using a traditional W-2 salary or your retirement income.

Freddie Mac

Freddie Mac’s Selling Guide also provides an outline for lenders on how to assess the income for self-employed borrowers. Although there are differences, Freddie Mac and Fannie Mae use similar criteria when it comes to assessing self-employed borrowers.

Freddie Mac uses Loan Product Advisor, an enhanced automated underwriting system, to help ensure loans meet their eligibility requirements. Even if you aren’t using self-employed income to qualify for a Freddie Mac mortgage, they must enter your self-employed status into this software.

Verification of Income

Your lender will calculate your average monthly income based on a review of your complete federal individual income tax returns (Form 1040) including W-2s and K-1s and your complete business tax returns (Forms 1120, 1120S, and 1065).

Analysis of Your Personal Income

If you are self-employed but not using self-employment income to qualify, your lender will request to see your individual federal tax returns to see if there is a business loss that may have an impact on the stable monthly income used to qualify. If a business loss is reported on your individual tax returns, your lender may need to obtain additional tax returns to fully assess the impact of a business loss on income for qualifying.

Eligibility for Freddie Mac

In addition to these special requirements for self-employed borrowers, you also must meet Freddie Mac’s normal eligibility:

  • If you are a non-U.S. citizen who is lawfully living in the U.S. as a permanent or nonpermanent resident alien, you are eligible for a mortgage on the same terms as a U.S. citizen.
  • For a manually underwritten mortgage, your credit history must have at least three credit accounts (on or off your credit report) or four noncredit payment references. Noncredit payment references must have existed for at least 12 months.
  • You must have a valid Social Security number or Individual Taxpayer Identification Number.
  • Per Freddie Mac’s Minimum Indicator Score Requirements, credit scores must meet the following criteria:
    • For a single unit and primary residence with an LTV less than or equal to 75%, you must have a minimum credit score of 620.
    • For a single unit and primary residence with an LTV greater than 75%, you must have a minimum credit score of 660.
  • Your monthly housing expense-to-income ratio should be no greater than 25% to 28%.
  • Your monthly debt-to-income ratio should be no greater than 33% to 36% of your stable monthly income. If your debt-to-income ratio exceeds 45%, you won’t be eligible for a Freddie Mac loan.
  • The purchase of a single unit principal residence must have an LTV of no higher than 97%.
  • Freddie Mac now offers a 3% down payment option.

Requirements for Your Business

In addition to looking at your personal financial situation, Fannie Mae and Freddie Mac also are required to evaluate the financial health of your business.

Fannie Mae

Fannie Mae says you are self-employed if you have 25% or greater ownership interest in a business. In order to qualify, Fannie Mae also analyzes several components of your business.

Length of Self-Employment

Fannie Mae asks lenders to review a two-year history of your previous earnings. However, if you have a shorter period of self-employment (12 to 24 months), your most recent signed federal tax return must reflect your income. It’s important your past income was earned in a field similar to your current business. In these cases, the lender will give careful consideration to your level of experience and the amount of debt your business has acquired.

Analysis of Your Business Income

If you are relying on self-employed income to qualify for a mortgage, and you don’t meet the requirements to waive your business tax returns (as mentioned in the previous section), your lender will also prepare a written evaluation of your business income. Your lender will use their knowledge of your industry to help determine the long-term stability of your business.

The primary goal of this analysis is to:

  • consider the recurring nature of your business income, including identification of pass-through income that may require additional evaluation;
  • measure year-to-year trends for gross income, expenses, and taxable income for your business;
  • determine (on a yearly or interim basis) the percentage of gross income attributed to expenses and taxable income; and
  • determine a trend for the business based on the change in these percentages over time.

Your lender may use Fannie Mae’s Comparative Income Analysis or other methods to determine your business’s viability.

Use of Your Business’s Assets

If you are planning to use assets from your business for a down payment, closing costs, or financial reserves, your lender will need to perform a cash flow analysis to make sure this transaction won’t have a negative impact on your business. This may require additional documentation, like several months of recent business asset statements, to evaluate your cash flow needs over time.

Freddie Mac

Freddie Mac also characterizes self-employed borrowers as people who own at least 25% of a business. Your business can be a sole proprietorship, a partnership, an S corporation, or a corporation. You may notice several similarities when it comes to how Fannie Mae and Freddie Mac evaluate your business. However, there are some distinctions you should be aware of.

Length of Self-Employment

For Freddie Mac, the lender will be required to document a two-year history of your self-employment to ensure your income is stable. If your self-employment history is less than two years, the lender must evaluate your company’s products and services in the marketplace. They will also need to document your two-year history prior to self-employment to show you’re currently earning the same or a greater income in a similar occupation. The lender must consider your experience in the business before looking at your income, and your tax returns must show at least one year of self-employment income.

Analysis of Your Business Income

Your lender will analyze your tax returns and provide a written analysis of your self-employed income. Noncash items like depreciation, depletion, and amortization can be added back to your adjusted gross income. Documented nonrecurring losses and loss carryovers from previous tax years can also be added back to your adjusted gross income.

If you are using self-employment income to qualify, Freddie Mac requires lenders to analyze tax returns and provide a written analysis of your self-employed income. If your income has significantly increased or decreased, you will need to provide sufficient documentation to prove your income is stable. Additional tax returns may be needed if your self-employment income has fluctuated.

Freddie Mac recommends lenders be careful when including additional income you have drawn from your corporation, partnership, or S corporation as qualifying income. Your lender will need to confirm you have a legal right to that additional income. Your lender also needs to verify your percentage of ownership from a review of your business’s tax returns.

Location of Your Business

If you are moving to another region, your lender must consider your company’s service or products in the new marketplace before reviewing your income. You will need to document how your income will continue to be stable in a new location.

Use of Your Business’s Assets

If your business’s assets are used for a down payment, closing costs, financing costs, prepaid or escrows, and reserves, these assets must be verified and must be related to the business you own. The withdrawal of assets from a sole proprietorship, partnership, or corporation may have a negative impact on your business’s ability to continue operating. The impact of this transaction will be considered in your lender’s analysis of your self-employed income. You will need to provide documentation of cash flow analysis for your business using your individual and/or business tax returns. You can learn more about the required documentation here.

What Types of Properties Are Eligible for a Fannie or Freddie Mortgage?

When you are comparing mortgage options, it’s important to know which types of properties are eligible. Here are the basics to keep in mind as you are assessing each choice.

Fannie Mae

Fannie Mae is willing to purchase first-lien mortgages that are secured by residential properties for dwellings that consist of 1-4 units. However, there are some cases where the number of units may be restricted. The property must be located in the United States, Puerto Rico, the U.S. Virgin Islands, or Guam.

The property must be safe, sound, and structurally secure and must be adequately insured per Fannie Mae’s guidelines for property and flood insurance. It must be the best use of the property, must be readily accessible by roads that meet local standards, and must be served by local utilities. Lastly, the property must be suitable for year-round use.

Freddie Mac

Freddie Mac expects lenders to equally assess both a borrower’s eligibility and the adequacy of the property as collateral. Freddie Mac is willing to purchase mortgages secured by residential properties in urban, suburban, and rural market areas. The property must be residential, be an attached or detached dwelling unit(s) located on an individual lot.

The property must be safe, sound, and structurally secure and must be covered by property insurance that meets Freddie Mac’s hazard requirements. It must be the best use of the property, have legal access, and have utilities and mechanical systems that meet local standards. It must be suitable for year-round use and not be subject to a pending legal proceeding.

Where to Go if Fannie and Freddie Reject You

If you don’t qualify for a mortgage backed by Fannie Mae or Freddie Mac, there are a number of private lenders worth exploring. These are considered nontraditional lenders. Some of the more reputable ones include SoFi, Quicken Loans, and PenFed, among many others. Additionally, you may want to reach out to major banks to learn about their nonconforming product options.

SoFi

SoFi’s unique proprietary underwriting uses free cash flow as the primary criterion in determining your eligibility. They also look at a history of financial responsibility and professional responsibility. For qualified borrowers, they offer mortgages with 10% down payments and no mortgage insurance for their 15-year and 30-year mortgage products. They also offer a 30-year 7/1 ARM. This is a hybrid mortgage that begins with seven years at a fixed rate, and changes every year after that.

Interest rates depend on your qualifications and the overall mortgage rate environment, but typically fall in the low 3% to low 5% range for both 15-year and 30-year mortgages.

SoFi estimates 10% of their borrowers are self-employed, so they are well equipped to assess each individual’s unique financial position. They cite their unique underwriting model and commitment to personal service as creating a friendly environment for self-employed borrowers. Additionally, SoFi doesn’t impose restrictions or rate adjustments for self-employed borrowers.

Quicken Loans

According to Quicken Loans, self-employed borrowers are eligible for all the same loans and terms as traditionally employed W-2 borrowers. The key difference is self-employed borrowers need to provide tax returns documenting their business’s income. They like to see two full years of tax returns with stable to increasing income. However, there are some situations on conventional loans that only require one year of tax returns if your business has existed for 5 or more years.

Quicken Loans points out some self-employed borrowers tend to keep all of their assets in business accounts. This can complicate documentation requirements when funds for closing are not from personal accounts. In these types of situations, they usually require business tax returns to review cash flow. This ensures the funds being used to buy a home won’t jeopardize the health of the company.

Conventional loans over 80% LTV require mortgage insurance, while FHA and VA loans have insurance built into the program, regardless of LTV.

Here are their general credit and debt-to-income guidelines for each type of loan:

  • Conventional – minimum FICO 620 and maximum DTI 45%.
  • FHA and VA – minimum FICO varies but is typically 580. DTIs will vary by lender but typically are permitted to 50%.
  • Jumbo – minimum FICO is typically 700 and the maximum DTI is typically 43%.

When it comes to eligibility, there is no difference between self-employed and traditionally employed borrowers for credit score, loan-to-value, or debt-to-income ratios. Quicken Loans also noted self-employment isn’t a deciding factor for interest rates. However, it’s important to know you probably won’t be approved with an income decline of more than 25%.

PenFed

PenFed, a national credit union headquartered in Alexandria, VA, verifies income of self-employed borrowers through copies of personal and business federal tax returns from the past two years. You are required to provide complete tax returns, including all schedules and supporting documents. In some cases, you may also need to provide corporate tax returns for companies you have significant ownership in.

PenFed reviews and averages your net income from self-employment that is reported on your tax returns to determine your income that can be used to qualify. If your income hasn’t been reported on your tax returns, it won’t be considered. Usually PenFed requires a one-year and sometimes a full two-year history of self-employment to prove your income is stable.

Nonconforming Loans from Traditional Lenders

It may not be the first option that springs to mind, but some banks do originate loans. These loans tend to be nonconforming and have higher interest rates.

For example, Chase offers jumbo mortgages for loans between $417,000 and $3 million. These are both fixed-rate and ARM loans for up to 30-year terms.

For these types of products, Chase typically will only work with existing customers, depending on their assets. If you don’t have a prior relationship with the bank, you won’t be eligible. If you’re interested in a nonconforming product, Chase recommends starting by applying for pre-qualification here.

In order to be approved for these types of products, you must meet the following requirements:

  • Credit score – 680 minimum
  • Down payment – 15% without mortgage insurance
  • Reserve balance – 18 to 24 months
  • Debt-to-income ratio – no more than 45%

When it comes to interest rates, Chase factors in all the above criteria. However, the larger the loan, the better rates are available. They prefer to use your pre-qualification information as a starting point and work through interest rate options from there.

How to Comparison Shop for a Mortgage Loan

Did you know nearly half of mortgage borrowers don’t comparison shop? A recent Consumer Financial Protection Bureau (CFPB) study found 77% of borrowers only apply with one lender or broker. These same borrowers were quick to rely on salespeople rather than doing their own research.

As we have outlined, mortgages are available through a variety of types of lenders. Because the process of qualifying for a mortgage when you are self-employed requires additional legwork, and may be more expensive, it’s even more important to shop around.

The CFPB’s interest rates tool is a great place to start. By plugging in your credit score, state, home price, and down payment percentage, you can see a graph of lenders and interest rates being offered in your region. Although this tool doesn’t state which lenders are offering these rates, you can Google the rate + your state + mortgage to find out exactly where it is being offered.

Remember, lenders want your business, and knowing what else is available will only give you more leverage. Like any other mortgage, you will want to ask about points, mortgage insurance, and closing costs. You can compare each lender’s Loan Estimates before making a final decision.

For conforming loans, backed by Fannie Mae or Freddie Mac, you can try the above tactic for shopping around. You can also try local banks and credit unions. For private lenders like SoFi, Quicken Loans, or PenFed, you are better off reaching out to these companies directly. For nonconforming loans from traditional lenders, it’s easiest to start with banks you have an existing relationship with.

Here is an example to help you determine what is right for you:

Conforming Loan from Fannie Mae or Freddie Mac

This example is for the state of Tennessee:

Credit score – 680-699
Home price – $200,000
Down payment – $6,000 (3%)
Loan amount – $194,000
Rate type – fixed
Loan term – 30 years
Interest rates – 4%-4.625%
Total cost for interest rates at 4% – $333,360
Total cost for interest rates at 4.625% – $358,031

Nonconforming Loan from SoFi

Credit score – 680-699
Home price – $200,000
Down payment – $20,000 (10%)
Loan amount – $180,000
Rate type – fixed
Loan term – 30 years
Interest rates – 3%-5%
Total cost for interest rates at 3% – $273,240
Total cost for interest rates at 5% – $347,860

Keep in mind credit score, home price, and down payment will all affect your interest rates. You should ask about points, mortgage insurance, and closing costs, which are not included in these examples.

Start Preparing Now

The entire process may feel daunting, but there are a number of things you can start doing now in order to put your best financial foot forward:

  • Stay Organized Keeping pristine records of your company’s profits and/or losses is a smart practice whether you are applying for a mortgage or not. Staying on top of paperwork from the beginning will be helpful for both you and your loan officer.
  • Avoid Co-Mingling Funds One of the biggest mistakes self-employed individuals make is co-mingling personal and business funds. Lenders may want to see separate statements for your credit card, checking, and savings accounts. If you are feeling overwhelmed by the process, you can start by comparing our favorites.
  • Improve Your Credit Score A recent Zillow study found self-employed borrowers are twice as likely to have a FICO score below 680. It’s never too soon to start making improvements. Start by pulling free reports from all three credit bureaus — Experian, Equifax, and TransUnion — once per year from AnnualCreditReport.com. Once you are armed with your current scores, you can take action with our credit score guide.
  • Pay Down Debt Regardless of your employment status, it is nearly impossible to be approved for a mortgage if your debt-to-income ratio is above 45%. In most cases, a maximum debt-to-income ratio of 33%-36% is preferred. If you are above that range, paying down debt will improve your chances of being approved.
  • Save a Larger Down Payment Offering a larger down payment may provide additional leverage when it comes to eligibility.
  • Build Up Your Cash Reserves Having a sizable emergency fund can signal to lenders you are prepared for the inevitable dips in income self-employed borrowers face. Help ease your bank’s nerves about irregular income by having extra cash on hand.
  • Carefully Evaluate Tax Deductions If you are planning to purchase a home within the next few years, it’s critical to begin weighing the pros and cons of your business’s tax deductions now. It may be worth writing off fewer business expenses in order to qualify for a less expensive conforming mortgage. This step is worth discussing with a trusted tax professional. For more information on self-employed taxes, you can visit the Self-Employed Individuals Tax Center.

Final Thoughts

When it comes to homeownership, there is a lot to think about, and being approved for a mortgage is just the beginning. The stress of buying a home is only elevated for self-employed borrowers, who face additional hurdles each step of the way. However, the process doesn’t have to be overwhelming. By crafting a game plan as early as possible, and sticking with it, you will have the best possible chance of being approved.

Kate Dore
Kate Dore |

Kate Dore is a writer at MagnifyMoney. You can email Kate at kate@magnifymoney.com

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Mortgage

Guide to Getting the Best Rate on Your Mortgage

Editorial Disclaimer: The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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Guide to Getting the Best Rate on Your Mortgage

A house is the single largest asset that most Americans will ever buy. The median price of a home sold in the United States is up to $301,300, and the median household income of a homeowner is $60,000. This means that a house now costs more than five times the income of a typical homebuyer.

With prices so high, it’s more important than ever to find a great rate on your mortgage. Finding the lowest rate can save you tens of thousands of dollars over the lifetime of a loan. But finding the best rates on the loans with the right features can be a challenge. In this guide we’ll teach you how to find the best mortgage rates.

Finding the best rate on a mortgage

When it comes to buying a house, you don’t just need to house hunt; you need to shop for a mortgage. According to the Consumer Financial Protection Bureau (CFPB), just 53% of Americans shop for mortgages, but comparing lenders has a huge payoff. Saving 1% on your rate will save you tens of thousands of dollars over the life of your loan. Your mortgage can make or break the affordability of a house, and it’s up to you to find the best rates. These are the steps you can take to find the best rates.

Compare rates using the CFPB’s handy tool

The CFPB offers a tool that allows you to compare the prevailing interest rates on various types of loans. To use the tool, you need to know your credit score, the amount you intend to borrow, and how much money you have for a down payment.

By exploring the different options, you can determine the best rates in your state, and the most common rates.

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This tool will give you an idea of the rate landscape in your state. However, you still need to do work to get the best rates.

Next, find lenders that offer the lowest rates

Once you know the lowest interest rates, you can find the lenders offering those rates through search engine queries. Enter the following formula: “State Mortgage, X% Interest Rate, Loan Type.”

For example, “Alabama Mortgage, 3.75% Interest Rate, 30-Year Fixed Rate.”

The bank or credit union with the best rate should emerge near the top of the search rankings. You will find mortgage comparison websites that will help you connect with the banks. Mortgage comparison websites can be a helpful resource, but they require your contact information. If you use a comparison site, expect to receive phone calls or email solicitations.

Continue to cross-reference the rates from comparison sites with information from the CFPB. The rates on a mortgage comparison site should be as good as those on the CFPB’s site.

If a lender has already pre-approved you, they may be willing to match the lowest rate. Talk with your loan officer about the rate you saw on the CFPB’s website. Ask them to match the rate. If they will, the conversation saves you time and money.

Get pre-approved for a mortgage from multiple banks

Once you find the banks with the best rates, consider getting pre-approved for mortgage rates from a few different banks. A pre-approval means that a bank plans to give you a loan at a given rate. You will need to submit documentation to a loan officer to get pre-approved. Typical documentation includes W-2 forms, tax returns, credit reports, and evidence of assets.

The bank will review your documentation and give you a pre-approval letter. The letter explains how much you can borrow and at what rate. If you’re denied at this stage, you can find out why.

A pre-approval is not a contract. It is not subject to underwriting or an appraisal. Rates can change after you get a pre-approval. That’s why we recommend getting multiple pre-approvals if you can.

When you’re pre-approved, a bank will give you a letter that you can submit with offers on a home. Home sellers want to see a pre-approval letter because it means that you’re likely to have access to the financing to close a deal.

Once you have pre-approvals in hand, start shopping for houses. You can submit a bid and negotiate a price using your pre-approvals.

Request loan estimates from lenders

Once a seller accepts your bid, request loan estimates from all the banks that pre-approved you.

A loan estimate is a three-page document that contains an estimated interest rate, monthly payments, and closing costs for the specific loan. It explains everything you need to know about the loan if you choose to move forward.

Compare all the loan estimates before committing to a particular mortgage lender. Loan estimates allow you a true apples-to-apples comparison of interest rates.

A loan estimate isn’t a contract. The bank may deny the loan based on the home’s appraisal values or due to underwriting problems. But a loan estimate will allow you to make an informed decision.

Factors that influence your interest rate

Shopping for a mortgage isn’t the only way to find the best interest rate. You can influence the rate by controlling these factors.

Credit score

The better your credit history, the better your rate will be. In some cases, the difference can be a full percentage point or more. Fixing your credit score is one of the best ways to influence your mortgage rate. Depending on your credit history, you might be able to fix your credit score on your own within a few months.

When you’re shopping for a mortgage, pay your bills on time and keep your credit usage low. Try to use 10% or less of your total available credit. Don’t close old credit accounts or apply for new accounts when mortgage shopping. These actions promote a high credit score while you shop for a mortgage.

Down payment & PMI

In general a bigger down payment means a lower interest rate.

If you put down at least 5%, you will probably qualify for the lowest advertised rates. But don’t confuse the lowest interest rates with the lowest cost financing. Most banks require you to purchase private mortgage insurance (PMI) if you don’t put at least 20% down on a home. PMI adds about .5%-1% per month on your mortgage. You won’t be able to remove PMI until you’ve built up at least 20% equity in your home. You build equity when your home rises in value and when you pay down your mortgage.

If you have a down payment less than 5%, you’ll need to look at FHA loans or VA loans. VA loans don’t require PMI, but you will have to pay an upfront financing fee. This is a fee that doesn’t help you build equity, but VA loans have competitive rates for people who don’t have a down payment. Check the fee schedule for VA loans to see if the financing fee is worth it to you.

FHA loans require just a 3.5% down payment, but FHA loans have require mortgage insurance premiums (MIP). The MIP is an upfront fee (usually 1.75% of the total mortgage) and monthly interest rate hike of around .5%. You can’t get rid of MIP unless you get rid of your FHA loan.

Location

Buyers looking for a mortgage in a rural area may see higher rates compared to equally qualified buyers in nearby urban areas. Most lenders have less familiarity with lending in rural areas. This leads to higher rates. In rural settings, you may get the best rates from nearby banks and credit unions.

Rates also differ on a state-by-state basis. States that have laws that make foreclosure difficult tend to have higher mortgage rates than states with looser foreclosure laws. Likewise, states that require lenders to have a physical presence in the state raises interest rates.

Loan size

Interest rates on small mortgages (less than $50,000) tend to be higher than rates on typical mortgage sizes. Small mortgages are less profitable than other loans, and many banks won’t issue this size mortgage. Borrowers may need to work with local banks or credit unions or government lending programs to find a micro-mortgage.

At the other end of the spectrum, jumbo mortgages tend to track closely to conforming loan interest rates. Banks can’t sell jumbo loans in the secondary market, so they are riskier for the bank compared to other mortgages. Usually, banks compensate higher risk with higher interest rates. However, the rigorous underwriting on jumbo loans may drive many poor prospects out of the market.

Length of loan (Loan term)

Mortgages with shorter terms have lower rates than those with longer terms. A longer term represents more risk for the bank. Banks compensate their risk with higher interest rates. This doesn’t mean that a shorter term loan is always the right choice. Choose the loan term that fits your needs before you compare rates. That way you’ll get the best interest rate on the right mortgage for you.

Fixed or variable rates

Adjustable-rate mortgages put more risk onto borrowers. You’ll initially pay a lower interest rate if you take out an adjustable-rate mortgage, but the rate might increase.

When you’re considering an adjustable-rate, learn when and how the interest rate adjusts. Most loans adjust based on a set index. In a low interest rate environment, you can expect rates to increase, but you need to guess how much. Weigh whether the low rates now are worth a potential high rate in the future.

Conforming vs. FHA vs. VA vs. conventional

The company that backs your loan may seem unimportant, but it influences your rate.

Conforming loans (those that can be purchased by Fannie Mae or Freddie Mac, the largest purchasers of mortgage loans in the U.S.) tend to have the lowest interest rates. Despite their low interest rates, conforming loans are profitable for banks. Banks can easily sell conforming loans to Fannie Mae or Freddie Mac and reinvest the proceeds in making more loans. Conforming loans require at least a 5% down payment and good credit. For conforming loans, put 20% down to avoid paying PMI.

FHA loans have more lenient down payment and credit standards. They tend to be expensive for well-qualified buyers. However, an FHA loan may be the right option if you have a low down payment or a poor credit score. Only you can determine if the extra cost is worth it for you. VA loans are available to veterans, and they charge an upfront fee. However, they offer competitive rates for first-time homebuyers. If you can qualify for a VA loan, look into it as an option.

Conventional loans can’t be purchased by Fannie Mae or Freddie Mac. They require more shopping around to find the best rates. Not every lender issues conventional loans. If you qualify, the rates should be competitive with rates on conforming loans.

If you’re taking out a jumbo mortgage, you need to qualify for conventional underwriting. Likewise, condo buyers may need to qualify for a conventional loan. Fannie Mae and Freddie Mac will not purchase a mortgage if the property is part of an association that has more than 50% renter occupants.

Buying points

Many lenders offer to let borrowers buy “discount points” off of a mortgage. This means that you pay a set fee in exchange for the lender to lower your rate. In some circumstances buying discount points makes sense. Divide the cost of the point by the change in your monthly payment. This will tell you the number of months it takes for the prepayment to pay off (in terms of savings). If you expect to stay in the house significantly longer than the payoff period, go ahead and purchase the points. Otherwise, pay the higher interest.

Closing costs

An advertised interest rate doesn’t account for your total cost to borrow money. Most banks make their real money by charging closing fees. Banks might charge loan origination fees, recording fees, title inspection fees, underwriting fees, and application fees.

All the financing charges will be disclosed on a loan estimate. The loan estimate will also provide you with an annual percentage rate (APR), which expresses the total cost of borrowing money including the financing fees.

Special programs

Cities and states often issue special interest rates on loans for homebuyers who meet certain criteria. For example, Raleigh, N.C., subsidizes a $20,000 down payment loan for low-income, first-time homebuyers in distressed neighborhoods. Check your city, county, and state websites to see if you qualify for special rate programs. These programs often have favorable borrowing terms in addition to great rates.

Accelerating payments

Some borrowers cut their total interest costs by accelerating their mortgage payoff. If you make a half mortgage payment every two weeks, you’ll make an extra mortgage payment every year. This cuts a 30-year mortgage down to 23 years.

Making extra payments early in the life of your loan will help you achieve 20% equity faster. This will allow you to drop PMI payments or refinance at a lower rate.

Determining a budget for your loan

Finding a great rate on a loan that you can’t pay back is a sure way to destroy your credit. Before you apply for a loan, establish a realistic budget for your monthly mortgage payment. Avoid borrowing more than you can comfortably pay back.

When banks approve you for a mortgage, they will lend based on your current debt-to-income ratio without considering your other costs of living. Lenders have some limits, but you need to establish your own limits. Most of the time, lenders will not extend mortgage loans to borrowers whose monthly debt liabilities eat up more than 43% of their gross monthly income.

To understand debt-to-income ratio, consider this example. A person with a $60,000 annual income and a $500 monthly car payment applies for a mortgage.

A bank will allow them to carry a debt load up to $2,150 per month (($60,000/12)*43%). The bank subtracts the $500 from the maximum allowed debt load and determines that this person can afford $1,650 in house payments each month.

The bank in this example determines that $1,650 a month is an affordable budget.

No matter how large a loan you can get, you need to be a savvy consumer. The Consumer Financial Protection Bureau recommends that your entire housing payment (including taxes, insurance, and association dues) should take up no more than 28% of your gross income.

The CFPB’s advice may seem too strict, but you need to determine your non-mortgage-related cost of living before committing to a new loan. Calculate costs like income taxes, transit expenses, and child care or education costs. If you pay alimony or for out-of-pocket health care, consider those costs too. Plus, you’ll need to factor in the costs of home maintenance. Experts recommend setting aside 1%-3% of your home’s purchase price for maintenance and upgrades.

A 43% debt-to-income ratio may be manageable for people who expect a significant salary bump in the near future. But for many, such a high ratio could get you into credit trouble.

If you’re seriously shopping for houses, use Zillow’s advanced affordability calculator to determine how much mortgage makes sense for you. You can also learn if buying makes financial sense by using the Rent vs. Buy Calculator from realtor.com.

Before you start shopping for houses, determine how a mortgage will fit into your budget. Don’t succumb to pressures to overextend your budget. A burdensome mortgage has the power to turn a dream house into a nightmare. You can avoid the nightmare by planning ahead.

Determining loan features you want

In addition to establishing a budget, you need to understand how to find the right features on a mortgage. A great rate on a bad mortgage could spell financial ruin. When you’re shopping for loans, ask yourself these questions:

How long will you stay in the home?

Some buyers purchase houses with the intention of staying just a few years. Someone who plans to sell in a few years might consider a lower interest rate adjustable mortgage. However, an adjustable-rate mortgage is risky for someone who intends to live in a home long term.

How risky is your financial situation?

Do you and your partner have two steady jobs and a large cash cushion? In such a stable situation, you might feel comfortable putting 20% down. You might also feel good locking into a 15-year mortgage to save on interest.

People with less stable income and finances might feel more comfortable with a smaller down payment and a longer payoff period. This will mean paying PMI and higher financing costs, but they can be worth it for peace of mind.

Do you expect to have better cash flow in the future?

If you think that you’ll have more accessible cash flow in the future, you can borrow near the higher end of your limits today. An interest-only loan will allow you to get into a house with lower payments now and higher payments in the future. Of course, you need to be realistic about your future expectations. Your future income may be more modest than you hope, or you may face high costs in the future. An interest-only loan could leave you trapped in a house if housing prices decline.

Even if you expect a higher income, borrowing near the top end of your budget could keep you “house poor.” If the raise doesn’t pan out, you’ll be stuck in a house that you can’t comfortably afford.

Do you have access to other sources of financing?

Alternative sources of financing like a home equity line of credit make a loan with a balloon payment more viable. Alternative financing means that you’ll have options if your original mortgage payoff plan falls through.

Anyone considering a balloon payment loan should have a solid lead on alternative financing before they take out the loan.

How much cash do you have for a down payment?

You can purchase a house with almost no money down. For example, the Federal Housing Association (FHA) offers “$100 Down” home financing on select HUD homes, or down payments as low as 3.5% for FHA-backed loans. Veterans can purchase homes using $0 down VA loans.

On the other hand, if you have more money to put down, you may qualify for a conventional mortgage or a mortgage backed by Fannie Mae or Freddie Mac. The more cash you have, the more options you have for loan types.

Do you have compelling uses for cash outside of a home down payment?

Putting a large amount of money down on your home locks up the cash. You can access home equity through a home equity line of credit, but that introduces a new element of risk. Even if you have a large amount of cash, you may not want to use it to fund a down payment. For example, you may want to hold cash for an emergency fund, to start a business, or to fund some other purchase.

If you have a compelling reason to hold onto cash, you may intentionally narrow your mortgage search to low down-payment options.

How quickly do you want to pay off your house?

A paid-off home might be your top financial priority. In that case, you might want to look for options with a short payoff period. For example, you might prioritize the forced savings of a 15-year mortgage. You might even aim to payoff a 5/1 ARM before the first rate adjustment if you have sufficient cash.

How important is the monthly payment?

A lot of people prioritize a low monthly payment above any other factor. You can achieve a low payment by avoiding fees (like PMI), finding the lowest possible interest rate, and extending the terms of the loan. Even more important than those factors is borrowing an amount that you can easily afford under most circumstances.

Common mortgage terms

Sometimes the most difficult part about shopping for a mortgage is understanding the terms that lenders use. Below we’ve defined a few of the most common mortgage terms that you should know before you sign a loan.

  • Interest Rate – The amount charged by a lender for a borrower to use the loaned money. This is expressed as a percentage of the total loan amount.
  • APR – The annual percentage rate is the total amount that it costs to borrow money from a lender expressed as a percentage. The APR factors in closing costs and other financing fees.
  • Amortization Schedule – A table that shows how much of each payment goes to the principal loan balance versus the interest portion of the loan.
  • Term – A set period of time over which a fixed loan payment will be due (often 15 or 30 years).
  • Fixed-Rate Mortgage – A mortgage where the interest rate stays the same for the entire term of the loan.
  • Adjustable-Rate Mortgage – A mortgage where the interest rate changes based on factors outlined in the loan agreement. Often, the adjustment is tied to a certain publicly available interest rate like the Federal Exchange Rate. Adjustable-rate mortgages are considered riskier than fixed-rate mortgages due to the potential volatility of payments. Adjustable-rate mortgages (ARMS) include:
    • 1-Year ARM – A mortgage where the interest rate adjusts up to once per year for the life of a loan.
    • 10/1 ARM – A mortgage where the interest rate is fixed for ten years and then increases up to once per year for the remaining life of the loan.
    • 5/1 ARM – A mortgage where the interest rate is fixed for the first five years of the loan and then increases up to once every year for the life of the loan.
    • 5/5 ARM – A mortgage where the interest rate is fixed for the first five years of the loan and then increases up to once every five years for the life of the loan.
    • 5/25 ARM – Also known as the five-year balloon mortgage. A 5/25 loan is a subprime loan with a fixed rate for the first five years of the loan. If a borrower meets certain standards (usually a record of on-time payments), they will receive the right to refinance the remaining 25 years on an adjustable-rate mortgage. Otherwise, the bank requires a “balloon” or remaining balance payment after five years.
    • 3/1 ARM – A mortgage where the interest rate is fixed for the first three years of the loan and then increases up to once per year for the life of the loan.
    • 3/3 ARM – A mortgage where the interest rate is fixed for the first three years of the loan and then increases up to once every three years for the life of the loan.
    • Two-Step Mortgage – A mortgage that offers a fixed interest rate for a fixed period of time (usually 5 or 7 years). After the fixed period, the rate adjusts to current market rates. Often, the borrower can choose either a fixed rate or an adjustable rate during the second step.
  • Interest-Only Mortgage – A mortgage where a borrower pays only the interest on a loan for a fixed period (usually 5-7 years).
  • PMI – Private mortgage insurance is a product that protects a bank if you default on your mortgage. Lenders often require borrowers with less than 20% equity to purchase PMI.
  • Jumbo Mortgage – A mortgage that is larger than the standards for a “conforming loan” set by government-backed agencies. In most parts of the U.S. a jumbo loan must be larger than $417,000. In some of the highest cost of living areas, a jumbo is in excess of $625,000.
  • Fannie Mae – The Federal National Mortgage Association is a government-sponsored enterprise that purchases mortgages that meet certain criteria from banks that issue the mortgages.
  • Freddie Mac – The Federal Home Loan Mortgage Corporation is a government-sponsored enterprise that purchases mortgages that meet certain criteria from banks that issue the mortgages.
  • Conforming Loan – A mortgage that meets the funding criteria of Fannie Mae and Freddie Mac. The most stringent criteria is the loan size.
  • FHA Loan – A loan guaranteed by the Federal Housing Administration. Qualifying standards are not as stringent, but the fees are higher. In addition to a monthly premium (similar to PMI), borrowers pay a “borrowing” premium when they take out the loan.
  • VA Loan – A mortgage guaranteed by the Department of Veterans Affairs. Veterans can purchase houses with a $0 down payment when using a VA loan, provided the veteran meets other lending criteria.
  • Conventional Mortgage – A mortgage that is not guaranteed by any of the federal funding agencies. Certain homes or condominiums will only qualify for a conventional mortgage financing option.
  • Down Payment – The initial payment that a homebuyer supplies when purchasing a home with a mortgage.
  • Balloon Mortgage – A mortgage where a borrower pays fixed payments for a period of time (usually 5 or 7 years) after which the balance of the loan is due. This is considered a high-risk loan.
Hannah Rounds
Hannah Rounds |

Hannah Rounds is a writer at MagnifyMoney. You can email Hannah at hannah@magnifymoney.com

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