Buying a home, especially your first, is a big step in life. It can also be confusing to navigate all the different aspects and terminology. When making such a big purchase, you want to make sure you're prepared from the start and are making all the right decisions as the process moves along. If you're thinking of getting a mortgage or refinancing the one you already have, here are a number of factors to consider.
- If you're planning to get a new mortgage, you need to review your credit report, make sure everything is accurate, and correct anything that is not accurate.
- To get a better mortgage rate, improve your credit score by paying down debt and restricting the use of credit cards.
- Lowering your debt-to-income ratio, or what you repay in debt versus your overall income, can demonstrate to lenders that you will be able to pay your monthly payments.
- Don't spend the maximum amount that you qualify for; instead, plan on spending only what you can reasonably afford to pay in monthly payments, such as 30% of your take-home pay.
- Don't assume that you can always refinance and get a better rate later, as rates may drift higher during the year.
What Influences Mortgage Rates?
Mortgage rates are influenced by a number of different factors: the economic environment, inflation, and the Federal Reserve.
The Federal Reserve's Fed Funds Rate, the key overnight bank lending rate that influences all kinds of other interest rates, has stood at a target range of 0.0% to 0.25% since March 15, 2020, at the start of the COVID-19 pandemic.
The Federal Reserve may start to raise interest rates, which can have an overall impact on your mortgage rate. When and how depends on what kind of mortgage you have.
Long-term fixed-rate mortgages are tied to the yields of long-term U.S. Treasury notes. When these yields rise, so do interest rates. Adjustable-rate mortgages (ARMs) and home equity lines of credit (HELOCs) are tied to the prime lending rate. When the Fed raises its rate, banks hike their prime rate, thus increasing your mortgage rate as well.
Using a mortgage calculator is a good resource to budget these costs.
Check Your Credit Report
Lenders review your credit report to determine if you qualify for a loan and at what rate. By law, you are entitled to one free credit report every year from each of the “big three” credit rating agencies—Equifax, Experian, and TransUnion. Take a close look at your credit report to make sure it’s accurate. If there are any mistakes, you should take immediate steps to fix them.
Watch out for suspicious items, identity theft, data from a former spouse that no longer belongs to you, out-of-date information, and incorrect notations for closed accounts. Follow up with the lender or creditor who reported the item and make sure you report inconsistencies directly to the three agencies.
Improve Your Credit Score
Generally, a high credit score means you'll qualify for a better mortgage, so it pays to keep it as high as possible. The most common is the FICO score, which many financial institutions provide for free to their customers each month. You can also purchase your FICO score from one of the three credit rating agencies.
Credit scores range from 300 to 850, with 300 signifying very poor credit and 850 signifying excellent credit.
To improve your credit score, pay down debt, set up payment reminders to pay bills on time, keep credit card and revolving credit balances low, and reduce the amount of debt owed. One of the best ways to do that is to stop using (or restrict usage of) your credit cards.
Lower Your Debt-to-Income Ratio
Lenders look at your debt-to-income ratio—or your debt repayment compared to your overall income—to measure your ability to manage your monthly payments. They also use it to determine how much house you can afford. Lenders like to see debt-to-income ratios lower than 36%, with no more than 28% of that debt going toward mortgage payments, or the front-end ratio. The stronger these ratios, the better your mortgage rate.
There are two ways to lower your debt-to-income ratio so you get a better mortgage rate:
- Reduce your monthly recurring debt: Stop spending money on anything except the most urgent purchases.
- Increase your gross monthly income: Get a second job or work extra hours to boost your income potential.
While these options are possible, keep in mind that neither of these is always easy to accomplish.
Consider the Amount of the Mortgage
Remember, qualifying for a certain amount doesn't mean you have to spend that much on a home.
A conservative approach is to spend no more than 30% of your take-home pay on housing costs, which includes your mortgage, property taxes, homeowner’s insurance, and homeowner’s association dues. Don't forget to add in maintenance costs if you really want to make sure you’re looking in the right price range.
When shopping for homes, decide what’s more important: having a more expensive home or having a little extra wiggle room in your budget each month. Bear in mind, being a homeowner with a mortgage is a 30-year commitment.
Don’t Count on Refinancing to Lower Your Interest Rate
Mortgage rates have started to edge up from historic lows, and they may keep rising off the historic lows, so it might not be the right time to refinance. But you may be able to save money by shortening your loan term.
For example, moving from a 30-year fixed-rate mortgage to a 15-year loan with a better rate, or through a cash-out refinancing, in which your new mortgage amount is greater than the existing one. This allows you to tap into your home equity to pay down other debts. Even though your monthly payment will rise, you could end up saving money by paying off higher-interest debt, such as your car loan, student loans, and/or credit cards.
Before doing any refinancing, you should crunch the numbers to make sure you aren't adding to your financial stress.
What Should You Not Say to a Mortgage Lender?
There are quite a few statements that you should not make to your mortgage lender, such as, "how much can I borrow?" (you should know this and be prepared), "I'm still putting together funds for my down payment," any lies, that you change jobs often, or any other statements that make you seem unprepared or appear like someone that is financially risky.
Do Mortgage Lenders Look at Your Spending Habits?
Mortgage lenders look at your financial statements to determine your financial stability and how likely you are to default on your mortgage. To assess these matters, they will look at your recurring costs, such as student loans, or other debt, your basic spending habits, any overdrafts in your accounts, or deposits that are irregular and cannot be accounted for.
How Do I Know If It’s Worth Refinancing?
Financial experts typically say a rule of thumb to determine if refinancing is worth it is if your interest rate will be between 1%-2% lower or more. Refinancing comes with costs and those costs need to be added to how much you will save by refinancing.
Usually, refinancing will make up for those costs after a certain period of time. So, if you expect to be staying in your home for a long time, it is more likely that refinancing will be worth those costs. If you plan on moving out or selling the home soon, then perhaps the cost to refinance is not worth it.
For What Reasons Would a Mortgage Be Declined?
A mortgage can be declined due to a variety of reasons, such as poor credit history/low credit score, not enough income from your job, or a high debt-to-income ratio.
How Far Back Do Lenders Look at Bank Statements?
Typically, lenders look back at bank statements between two to three months; however, a lender can look back even further if they feel there is reason to do so to get a better understanding of your financial history.
The Bottom Line
Even a small change in interest rates can make a big difference in monthly payments, the amount of interest paid over the course of the loan, and the size of the loan (and house) for which you’ll qualify.
If you have a $200,000 30-year fixed-rate mortgage at 4%, for example, your monthly payment would be $954.83, and you’d pay $143,739.01 in total interest. Bump the rate up by 0.5% (for a total of 4.5%), and you’d be looking at a monthly payment of $1,013.37, and your total interest paid would be $164,813.42—that’s about $2 more per day for 30 years.
Given the above, it is always a good idea to work on improving your credit score, credit history, and debt-to-income ratio, so you can qualify for the best rate available. And, of course, don’t take on more debt than you can comfortably afford.