Someone once said success happens when preparation meets opportunity. Whatever lender or type of financing you ultimately select, it’s vital that you start preparing well in advance of application. Here are some key steps to make the process simple and efficient:
Obtain Your Credit Information
Well in advance of home shopping, you need to order your national credit files — ideally from all three credit bureaus (Equifax, Experian, Trans Union). Make sure there are no inaccuracies or outdated information. You can get your files free once a year at Annual Credit Report. Correct anything you find in error upfront; otherwise you’ll delay the entire financing process. Also order your FICO credit scores from one or more of the bureaus. They’ll play a key role in determining what sort of terms your lender will offer.
Any lender will need to see documentation of your income, employment, two years of IRS filings if you are self-employed, bank accounts, 401(K) funds and other assets. It’s smart to compile this before you even begin shopping for financing options. It’s also useful to have at least a rough idea of your current household expenses; they will affect the amount of mortgage you can obtain and the maximum price of the house you can finance.
Determine How Much You Can Afford
You can get a good idea about this well in advance of shopping by checking calculators that most lenders and builders provide on their websites. Simple rules of thumb (such as, you can afford a home two to two-and-a-half times your gross annual income) were cited in the past. However, today’s rules are much more complex. Most lenders take your basic information and enter it into automated underwriting models that blend credit scores, debt-to-income ratios and other factors to make decisions about loan sizes, rates and fees.
The bottom line is: get accustomed to experimenting with different rates, down payment amounts, loan terms (30-year, 15-year, fixed-rate, adjustable-rate) to see how your maximum mortgage amount varies and how that affects the top price you can afford for a new house.
The Many Shades of Loans
Mortgage loans come in different shapes and sizes. Think of them in terms of their problem solving characteristics:
If you’ve got only minimal cash to make a down payment and your credit history has a few blemishes, a federal government-backed loan is most likely your best choice. FHA (Federal Housing Administration) loans allow down payments as low as 3.5 percent along with generous credit underwriting.
VA loans require no down payment, but you must be a veteran to qualify. USDA rural loans also allow zero down, but they’re limited to areas with relatively small populations and may have income restrictions. The caveats are the FHA has been increasing its insurance fees recently, which increases your monthly payments. The VA has increased its guarantee fee, as well.
If you have more than 10 percent or 20 percent to put down, these may be your best bet. Conventional loans are designed to be sold to Fannie Mae and Freddie Mac (the government-chartered mega-investors). The downside is conventional underwriting rules are more strict and banks may impose add-on fees to loans, increasing your cost. Down payments below 10 percent may be possible but they require high private mortgage insurance premiums.
New-Construction Loan Financing
A construction loan is likely to be useful to you if you are building a home yourself as general contractor or working with a custom builder. Most new home construction loans provide short-term funds designed to get you through the building stage of your project (six to 12 months) followed by a conversion into a permanent long-term loan of 30 or 15 years. Some key features to be aware of in advance include:
Sources:New-home construction loans are a specialized niche in the lending industry and nowhere near as widely available as standard mortgages. Your best bet is to shop among community banks that know the local or regional marketplace, especially savings banks and thrift institutions, though some brokers advertise online and are worth checking out.
You can expect an installment schedule of drawdowns of funds in any loan contract. Though always negotiable, a typical schedule might provide for an initial draw of 15 percent of the full loan amount for the site preparation and foundation stage; a second draw of another 15 percent to 20 percent for the framing, and additional draws over the remaining months for the work on plumbing, electrical system, interior carpentry, installation of appliances, etc. Before each draw is paid out, the bank will send an inspector to the site to report on the progress of the work and to determine whether it meets local building codes and regulations.
Most banks who offer construction financing want to see substantial down payments upfront — typically at least 20 percent to 25 percent. However, some lenders have specialized programs that link FHA-insured permanent loans with short-term construction loans. So say you plan to build a house that is expected to be valued at $400,000 at completion on a piece of land you already own. A local commercial bank might offer you a nine-month, $300,000 loan to construct the house — figuring $100,000 as the land value — and ask for an $80,000 (20 percent) down payment based on the projected appraisal at completion. At the end of the construction period, you’d end up with a $300,000 permanent loan.
Generally the short-term, construction-period segment of the financing package will carry a “prime-plus” interest rate. If the prime short-term bank lending rate is 3 percent, the construction period loan might be set at 4.25 percent to 4.5 percent. The permanent 30-year or 15-year portion of the package generally will be near the going rate for regular mortgages — say 4.25 percent to 4.5 percent on a fixed 30-year loan. Rates can be significantly lower for adjustable rate options such as a popular “5/1” ARM where the rate is fixed for the first five years of the loan, but can vary each year thereafter, typically within a pre-specified range.
So-called “bridge” loans can also be important tools for you. These short-term (six to nine months) financings are designed to get you past a timing squeeze, such as when you’re buying a new home but haven’t yet sold your current house and don’t have all the cash you need.
The lender, who may be a local bank or a subsidiary of your builder, agrees to advance you money using the equity you’ve got in your current home as collateral.
Say you’re short by $50,000 on a down payment needed to buy your new house. Your current home is for sale, but you don’t yet have a buyer. However, you do have $250,000 in net home equity in your current home and only a small first mortgage. A lender could advance you the $50,000 you need either by placing a second mortgage on your current home or by paying off the existing mortgage and taking a first lien position, well-secured by your remaining equity. Once your house sells, part of the proceeds pay off the bridge loan.
Keep in mind that bridge loans are strictly short term and things get dicey if your current home doesn’t sell within the contracted time period. Bridge loans also come with higher rates than regular mortgages, often at least 2 percentage points higher.
Most large- and medium-sized builders either have wholly owned mortgage subsidiaries or affiliate relationships with outside mortgage companies. This allows builders to offer a menu of financing options to qualified buyers.
Your builder may also offer affiliated title insurance and settlement services. Sometimes the entire financing package comes with sales incentives on the new house, such as upgrades and price breaks. Since there can be significant value in builders financing packages, you should carefully consider the offer. However, you should also know that federal law allows — even encourages — consumers to shop around in the marketplace and use whatever mortgage, title insurance and settlement service company you choose.
As a general rule, the builder’s financing may reduce the time needed to proceed from application through settlement since the entire process is essentially under the control of the builder. It may also give you a slight edge on approval of your financing application and save you money on the total bundle of incentives you’re being offered (on the house combined with the costs of the mortgage and closing).
On the other hand, the builder’s mortgage terms (interest rate, fees and range of loan types) may not be the most favorable available in the marketplace, something you can only know by shopping around and comparing the total package being offered with competing sources.