Financing Basics for First-Time Homebuyers

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Obtaining a mortgage is a crucial step in purchasing your first home, and there are several factors for choosing the most appropriate one. While the myriad of financing options available for first-time homebuyers can seem overwhelming, taking the time to research the basics of property financing can save you a significant amount of time and money.

Understanding the market where the property is located, and whether it offers incentives to lenders, may mean added financial perks for you. And by taking a close look at your finances, you can ensure that you are getting the mortgage that best suits your needs. This article outlines some of the important details that first-time homebuyers need to make their big purchase.

KEY TAKEAWAYS

  • Obtaining a mortgage is a crucial step in purchasing your first home, and there are several factors for choosing the best one.
  • Lenders will evaluate your creditworthiness and your ability to repay based on your income, assets, debts, and credit history.
  • As you choose a mortgage, you’ll have to decide between a fixed or floating rate, the number of years to pay off your mortgage, and the size of your down payment.
  • Conventional loans are mortgages that the government does not insure.
  • Depending on your circumstances, you may be eligible for more favorable terms through a Federal Housing Administration (FHA) loan, a U.S. Department of Veterans Affairs (VA) loan, or another type of government-guaranteed loan.
  • As a first-time homebuyer, you may be eligible for special programs that allow you to access deeply discounted homes and put low or no money down.

First-Time Homebuyer Requirements

To be approved for a mortgage, you’ll need to meet several requirements depending on the type of loan for which you are applying.

To be approved specifically as a first-time homebuyer, you’ll need to meet the definition of a first-time homebuyer, which is broader than you may think. A first-time homebuyer is someone who has not owned a principal residence for three years, a single person who has only owned with a spouse, an individual who has only owned a residence not permanently affixed to a foundation, or an individual who has only owned a property that was not in compliance with building codes.1

You’ll generally need to have proof of income for a minimum of two years sufficient to pay the mortgage, a down payment of at least 3.5%, and a credit score of at least 620. However, as a first-time homebuyer, there are programs that can allow you to buy a home with a low income, $0 down, and credit scores as low as 500.

Loan Types

Conventional Loans

Conventional loans are mortgages that are not insured or guaranteed by the federal government. They are typically fixed-rate mortgages. They are some of the most difficult types of mortgages to qualify for because of their stricter requirements: a bigger down payment, higher credit score, lower debt-to-income (DTI) ratios, and the potential for a private mortgage insurance (PMI) requirement. However, if you can qualify for a conventional mortgage, they are usually less costly than loans that are guaranteed by the federal government.

Conventional loans are defined as either conforming loans or nonconforming loans. Conforming loans comply with guidelines, such as the loan limits set forth by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. These lenders (and various others) often buy and package these loans, then sell them as securities on the secondary market. However, loans that are sold on the secondary market must meet specific guidelines to be classified as conforming loans.

The maximum conforming loan limit for a conventional mortgage in 2022 is $647,200, although it can be more for designated high-cost areas.2 A loan made above this amount is called a jumbo loan, which usually carries a slightly higher interest rate. These loans carry more risk (since they involve more money), making them less attractive to the secondary market.3

For nonconforming loans, the lending institution that is underwriting the loan, usually a portfolio lender, sets its own guidelines. Due to regulations, nonconforming loans cannot be sold on the secondary market.

Federal Housing Administration (FHA) Loans

The Federal Housing Administration (FHA), part of the U.S. Department of Housing and Urban Development (HUD), provides various mortgage loan programs for Americans. An FHA loan has lower down payment requirements and is easier to qualify for than a conventional loan. FHA loans are excellent for first-time homebuyers because, in addition to lower up-front loan costs and less stringent credit requirements, you can make a down payment as low as 3.5%.4 FHA loans cannot exceed the statutory limits described above.

However, all FHA borrowers must pay a mortgage insurance premium, rolled into their mortgage payments. Mortgage insurance is an insurance policy that protects a mortgage lender or titleholder if the borrower defaults on payments, passes away, or is otherwise unable to meet the contractual obligations of the mortgage.

U.S. Department of Veterans Affairs (VA) Loans

The U.S. Department of Veterans Affairs (VA) guarantees VA loans. The VA does not make loans itself but guarantees mortgages made by qualified lenders. These guarantees allow veterans to obtain home loans with favorable terms (usually without a down payment).

In most cases, VA loans are easier to qualify for than conventional loans. Lenders generally limit the maximum VA loan to conventional mortgage loan limits. Before applying for a loan, you’ll need to request your eligibility from the VA. If you are accepted, the VA will issue a certificate of eligibility that you can use to apply for a loan.5

In addition to these federal loan types and programs, state and local governments and agencies sponsor assistance programs to increase investment or homeownership in certain areas.

Equity and Income Requirements

Home mortgage loan pricing is determined by the lender in two ways, and both methods are based on the creditworthiness of the borrower. In addition to checking your FICO score from the three major credit bureaus, lenders will calculate the loan-to-value (LTV) ratio and the debt-service coverage ratio (DSCR) to determine the amount that they’re willing to loan to you, plus the interest rate.6

LTV is the amount of actual or implied equity that is available in the collateral being borrowed against. For home purchases, LTV is determined by dividing the loan amount by the purchase price of the home. Lenders assume that the more money you are putting up (in the form of a down payment), the less likely you are to default on the loan. The higher the LTV, the greater the risk of default, so lenders will charge more.7

For this reason, you should include any type of qualifying income that you can when negotiating with a mortgage lender. Sometimes an extra part-time job or other income-generating business can make the difference between qualifying or not qualifying for a loan, or in receiving the best possible rate. A mortgage calculator can show you the impact of different rates on your monthly payment.

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