This is the twenty-ninth day in our 31-Day Money Challenge. Over 31 days we’ll publish 31 podcasts, each designed to help you move closer to financial freedom. Yesterday we looked at an how one couple built a 6-figure eCommerce business in under a year.. In today’s podcast, we cover the basics of mortgages.
Sponsors: The 31-Day Money Podcast is sponsored by Betterment and Personal Capital. Betterment and Personal Capital are two tools I use to make investing easier, less expensive, and more effective.
1. Credit score
Your FICO credit score is a critical part of qualifying for a mortgage. The 3-digit number determines if you can get a mortgage, the interest rate on your mortgage, how much you can borrow, and even how big of a down payment you’ll need to make. Here’s the rundown on each of these topics.
Listen to my interview of FICO’s credit expert, Tom Quinn
Score needed to qualify for a mortgage
Generally, you need a FICO score of 620 or higher to qualify for a mortgage. While there may be sub-prime options available, a score of at least 620 is the rule of thumb for a conventional mortgage.
For an FHA mortgage, the minimum score is lower. Based on guidelines issued by HUD, a borrow with a credit score of at least 500 can qualify for an FHA mortgage. To qualify for the 3.5% down payment that FHA loans are known for, a borrow must have a score of at least 580. A score between 500 and 579 requires a 10% down payment. Further, although technically eligible, many banks won’t approve FHA loan applications for scores under 620.
Did you know: For FHA loans with a 3.5% down payment, MIP (Mortgage Insurance Premium) must be paid for the life of the loan. It can no longer be cancelled when the balance equals 78% of the original balance.
Which score is used
Most consumers have three FICO scores based on credit files from the three major credit bureaus. Lenders typically use the middle of the three scores. For those with just two FICO scores, the lower score is used. For FHA loans, the score used is called the “decision credit score.”
With two borrowers, decision credit scores are calculated for each and the lowest score is used.
How your credit score affects the interest rate
A qualifying credit score is just the beginning. The higher the score, the lower the interest rate. For the best rates, aim for a FICO score of 760 or higher. At today’s mortgage rates, a score of 760 will qualify a borrow for a rate of about four percent. A score of 620 increases that rate to about 5.6%. Over the life of the loan, the 1.6% difference can mean tens of thousands of dollars in interest.
How your interest rate affects how much you can borrow
How much you can borrow is in part a function of your mortgage payment and your income. As we’ll see in the next section, lenders have strict debt-to-income (DTI) requirements. Mortgage payments cannot exceed a certain percentage of a borrower’s income.
As interest rates rise, the monthly payment for a given loan amount also rises. As an example, here are rates by credit score range and monthly payments (principal and interest only) for a 30-year fixed rate $250,000 mortgage:
If a borrower’s DTI could not exceed $1,300, they would need a credit score of at least 660 in the above example to qualify for the loan.
2. Debt-to-income ratios
Lenders use two DTIs to qualify borrowers: front-end and back-end.
The front-end ratio is calculated by divided the monthly mortgage payment (including taxes and insurance) into the borrower’s gross monthly income. While the front-end DTI varies from one loan program to another, 28% is a common requirement. For every $280 in monthly mortgage payments, the borrowers would need $1,000 in gross monthly income.
Using the example from above, we can now bring together the credit scores, interest rates, and required gross income:
760-850: 4.034%–$1,198 ($4,278/mo. or $51,336/yr.)
700-759: 4.256%–$1,231 ($4,396/mo. or $52,752)
680-699: 4.433%–$1,257 ($4,489/mo. or $53,868)
660-679: 4.647%–$1,289 ($4,603/mo. or $55,236)
640-659: 5.077%–$1,354 ($4,835/mo. or $58,020)
620-639: 5.623%–$1,439 ($5,139/mo. or $61,668/yr.)
Credit scores affect interest rates, interest rates affect required gross income.
The back-end DTI adds up all required monthly debt payments (e.g., mortgage, car loan, school loans, credit card minimum payments) and divides them into the borrower’s gross monthly income. While 36% is a common back-end requirement, some loan programs allow a ratio as high as 43%.
3. Down Payment Requirements
Required minimum down payments change over time. Before the housing crash, nothing down mortgages were readily accessible. Following the crash, banks were requiring 20% down payments. Today, these requirements have begun to soften.
Five percent down loans are now available. FHA loans require a 3.5% down payment for those with qualifying credit scores. With down payments less than 20%, however, private mortgage insurance is typically required.
4. 15 year vs. 30 year
There is no “right” or “wrong” answer to this perennial debate. The advantage to a 15-year mortgage is that the interest rate is lower than on a 30-year mortgage. The advantage to a 30-year mortgage is that the required monthly minimum payment is lower. Period.
A 15-year mortgage “forces” a borrower to pay off the mortgage sooner. Some view this is a benefit. For those who struggle to control spending and want to retire their mortgage early, a 15-year mortgage will help.
5. Fixed vs. Adjustable
The advantage of a variable rate loan is that its starting interest rate is lower than a fixed rate loan. The disadvantage is that the rate can go much higher when interest rates start to rise. For most borrowers, it’s not worth taking this risk. For more on this topic, here’s the rundown on fixed vs. adjustable rate mortgages.
There’s good news and bad news. The good news is that the standards for qualifying for a mortgage are the same whether you are an employee or self-employed. The bad news is that the self-employed must jump through extra hoops to document proof of income. Be prepared to document a 2-year history of self-employed income.