Personal Finance

A Guide to First-Time Homebuyer Loans

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Want to buy a home? For most people, the promised land of homeownership lies through the mortgage loan. A mortgage is a loan you can use to buy a house or condo.

A mortgage can be a tricky loan to navigate because houses are so much more expensive than other assets. 

Small differences in rates and terms may cost (or save you) a huge amount of extra cash by the end of the loan term. Mortgages can also be tough to qualify for.

In this guide, we’ll explain how mortgages work and give you tips on how to prepare for this gargantuan loan.

What Are First-Time Buyer Loans?

There are a variety of first-time homebuyer loans that can help make homeownership a reality with lower down payments and other forgiving terms. The first step to finding a loan is understanding the options and what to expect during the loan process..

What Is a Mortgage?

A mortgage is essentially a loan. When you put a down payment on a home, it pays for part of the home’s cost (typically 20%). A bank or mortgage company loans you the rest of the money to pay for the home. 

You then set up a series of payments to pay back the loaned money, along with interest, for a fixed term. The catch is: to ensure you pay back the money, your newly purchased house becomes collateral, meaning if you don’t pay, your house goes away, meaning the lender takes ownership of your house from you to pay back the loan—you will need to find another place to live.

That’s the simple definition of a mortgage, but there are a lot more details and specifics that are important to learn about before rushing into getting one.

How Is a Mortgage Different Than a Loan?

Is there a difference between mortgages and other types of loans?

A mortgage is a type of loan that’s secured by real estate property. When you take out a mortgage, the lender makes a claim on the home that you’re purchasing. If you’re unable to make your mortgage payments, the lender can foreclose on the home and sell it to recuperate the money you didn’t pay.

Mortgages are also unique in that you typically spend more years paying them off. Many people pay off mortgages over a term of 30 years. There are mortgages available with a 15-year term, but they’re harder to qualify for, and they typically come with much higher monthly payments.

You might think that there isn’t much difference between a 4% and  5% interest rate, but over 30 years, that could amount to thousands of extra dollars spent or saved.

You may need a higher credit score for a mortgage than for other types of loans. To get the best interest rates on a mortgage, many people start working on their credit score years in advance.

Why Do People Get Mortgages?

According to Zillow, the typical American home is valued at $354,165. However, if you’re living in urban areas, this number can go up drastically. Many of us don’t have that much cash just laying around, so instead of robbing a bank, most people take out a mortgage. 

Who Qualifies for a Mortgage?

When you apply for a mortgage, lenders will take a deep dive into your personal finances. They’ll usually evaluate the following criteria:

  • Credit Check: The lender will check your credit score. Your credit score may give clues on how likely it is you’ll pay off the mortgage. If you have a high credit score, then you probably have a strong track record of making loan payments on time. If you have a poor credit score, then it’s possible you haven’t been paying your loans on time, or you’ve been maxing out your credit cards too often. Your credit score is a complicated subject, so be sure to read up on it if you need more clarity on how your credit score is determined.
  • Latest Tax Return: The lender may ask to see your most recently filed tax return for proof that your income is high enough to pay the mortgage payments along with other expenses like taxes without hardship.
  • Proof of Employment: You may also be asked to provide proof of employment, like a pay stub. The lender wants to know that you’re truly earning the amount of income you claim to be making.
  • Down Payment: It’s common to place a down payment on the house when you take out a mortgage—in other words, you’re paying for a percentage of the house right from the start. Historically, it was common to make a 20% down payment when you take out a mortgage, but some types of mortgages may only require a down payment of 3.5%. It all depends on the type of mortgage you’re getting and the preferences of the lender. Most lenders will not qualify you without a down payment.

Your mortgage application can be denied if you have a poor credit score, have taken on too much debt that’s straining your finances, or have gone through a bankruptcy or a civil case—for instance, if a court requires you to pay damages for an incident.

If you don’t qualify, you can seek out a different lender, or you can work to improve your credit and personal finances before moving forward.

How Do Mortgage Payments Work?

Every month, you’ll make a payment on your mortgage loan, plus the annual percentage rate (APR) you agreed to pay. If you did not make a down payment of at least 20%, you might also need to pay for monthly mortgage insurance.

It’s important that you pay your monthly mortgage payments on time. Failure to pay on time may result in your lender foreclosing on the home.

Do You Need Mortgage Insurance?

If you make a down payment of less than 20%, you’ll probably be required to get mortgage insurance (also known as private mortgage insurance).

Mortgage insurance protects the lender – not you. If you fail to pay your mortgage, the money you’ve put into the mortgage insurance will be used to cover the lender’s expenses when they foreclose on your home. Typically, mortgage insurance is included in your monthly payments.

Most of the time, you will not have to pay mortgage insurance if you’re able to make at least a 20% down payment on the home.

Financial Responsibilities of Having a Mortgage

It’s crucial to your financial health to also know what can happen if you sign up for a mortgage you’re not going to be able to pay. 

Your new house will be foreclosed, you’ll have trouble getting another mortgage in the future, you could get a huge tax bill, and your credit score will drop significantly. 

Before you take the plunge, make sure you have thoroughly researched your chosen lender and the structure of the mortgage, so you’re not hurt later on because you took on something you couldn’t afford. (Check out our guide on how to budget for a house.)

Adjustable vs. Fixed-Rate Mortgages

There are two main types of home loans that you can choose from: a fixed-rate mortgage or an adjustable-rate mortgage.

 A fixed-rate mortgage functions exactly how it sounds. Your interest rate will remain fixed and will not change during the life of the loan. Additionally, your monthly payment, including both principal and interest, stays the same. 

Sounds like a great deal right? Well, the drawback is that the interest rates on fixed-rate loans are typically higher than the rates on adjustable-rate mortgages. So you could end up paying a bit more for the security of knowing that your payments will never change.

Now, if your goal is to save money in the short term, you might want to consider an adjustable-rate mortgage or ARM. 

These home loans have a lower initial interest rate compared to fixed rates but could adjust after a set period of time (typically five to seven years) depending on changes in market rates. That means your monthly payments could increase or decrease based on how the interest rate changes. While you’re rolling the dice with these types of loans, they can end up saving people a lot of money, which you can invest back into paying off your debt.

If you’re trying to decide between a fixed-rate or ARM, one very important thing to consider is, what are your future plans? 

Fixed-rate repayment plans last either 15 or 30 years. Yes, you read that right: 30 years!  So if you have no plans to pack up everything and move across the world on a whim, a 15 or 30-year fixed-rate mortgage could be the right fit for you.

But if you can’t be tamed and want to keep your long-term options open, Lance Davis at Bankrate notes that “[Adjustable-rate mortgages] offer a cheaper way for borrowers who don’t plan on living in one place for very long to buy a house.” If you’re a first-time homebuyer, but are young and constantly on the move, an ARM could be a suitable option.

Applying for a Mortgage

Once you’ve determined what type of mortgage fits you and you’re ready to buy a home, it’s time to apply! But how do you actually go about doing that? Well, before you fill out an application, you’ll need a few things first, including: know what type of mortgage you want, which lender you want to work with, check your credit score, get preapproved for a loan amount, and gather all your paperwork.

If you have the first two items ready to go, the next step is to check your credit score. Your credit score could impact whether you will qualify for a loan and the rate you will be offered. 

You’ll want to have your credit score and debt-to-income ratio, in excellent shape to qualify for the best loan possible. What is debt-to-income ratio? This measures the amount of monthly debt you have compared to your monthly income. 

It’s recommended to check these numbers before you apply to get pre-approved because mortgage pre-approvals evaluate your financial history to see how big of a loan you can qualify for. With Turbo you can easily check your numbers to see if you might be financially ready to buy or if you still need time to improve where you stand.

Make sure you don’t skip over the preapproval process, because pre-approval letters can actually help you in the home loan process. A mortgage pre-approval is like a golden ticket: not only does it show that you’re a serious buyer, but it can put you ahead of other buyers who are looking at the same home as you. 

One word of caution: don’t do this unless you are ready to buy and your credit score is as high as possible. Once you’re ready, this letter will help you find a lender who can work with you to find the loan that best suits you.

Helpful hint — now that you’re well versed in what you should do when applying for a mortgage,  you should also be aware of what not to do, so you aren’t caught in an awkward situation later.

And that’s it! You’ve passed this mortgage lesson with flying colors.

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