How does applying for a mortgage work

Eager to purchase the home of your dreams and start building equity for the future in this thriving housing market? For many, shopping for a home is the fun part, but obtaining a mortgage is another story. Whether you know a little about the mortgage process or have no idea how to get a home loan, dont fret. This guide to getting a mortgage breaks down every step of the process so youll know what to expect.

How to get a mortgage, step by step

• 1. Strengthen your credit
• 2. Know what you can afford
• 3. Build your savings
• 4. Choose the right mortgage
• 5. Find a mortgage lender
• 6. Get preapproved for a loan
• 7. Begin house hunting
• 8. Submit your loan application
• 9. Wait out the underwriting process
• 10. Close on your new home

Step 1: Strengthen your credit

A strong credit score demonstrates to mortgage lenders that you can responsibly manage your debt. So, youre likely to get approved for a mortgage with a competitive interest rate if you have good or excellent credit. If your credit score is on the lower side, you could still get a loan, but youll likely pay more in interest.

Having a strong credit history and credit score is important because it means you can qualify for favorable rates and terms when applying for a loan, says Rod Griffin, senior director of Public Education and Advocacy for Experian, one of the three major credit reporting agencies.

To improve your credit before applying for your mortgage, Griffin recommends these tips:

• Make all payments on time and reduce your credit card balances. Your payment history on your report goes back two years or longer, so start now if you can.
• Bring any past-due accounts current, if possible.
• Review your credit reports for free at AnnualCreditReport.com. Check for errors on your credit reports, and contact the reporting bureau immediately if you spot any. An error might be a paid-off loan that hasnt been recorded as such, or an incorrect address, for example.
• Check your credit score (often available free from your credit card or bank) at least three to six months before applying for a mortgage. When you review your score, youll see a list of the top factors impacting it, which can tell you what changes to make to get your credit in shape, if needed.

Follow these steps to help boost your score and nab a lower interest rate on a home loan.

Step 2: Know what you can afford

Its fun to fantasize about a dream home with every imaginable bell and whistle, but its much more practical to only purchase what you can reasonably afford.

Most analysts believe you should not spend more than 30 percent of your gross monthly income on home-related costs, says Katsiaryna Bardos, associate professor of finance at Fairfield University in Fairfield, Connecticut. This includes home maintenance and utilities.

Bardos says one way to determine how much you can afford is to calculate your debt-to-income ratio (DTI). This is calculated by summing up all of your monthly debt payments and dividing that figureby your gross monthly income.

Fannie Mae and Freddie Mac loans accept a maximum DTI ratio of 45 percent. If your ratio is higher than that, you might want to wait to buy a house until you reduce your debt, Bardos suggests.

Even with the 45 percent threshold, the lower your DTI ratio, the more room youll have in your budget for expenses not related to your home. Thats why many financial advisors recommend keeping the ratio closer to 36 percent, if feasible.

Andrea Woroch, a Bakersfield, California-based finance expert, says its essential to take into account all your monthly expenses including food, healthcare and medical costs, childcare, transportation, vacation and entertainment expenses and other savings goals.

The last thing you want to do is get locked into a mortgage payment that limits your lifestyle flexibility and keeps you from accomplishing your goals, Woroch says.

You can determine what you can afford by using Bankrates calculator, which factors in your income, monthly obligations, estimated down payment and other details of your mortgage, including the interest rate and homeowners insurance and property taxes.

Step 3: Build your savings

Your first savings goal should be your down payment.

Saving for a down payment is crucial so that you can put the most money down preferably 20 percent to reduce your mortgage loan, qualify for a better interest rate and avoid having to pay private mortgage insurance, Woroch explains.

Its equally important to build up your reserves. One general rule of thumb is to have the equivalent of roughly six months worth of mortgage payments in a savings account, even after you fork over the down payment. This can help safeguard you if you lose your job, for example, or something else unexpected happens.

Also, dont forget closing costs, which are the fees youll pay to finalize the mortgage. They typically run between 2 percent to 5 percent of the loans principal. They dont include escrow payments, either, which are a separate expense. Generally, youll also need around 3 percent of the homes price for annual maintenance and repair costs.

Overall, aim to save as much as possible until you reach your desired down payment and reserve savings objectives.

Start small if necessary but remain committed. Try to prioritize your savings before spending on any discretionary items, Bardos recommends. Open a separate account for down payment savings that you dont use for any other expenses. This will help you stick to your savings goals.

Step 4: Choose the right mortgage

Once your credit score and savings are in an adequate place, start searching for the right kind of mortgage for your situation. Youll also want to have an idea of how mortgages work before moving forward.

The main types of mortgages include:

• Conventional loans These are best for homebuyers with solid credit and a decent down payment saved up. Theyre available at most banks and through many independent mortgage lenders.
• Government-insured loans (FHA, VA or USDA) These can be great options for borrowers who do not qualify for a conventional loan or meet specific criteria, such as being a member of the military for a VA loan.
• Jumbo loans These loans are for more expensive properties. Conforming loans have a maximum allowable value, and if you need to finance more than that ($647,200 in most parts of the country or $970,800 in more expensive areas), youll need to get a jumbo loan.

A first-time homebuyer, for instance, might consider an FHA loan, which requires a minimum credit score of 500 with a 10 percent down payment or a minimum score of 580 with as little as 3.5 percent down. A conventional loan could be a better fit for a homebuyer with a higher credit score and more down payment savings.

Mortgages can have a fixed or adjustable rate, meaning the interest rate stays the same for the duration of the loan term or changes over time, respectively. Most home loans have 15- or 30-year terms, although there are 10-year, 20-year, 25-year and even 40-year mortgages available. Adjustable-rate loans might come with a lower monthly payment initially, but can become more expensive over time if rates rise. If you cant afford that risk, the fixed-rate is the way to go.

Sign up for a Bankrate account to determine the right time to strike on your mortgage with our daily rate trends.

Step 5: Find a mortgage lender

Once youve decided on the type of mortgage, its time to find a mortgage lender. Its important to shop around for multiple offers to make sure youre getting the best possible deal, not just the lowest interest rate. Be mindful of the lender fees when evaluating your options.

To find the right lender, speak with friends, family members and your agent and ask for referrals, advises Guy Silas, branch manager for the Rockville, Maryland office of Embrace Home Loans. Also, look on rating sites, perform internet research and invest the time to truly read consumer reviews on lenders.

[Your] decision should be based on more than simply price and interest rate, says Silas. You will rely heavily on your lender for accurate preapproval information, assistance with your agent in contract negotiations and trusted advice.

Remember that interest rates, fees and terms can vary substantially from lender to lender.

Thats why its important to shop around carefully and ask questions, Woroch says.

For many borrowers, applying for a mortgage is overwhelming. If youre not sure exactly what to look for, you might want help. A mortgage broker can help you navigate all the different loan options available to you and possibly help you get more favorable terms than youd be able to secure by applying on your own.

Step 6: Get preapproved for a loan

Its a good idea to get preapproved for a mortgage once youve found a suitable lender. With a preapproval, the lender will review your finances to determine if youre eligible for funding and an amount theyre willing to lend you.

Getting preapproved before shopping for a home is best because it means you can place an offer as soon as you find the right home, Griffin says. Many sellers wont entertain offers from someone who hasnt already secured a preapproval. Getting preapproved is also important because youll know exactly how much money youre approved to borrow.

Be mindful that mortgage preapproval is different from prequalification. A mortgage preapproval involves much more documentation; prequalification is less formal and is essentially a way for a lender to tell you that youd be a good applicant. Still, it doesnt guarantee any particular loan terms.

Step 7: Begin house hunting

With preapproval in hand, you can begin seriously searching for a property that meets your needs. Take the time to search for and choose a home that you can envision yourself living in.

When you find a home that has the perfect blend of affordability and livability, be ready to pounce quickly. In a competitive market where available homes go fast and bidding wars are common, youll need to be aggressive.

Its essential to know what youre looking for and what is feasible in your price range, Bardos notes. Spend time examining the housing inventory, and be prepared to move quickly once the house that meets your criteria goes on the market.

Utilize social media and ask your agent for leads on homes going on the market before they are listed on the MLS, Bardos also recommends.

Step 8: Submit your loan application

If youve found a home youre interested in purchasing, youre ready to complete a mortgage application. These days, most applications can be done online, but it can sometimes be more efficient to apply with a loan officer in person or over the phone. You might be better able to establish a relationship with the loan officer in person, too, which can work to your advantage if you have questions in the process or issues come up.

The lender will require you to submit several documents and information with your application (which you should keep multiple copies of), including:

• Recent tax returns, pay stubs and other proof of income (e.g., bonuses and commissions, overtime)
• Employment history from the past two years
• Financial statements from your bank and other assets, such as retirement accounts or CDs

The lender will also pull your credit report to verify your creditworthiness.

Step 9: Wait out the underwriting process

Even though youve been preapproved for a loan, that doesnt mean youll ultimately get financing from the lender. The final decision will come from the lenders underwriting department, which evaluates the risk of each prospective borrower, and determines the loan amount, how much the loan will cost and more.

After all your financial information is gathered, this information is submitted to an underwriter a person or committee that makes credit determinations, explains Bruce Ailion, an Atlanta-based real estate attorney and Realtor. That determination will either be yes, no or a request for more information from you.

There are a few steps involved in the underwriting process:

1. First, a loan processor will confirm the information you provided during the application process.
2. After you make an offer on a home, the lender will order an appraisal of the property to determine whether the amount in your offer is appropriate. The appraised value depends on many factors, including the homes condition and comparable properties, or comps, in the neighborhood.
3. A title company will conduct a title search to ensure the property can be transferred, and a title insurer will issue an insurance policy that guarantees the accuracy of this research.
4. Finally, youll get a decision from the underwriter: approved, approved with conditions, suspended (meaning more documentation is needed) or denied.

Step 10: Close on your new home

Once youve been officially approved for a mortgage, youre nearing the finish line. All thats needed at that point is to complete the closing.

The closing process differs a bit from state to state, Ailion says. Mainly it involves confirming the seller has ownership and is authorized to transfer title, determining if there are other claims against the property that must be paid off, collecting the money from the buyer, and distributing it to the seller after deducting and paying other charges and fees.

Common closing costs include:

• Appraisal fee
• Credit check fee
• Origination and/or underwriting fee
• Title insurance and services fees
• Prepaids
• Attorney fees
• Recording fees

You will review and sign lots of documentation at the closing, including details on how funds are disbursed. The closing or settlement agent will also enter the transaction into the public record.

Bottom line

They say you shouldnt put the cart before the horse. The same is true in the home-buying process. Youll need to complete several steps to finance a home, so the more you learn about whats required, the better informed your decision-making will be.

If youre denied a mortgage, theres no barrier against trying again in the future.

If you are unable to qualify for a loan with favorable terms, it may make more sense to simply wait until you can make the necessary changes to improve your credit history before trying again, Griffin suggests. A bit of patience and planning can save a lot of money and help you get the home you want.

Learn more:

• FHA loans: Everything you need to know
• What is the best debt-to-income ratio for a mortgage?
• What is PMI? Guide to how private mortgage insurance works