You may be asking why this chapter focuses on financing your new home when you haven’t even found the house you want to buy yet. The earlier you begin to think about how you’ll finance (that is, pay for) it, the better. Finding out how much money you’ll qualify for and whether you’ll even be approved for a loan will make your search easier and quicker. No sense looking for more than you’ll be able to spend.

Over the next few chapters, you’ll read about the types of mortgage loans that are available, learn about how much money you’ll need for a down payment, and walk through the approval process. Right now, though, you need to take your first steps in financing your new home—finding the right lender and getting preapproved or prequalified.

This chapter focuses on helping you find a lender by asking the right questions; explains the differences between a credit union, a bank, and a mortgage broker; and tells you how to get preapproved for a mortgage. You’re getting closer to your dream home!

Unless you’re paying cash for your home—and some people do—you’ll have to finance your home by taking out a mortgage loan. This loan will come from either a bank or credit union, or a mortgage broker, sometimes referred to as a loan broker. Each has its own advantages and disadvantages.

A mortgage broker is an individual who, in most states, is licensed by the state in which he practices. Licensing requirements vary from state to state. For example, California requires that the mortgage broker be licensed as a real estate salesman, and his activities are regulated by the same agency that regulates Realtors: the California Department of Real Estate.

A mortgage broker presents your loan application to any number of lending institutions that he feels can give you the best loan based on your financial situation. He may feel that he has to approach only a single institution to achieve the best results, or he may decide that you would be better served if he presents your application to a number of lenders. His decision is usually based on a combination of factors, such as your credit score,loan amount, type of loan, desired interest rate and other loan costs, and, in some cases, a particular bank’s ability to meet time frames as they relate to your purchase agreement. In addition to qualifying you for a mortgage, a good broker will discuss with you the advantages and disadvantages of one loan over another.

A broker maintains contact with the lender(s) throughout the process and, if they need further information, obtains it from you. Once the loan is approved, he maintains contact throughout the appraisal process and closely follows the drawing of loan documents.

If you have used a mortgage broker in the past and you’re happy with her, contact her again for this purchase—unless, of course, you’re moving out of state and she’s not licensed to practice in the state where you’re buying. However, if you need a broker, finding one isn’t any different than locating and choosing a Realtor. Start by asking friends, family, or co-workers for references; ask them what they liked or didn’t like about that particular broker. Ask your real estate agent for a referral, too. Most agents know or have worked with a number of mortgage brokers.

Once you have some names, whittle them down by comparing pluses and minuses. For example, if one broker received many good reviews but only one bad review, that’s a plus, but if another broker has a few more bad reviews, it might be best to remove that broker from the list. Once you have your short list, set up an interview with each broker and discuss the following:

Beyond these standard issues, you can learn about the broker by asking some questions that pertain to his methods. You might want to ask what his most difficult client situation has been in terms of getting a loan. Why was it so difficult and how did he deal with it? What were the results? What was the most unusual property or property location he had to deal with? These answers can help give you a fuller picture to determine whether this broker is the right one for you.

When deciding on a lender, you can try a bank. Although you’re not obligated to use your current bank for your mortgage, the benefit of this is that you will be dealing with a familiar entity. Assuming that the relationship to date has been a good one, using a familiar bank for your mortgage is a plus.

If you’re not crazy about your bank—maybe you were turned down for a credit service because you were delinquent on past loans with them or you simply aren’t pleased with their customer service—you can try another bank. Trying another bank will not successfully hide any previous delinquencies that your credit report shows, but a new bank might be more lenient and willing to approve you for a mortgage.

Keep in mind that mortgages are lengthy—often 15 or 30 years long—so you need to be happy with the lender you choose if you plan to keep that loan for that long. Of course, many homeowners refinance their loans throughout the time they own the home, so you could use that time to switch lenders if you aren’t happy.

Whereas a bank is a for-profit company, a credit union is owned by its members. Typically, credit unions charge lower interest rates and fees, but that’s not always the case: read the fine print and weigh your options carefully. Most credit unions are open to anyone, but some have membership restrictions. For example, a credit union may require that you work at a particular company where there is a credit union just for those employees. Some credit unions require that you live in a particular area where that credit union is located. Others are limited to those who attend church in that particular city or county. In those cases, you won’t be able to apply for a home loan with that credit union unless you meet the qualifications.

The Credit Union National Association can help you find a credit union by calling 1-800-358-5710. You’ll hear an electronic message that includes the name and telephone number of a person at the credit union league in your state who can help you find a credit union to join. You can also check its online database of credit unions.

When you first spoke to your Realtor about looking for a home, she may have asked you if you’re already prequalified or preapproved for a loan. To get prequalified or preapproved for a loan, you must submit some basic information to your lender, including your Social Security number, employment details, asset and liability information, and more. Your lender then reviews this information to give you an idea of whether you will get his blessing as a potential borrower. If you get this blessing, you’re in good shape to receive a final mortgage loan approval, but—this is very important—this is not an official approval.

If you receive a preapproval or prequalification, share this information with your real estate agent, who can then share it with the sellers so they know you’re a serious buyer. You can then make a bid on a home you’re interested in based on the preapproval or prequalification. As a matter of fact, some sellers won’t even allow a buyer to see their home if the buyer has not gone through the prequalification or preapproval process or has been denied. If your offer on the home is accepted, the lender will move forward with a more detailed approval process at that time, to give you the final okay on your mortgage loan.

It’s important to understand that these two terms have vastly different meanings. Each is good to get from a lender or mortgage broker, but one carries far more weight than the other.

A prequalification is the most basic form of lender approval. It doesn’t carry nearly as much weight as a preapproval, but it’s a good start. Written on the lender’s letterhead, it says that you have given that lender or broker some basic financial information about yourself (and your spouse, if this is a joint application) and, based on that information, it appears likely that you’ll be able to obtain a mortgage loan at some time in the near future. It also specifies either the maximum amount of a loan or the maximum purchase price that you might qualify for when you actually complete a formal application. The letter also clearly states that it is not meant in any way to constitute a commitment to lend or a guarantee of a loan being approved. You’ll still have to go through that final approval process, and you can still be denied.

Consider a prequalification as “mind candy” for potential sellers of property and you, the buyer. It will make both of you more comfortable with your chances of having a loan granted to you.

A preapproval, however, states that you have undergone a full loan underwriting and analysis and have been approved for a loan of a specific amount. A preapproval also means that the lender will fund the loan based on your credit, but it also depends on the results of an appraisal of the property, title report,and purchase contract of the home you decide to buy once you find it.

When you apply for a mortgage, you may find out that you qualify for a much larger loan than you’d ever thought possible. For example, let’s say you are interested in a $225,000 home. When you apply for the loan, the lender tells you that, thanks to your excellent credit and your ability to pay bills on time, you are eligible for a $350,000 loan. On one hand, it’s good to know that you qualify for that large of a loan. It means that you’re doing well with your credit and will likely sail through to approval on a home in your preferred price range.

However, this information opens up the possibility that you can now buy a bigger home. For example, instead of the house with three bedrooms, two baths, and a living room on a 10,000-square-foot plot of land, you can now afford the four-bedroom house that also features a spacious family room, fully equipped home office, and in-ground pool on an acre of land. Sounds great, doesn’t it? Maybe, but it really depends on your current financial situation. Remember, a bigger mortgage means that unless you offer up a much larger down payment on the loan, you’ll be making bigger mortgage payments every month. Is that something you can afford? If so, will you have any money left over to pay your everyday bills and to put away funds in case of unexpected expenses or circumstances, such as a job loss?

In my book Save Your House From Foreclosure!,I note the four largest causes of default and foreclosure: “Life, Wife, Health, and Wealth.” If your spouse dies, if you or an immediate family member has a major health crisis with inadequate or no insurance, if you get divorced, or if either one of you loses a job, it can seriously impact your ability to pay your mortgage.

All of these are common occurrences, and any one can place your home in jeopardy. When you’re deciding whether to buy a bigger home because you were approved for it, think about this—it is better to have a smaller obligation to your mortgage lender in case something like this occurs. As has been said before, it is far better to own your house than to have your house own you. Only borrow what you’re financially and emotionally comfortable with.

Banks use two debt ratios to see if you will be able to carry a mortgage loan: debt-to-income and debt-to-equity. The first, debt-to-income ratio, is the relationship between the total amount of debt you have at a particular time to the amount of income you are earning. The higher the percentage of debt, the more difficult it can be to get approved for your loan. This is because the banks are concerned that something could impact your income and reduce your ability to pay your debts. The second, debt-to-equity ratio, is the relationship between the amount of debt you have at any one time and your net worth. Net worth is the amount of money left over when you subtract all your debt from the value of all your assets. This debt-to-equity ratio is sometimes also referred to as the debt-to-worth ratio.

Debt-to-income is used to figure out the percentage of debt you have compared to your total amount of income. In the past, a debt-to-income ratio of as much as 50 percent of income was an acceptable maximum ratio. Today, as lenders have tightened up on lending standards, it has shrunk to the low 40 percent range.

In some cases, a borrower has only housing debt, so a housing debt-to-income is used. This tells the lender how much of your overall debt specifically belongs to your current rent or mortgage payment. This is a lower percentage than total debt-to-income, since most people have other debt beyond housing. In other words, for these folks, the debt-to-income ratio tells the lender what the relationship is of overall debt to an individual’s income. If the housing debt-to-income is too high, this gives the lender an indication that you may not be able to handle your mortgage payments. Theoretically, if you have no debt other than housing, your ratio could be as high as 45 percent of your income.

The actual ratio on a particular loan also takes into account your overall financial picture. And, of course, having more liquid assets is much more attractive to a lender.

When lenders are making a decision, however, they look at both ratios, usually beginning with housing debt-to-income, to get a sense of how much you’re allocating for your housing costs. Then they apply the tougher standard of total debt-to-income because it provides a more accurate picture of your overall situation and allows lenders to determine whether you can still comfortably pay the mortgage if all your debt is taken into consideration.

These standards apply regardless of what type of loan you’re applying for. Either you have the ability to pay it or you don’t. If you’re within a lower ratio, you’ve got more of a cushion in case something goes wrong financially for you. It’s just more prudent lending.

Debt-to-equity, sometimes referred to as debt-to-worth or loan-to-value (of the home), is the relationship of the mortgage debt to the amount of money you’re investing in it with a down payment. Yes, you’re spending the money, but, as with buying stock or any other investment, the money you’re spending is to purchase the investment involved. In the case of a home, your purchase is definitely an investment—possibly the biggest one you’ll ever make. It’s a simple mathematical ratio. In the early 1970s, the standard debt-to-equity ratio was 70/30, which meant that the buyer had to come up with 30 percent of the purchase price of the home. That 30 percent was considered the equity portion of the purchase. As an example, if your home cost $100,000, you’d borrow $70,000 and have $30,000 in equity from your own funds to complete the purchase.

By the 1980s, mortgage lenders commonly financed at least 80 percent of the purchase price, with some loans going as high as 90 percent. There was so much growth in the number of potential borrowers that the competition to lend to them led lenders en masse to loosen their limits on the loans.

In the early 2000s, in some cases, loans of as much as 130 percent of value were available. For example, imagine that you bought a home for $200,000, but your loan was for 130 percent of that, or $260,000. No equity was required, and more than the purchase price was loaned because it was thought that continuing increases of the prices would cover the excess loan amounts. None of these loans include “special” loan programs, such as loans from the VA or the FHA. These loans meant that you were able to obtain a larger loan and thus have a higher debt level; you would also be able to obtain more than 100 percent financing of the property. Both FHA loans,at 97 percent debt, and VA loans,at 100 percent debt, were made because the organizations making the loan had the guarantee of repayment by the federal government, no matter what happened.

Over the last few years, relaxed lending standards caused a major upheaval in the mortgage markets. As a result, a number of lenders got federal financial assistance, while some lenders were forced to close their doors. However, this chaos accomplished one good thing: it virtually eliminated from the marketplace nonfederal guaranteed loans of 100 percent of value.

In other words, as regulators have forced lenders to tighten lending limits, lenders who previously made loans of 100 percent or more of value are no longer able to do so. Larger banks have cut these loans from their product lists, while smaller lending institutions that made these loans have been forced out of the market. It’s not completely impossible to find such a loan, but it’s rare. In the few relatively rare cases, some mortgage brokers are placing the loans with what are called “hard money” lenders to get them funded. Although these are perfectly legal, the sources of funding for these “hard” lenders are not the traditional bank deposit type. Instead, they are investors willing to carry extra risk found in such loans in exchange for a higher rate of return through the interest they’ll earn. This is a classic example of how higher risk generates a higher interest rate.

Standards have now generally returned to buyers’ equity participation of between 10 and 20 percent of the purchase price. So when you buy a home, unless you obtain an FHA or VA loan, you will be required to put up more of your own money as part of the purchase price than before. If you’re buying a house for $200,000, you now will probably have to put down at least $20,000, and possibly $40,000, of your own money at closing.

The worst news … you’ve been denied for a preapproval or a prequalification. If this happens, you need to find out why. Are there mistakes on your credit report? If so, you’ll need to get these mistakes remedied (we talk about this in Chapter 5). You can still attempt to buy a home, but it may take a bit longer, as you’ll have to start the loan process all over again. Usually, if your credit score and history are at least minimally satisfactory (again, see Chapter 5 for a full discussion of credit scores), you’ll be able to qualify somewhere. However, it likely will be for a much higher rate of interest than someone with a higher credit score and better history would receive.

Some time ago, buyers would go through the home-buying and lending process and then get to the closing, only to be blown away when they learned how much additional money they had to come up with on the spot to cover several closing costs. Today a good faith estimate prevents this sudden shock and helps buyers to be certain in advance that they have the up-front cash they need to buy their home. The method of payment can vary from place to place and state to state, and sometimes even within a state. Many locales require cashier’s checks for these costs, but some allow a personal check. Ask your Realtor what the practice is where you’re buying.

A good faith estimate is a federally mandated document that lists all the fees related to the loan that you will have to pay at closing. Included in such fees are, typically, title fees,settlement fees,and prepaid real estate taxes. This document must be given to you within three days of initially signing your loan application. However, it’s best to request it before you even apply for a loan. There may be a big difference between Bank A and Bank B’s closing costs and it might be a reason to choose one bank over another if all other things are equal.

Keep in mind, however, that this may all depend on where you live. California, for example, uses a Mortgage Loan Disclosure Statement/Good Faith Estimate. The document includes all the information mandated by the feds and also shows who will receive each of the itemized fees. For example, your first year’s hazard insurance will be itemized here as being paid to the insurance company or broker providing it. It requires that you, the buyer, are told how much money you’ll have to pay, lump sum, for such things as property taxes.

Impound accounts, also called “escrow” accounts in certain parts of the country—the terms are interchangeable—are established by the lending institution as a condition of making the loan. They are used to collect funds from you to make annual payments of insurance premiums, property taxes, and so on. The idea is that those items are large annual or semiannual payments—possibly too large to count on the homeowner to have the funds available to pay them when they’re due. Usually, impound accounts are a requirement of the loan when your FICO is on the lower end of acceptability or you are at the extreme high end of the range of debt ratios that we discussed earlier in this chapter.

Having an impound account means the funds will be there when the bills must be paid, and the lender will make the payments on behalf of the homeowner. Until the early 1980s, impound accounts were standard, no matter how large or small your loan was or what the debt/equity relationship was. The account carried no interest; monies were just collected from the buyer along with the mortgage payment and held until the bill was due.

After a great deal of consumer complaints, followed by state legislation in many states, lenders began paying interest on impound accounts. The interest, where it’s paid, won’t make you rich—not by a long shot—but it’s a little something in return for having the lender hold your hard-earned cash. The lenders also stopped making impound accounts a requirement of all loans, but started tying that requirement to the borrower’s overall financial situation and the debt/equity relationship of the mortgage. While not all borrowers are required to have impounds, anyone not required to do so is permitted to have the bank establish impounds for them if they feel it’s more convenient.