Mortgages Explained: A First-Time Buyer’s Guide

Mon Nov 23 2020

Without the funds to buy a home outright, you’ll need a mortgage to buy your first home. And you’re not alone – 63 percent of homeowners currently have a mortgage.

Of the 37 percent of homeowners that are mortgage-free in 2020, nearly all of them had a mortgage at one point.

But what should you look for in a mortgage? How do you go about getting one? What down payment should you expect? And what’s a debt-to-income ratio, anyway? These are some questions we set out to answer in your guide to mortgages.

Mortgages Explained: What Is a Mortgage?

A mortgage is a legal contract, usually between you, the home buyer, and the lender that’s facilitating your home purchase. In exchange for regular and timely payments, the lender will provide the funds for the property.

If you don’t make those mortgage payments, the lender has the right to foreclose on the property – that means it can take possession of the home and sell it.

Unlike other forms of debt, like credit cards, mortgages are a secured debt because they are backed by the full value of the property.

A mortgage term is how long the mortgage lasts. The most common terms are 30-year and 15-year mortgages.

Types of Mortgage Loans

When applying for a mortgage, it helps to know what type of mortgage is right for you. Each type of mortgage has different credit score and down payment requirements. Some loan options, like an FHA loan, have government backing, which means the requirements are less strict.

Here are the most common types of mortgage loans for first-time home buyers.

Federal Housing Administration (FHA) Loan

An FHA loan is a mortgage backed and insured by the Federal Housing Administration. The FHA doesn’t lend money itself, but it does partner with lenders for this program.

FHA loans are a good starter mortgage if you have less-than-perfect credit or you don’t have a lot in savings that you can put toward a down payment. Think of an FHA loan as a way to literally get your foot in the door of your first house:

  • If you’re a first-time home buyer with a FICO credit score of at least 580, you may qualify for an FHA loan and can put as little as 3.5 percent down.
  • If your credit score is below 580, you can still qualify for an FHA loan, but you will likely be required to put down 10 percent.

If you use the FHA program, you will have to pay private mortgage insurance (PMI) until you’ve accumulated about 20 percent of equity in the home. If you put down 10 percent on the home, you’ll pay PMI for 11 years.

Department of Veterans Affairs (VA) Loan

A VA loan is a type of mortgage available to service members, veterans, and eligible spouses. This mortgage is insured by the Department of Veterans Affairs for eligible applicants to purchase a primary residence through partner lenders.

The biggest draw of a VA loan? Recipients can put $0 down, making this one of the most affordable paths to homeownership on the list. There is no credit requirement for this loan based on VA rules, but most lenders require a score of 580 or more, like an FHA loan.

Unlike an FHA loan, a VA loan doesn’t require borrowers to pay PMI.

US Department of Agriculture (USDA) Loan

The USDA loan is similar to the FHA and VA loans. These are loans fund home purchases in rural communities and are guaranteed by the USDA. The goal is to help improve both the economy as well as the quality of life in rural areas of the United States.

These are zero down loans, but PMI is required. Borrowers must have at least a 580 FICO score to be eligible.

Fannie Mae

Fannie Mae is a conventional mortgage that is offered by a partner lender. The Federal National Mortgage Association (FNMA or Fannie Mae) backs the loan in the secondary market.

These loans have higher credit requirements for first-time home buyers: a 620 FICO credit score. Qualifying borrowers only need 3 percent down for a fixed-rate mortgage or 5 percent for an adjustable-rate mortgage.

Freddie Mac

Freddie Mac is another conventional mortgage program that requires a 620 FICO score and allows as little 3 percent down. Rather than be guaranteed by FNMA, a Freddie Mac mortgage is backed by the Federal Home Loan Mortgage Corporation.

Credit Score Requirements by the Mortgage

Before you start shopping for lenders, check your credit score. Credit Karma is free and allows you to monitor your TransUnion and Equifax credit scores.

Knowing your credit score can help you set expectations for which loans you qualify for. It can also help you dispute claims on your credit report to improve your score before you begin house hunting.

Your credit score also informs the interest rate on your mortgage (among other factors). Taking steps to improve your score now can help you pay less interest in the long term.

These are the credit score requirements for loans.

Loan Type Minimum Credit Score
FHA (3.5% Down) 580
FHA (10% Down) 500
VA Technically no minimum, but depends on the lender
USDA 580
Fannie Mae 620
Freddie Mac 620

Understanding Your Debt-to-Income Ratio

Your debt-to-income (DTI) ratio is another big factor in whether you qualify for a mortgage. A DTI ratio is the percentage of your monthly income that is used to pay monthly debt. That includes car payments, credit card payments, student loans, and the proposed mortgage payment. In many ways, DTI tells you how much house you can afford.

Now roll up your sleeves because we’re going to get into the weeds a bit. There are two DTIs you need to know:

  • Front-end DTI: This figure compares your mortgage payment to your income.
  • Back-end DTI: In addition to your housing expenses, this figure includes the other debts in its comparison to the money you bring in.

Lenders look at DTI ratios to make sure you can handle your monthly payments – including the proposed mortgage and PMI. The lower your DTI, the better because it means you have extra money every month.

Let’s look at an example of calculating back-end DTI. Say your monthly income is $3,500. Between credit card payments, a car loan, your student loans, and your proposed mortgage payment, your monthly debt is $1,500.

DTI = Monthly Debt Payments / Monthly Income

So $1,590 divided by $3,500 is a DTI of 45.4 percent.

You can see in the chart below the DTI ratio lenders may look for depending on the loan you want.

Loan Type Front-End DTI Back-End DTI
FHA (3.5% Down) 31% 43%
FHA (10% Down) 31% 43%
VA 41% 41%
USDA 29% 41%
Fannie Mae 36% 50%
Freddie Mac 36% 50%

Mortgage Pre-Qualification vs. Pre-Approval

It’s important to understand the difference between a pre-qualification and pre-approval because it can affect your ability to win a bid on a home:

  • A pre-qualification is a letter from a lender with an estimate of what you might borrow based on your finances and a credit check.
  • Pre-approval letters are an offer to lend you a specific amount of money, and it’s good for 90 days.

Pre-approval letters hold more weight when you bid on a home because the lender has done all the underwriting on you with the exception of having the actual purchase home in place. Essentially, the lender has gone through the credit score, verified your income, and done a complete debt-to-income ratio score. The loan is approved contingent on the home appraisal coming in at a high enough number and barring any change in your credit profile.

Changes in your credit profile might include acquiring more debt (don’t finance that furniture just yet), loss of income (keep your boss happy), or derogatory credit items appearing (make sure everything is paid on time).

What Happens When You Apply a Mortgage

Getting a mortgage starts with an application with a lender. Lenders can be banks, credit unions, or even private parties, though private parties may not have the same lending standards that banks and credit unions have.

During the application process, the lender will gather information about your income, debts, and credit scores. You may have a specific property in mind when applying, but it’s also not necessary to get the process started.

The lender will determine if you can afford the property and how much it will cost in interest. If no property is designated for the loan, a price cap is determined as the top amount of money that a buyer can afford based on the total DTI.

When you apply for a mortgage, you will need to provide the lender with your Social Security Number, pay stubs, previous tax returns, and debt. The lender will use this information to determine if you are eligible for the loan and if so, how much you can borrow for a home purchase.

Stay tuned for more tips on mortgages and the home buying process.

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