First home mortgage: an insider's guide
Are you thinking about getting your first mortgage? Do you know how much you can afford? Are you familiar with the terms used to define home loan agreements? While getting a mortgage can be a great step towards financial freedom, it can also be a challenging, complex, and risky endeavor.
Not only do you have to set a budget and understand the application process, you also need to look into tax benefits and first home buyer programs. Once you have a working budget, it's important to approach lenders and receive mortgage pre-qualification or pre-approval.
When your budget has been qualified by a lender, it's time to start hunting for your perfect home.
While this stage of the process is crucial, it can't be rushed. Where do you want to live? What type of home are you looking for? Do you know you to interpret property market data and minimize financial risk?
Let's take a look at all the steps involved with getting your first mortgage. When you understand the process from the inside, you can be prepared and avoid nasty surprises along the way.
Do you really want a mortgage?
Before you start this long and difficult process, it's important to sit back and decide if you really want a mortgage in the first place. While owning your own home is one of the best feelings in the world, it does not come without significant lifestyle compromises and financial risks. Along with being aware of the benefits of home ownership, you should also be familiar with the disadvantages.
Owning a home is often more expensive than renting.
Owning a home is a greater responsibility than renting.
Looking after your own home can be time-consuming and stressful.
Home ownership often involves lifestyle constraints and compromises.
Before you start, it's important to be honest with yourself about your financially stability and personal discipline. Are you ready for the burden of home ownership?
If you've thought through all of these issues and still want to go ahead - congratulations. Getting your first mortgage is a clever move, a great feeling, and one of the best signs that you've become a financially secure adult. Not only will you be able to secure a home for yourself and your family for years to come, you'll also be able to build equity for your future and possibly generate rental income in the meantime.
Setting a budget
If knowing that you want to buy a home is the first step, then setting a budget is definitely the second. Rather than jumping to the end of the process and hunting for a home you can't afford, it's crucial to get real about your finances and set realistic goals and timelines. If you're unable to save for a deposit, you may need to spend more time in the rental market. If your credit score is compromised, your options may be limited.
While every problem has a solution, being aware of potential roadblocks is fundamental.
Your budget should always be based on the lending criteria used by lenders in your area. Generally speaking, banks and other lenders will look at your deposit amount, your income and work history, your monthly expenses, and your credit scores. Well-known qualification ratios are used during this process, so you can get a good idea of your chances before you submit an application.
Adding up your income and subtracting your expenses is not enough by itself, however, you also need to be aware of any possible new expenses as a homeowner. For example, you will have to pay for repairs and renovations, property taxes and insurance, and monthly condo fees if applicable. Interest rates are the glue that holds every mortgage together, and the more you need to borrow, the bigger effect they will have on your monthly payments.
Saving for a deposit
The days of zero percent down payments are over, with conventional loans requiring a deposit of 20 percent and non-conventional loans needing a 3.5-10 percent down payment depending on your credit score and other circumstances. If you have nothing to work with, it's time to knuckle down and save as much capital as you can, with a larger deposit giving you more options when it comes time to sign a contract. While existing property owners may be able to utilize their existing equity to get a second or third mortgage, first home buyers don't have this option.
Review your credit score
Before you begin, you may want to review your credit scores so that you can see yourself through the eyes of potential lenders. Along with your deposit, income, and expenses, it's your credit scores that define how much money you can borrow and what interest rate is made available to you. There are two credit reporting systems operating in the US - Fair Isaac Corporation (FICO) scores and VantageScores, with the later being a collaboration between Experian, Equifax, and TransUnion.
You can review your score directly from the providers under the Fair Credit Reporting Act. Your credit rating is a three-digit number within the range of 300 to 850, with 700 or more considered "good" credit and 750 or more "excellent". Canadian credit scores operate on a slightly different scale, with 720 or more considered "good" and around 800 needed for an "excellent" score. It's important to note that there are only two major credit bureaus operating in Canada: Equifax and TransUnion.
Income and employment history
Your current and projected income have a huge role to play when you're making mortgage plans. How much money you can generate has a direct relationship on how big your monthly mortgage payments can be. When setting a budget, it's important to analyze your current income levels, projected future income levels, and the likelihood of your income rising or dropping in the future.
While everyone wants their income to rise, setting a conservative budget based on current data is always recommended. After all, the banks are only interested in cold hard facts when they assess your mortgage application. Along with income amounts, banks and other lenders will also be concerned with the length and stability of your employment history. If you've just started a new position, it might be a good idea to wait six months before you apply for a mortgage.
Expenses and qualification ratios
Your existing and future expenses need to be deducted from your income in order to set an accurate budget. You need to be honest during this process, not just listing your current bills but also any new bills you're likely to incur as a homeowner. Mortgage lenders use qualification ratios to determine loan limits, and you can use the same ratios to test eligibility prior to making an application.
Your monthly mortgage payments should not exceed 28 percent of your gross monthly income.
Your total housing payments (property taxes, insurance etc) should not exceed 32 percent of your gross monthly income.
Your total debt payments (housing payments, credit cards etc) should not exceed 40 percent of your gross monthly income.
Benefits for first home buyers in the US
As a first home buyer, you may be able to access tax benefits, federal and state grants, and other options designed to support first time buyers. US residents have a number of options available to them, including tax credits, tax benefits, IRA withdrawals, and Size Up state programs just to name a few. It’s important to understand the difference between tax credits and tax benefits, with the former being a dollar-for-dollar reduction in the taxes you owe, and the later able to reduce your taxable income.
First-time Home buyer Credits are a tax provision made under the Housing Economic and Recovery Act (HERA) in 2008. While now expired, some incentives are still available on a state and local level.
Size Up programs are available in many states, and are based on your income and property expenses.
The US Department of Agriculture support some rural property buyers.
US veterans may be able to access help from the Department of Veterans Affairs.
Native Americans may be able to apply for a Section 184 loan.
Every first home buyer in the US can take out $10,000 from their traditional or Roth IRA without paying the 10 percent penalty for early withdrawal. The government's definition of a first-time buyer is someone who hasn't owned a personal residence in three years.
Along with specific provisions for first home buyers, there are also tax benefits available for all home buyers:
Home mortgage interest deduction
Loan origination fees deduction
Property tax deduction
Benefits for first home buyers in Canada
The FTHB tax credit is a $5,000 non-refundable income tax credit on a qualifying home acquired after January 27, 2009, at up to $750 in federal tax relief.
The HBP is similar to IRA withdrawals in the US, with Canadians able to borrow up to $25,000 from their Registered Retirement Savings Plan for their first home.
The GST/HST Housing Rebate allows new home buyers to qualify for a government GST or HST rebate on a home purchase, along with renovations, revisions and conversions.
Pre-qualification vs pre-approval
Once you have a good idea of how much you can afford, it's time to see whether or not the banks agree. The pre-qualification or pre-approval process allows you to get a solid estimate of how much money they're likely to lend you. Rather than waiting until you've chosen a house or even a neighborhood, this process helps you to make your house hunting decisions based on reality rather than wishful thinking.
Pre-qualification or pre-approval will include a maximum loan amount, available interest rate, and mortgage payment estimation. While this information is very valuable, you don't have to use the maximum amount on offer.
While mortgage pre-qualification and pre-approval fulfill a similar function, they are different. Pre-qualification is less formal and often takes place at the outset of the mortgage application process. While you're still provided with a loan amount estimate, you will not be asked to provide documentation or proof of your financial status and history.
In contrast, pre-approval is a more formal process that requires detailed documentation rather than self-reporting. It should be noted that neither pre-qualification or pre-approval provide a guarantee of an application's success or the interest rate available at the time the loan is offered.
Despite their ubiquity, every home loan is a complex financial and legal agreement that can be challenging to understand. Before you formally apply for a mortgage, it's important to understand the different types of mortgages and lenders available. Home loans last for a very long time, with each decision you make now possibly having an impact on your life for years or even decades to come. Let's distinguish some common mortgage terms so you can make the right decision for you and your family.
Conventional vs non-conventional
As a first home buyer, you will have the choice between a conventional or non-conventional home loan. There are pros and cons associated with each option, depending on your deposit amount, financial status, and plans for the future. A conventional home loan includes any mortgage that is not insured or guaranteed by the federal government, including all loans available from standard banks and credit unions. Conventional loans typically require a 20 percent deposit, which can be a lot of money for first-time home buyers.
Non-conventional home loans are also available to first home buyers, with these high-ratio mortgages needing a much smaller down payment of between 3.5 and 10 percent. As you can imagine, this is obviously very enticing to new buyers because it helps them to get in the market faster. Non-conventional loans require government insurance and are available from the Federal Housing Administration (FHA) and other government departments. In Canada, high ratio mortgages need to be insured by the Canada Mortgage and Housing Corporation (CMHC).
FHA loans have been designed to help first time property buyers rather than property investors, although you do have to fulfill certain criteria. In order to access the minimum down payment threshold of 3.5 percent, you will need a credit score of 580 or more. In order to access a 10 percent down payment, you will need a credit score of 500 or more. Other criteria also need to be met. For example, the applicant needs a steady employment history, the property needs to be used as the primary residence, and front-end and back-end ratios are set by the FHA to define loan limits.
The front-end ratio (property-related expenses in relation to gross income) should be 30 percent or less, or 40 percent with compensating factors.
The back-end ratio (all living expenses in relation to gross income) should be less than 43 percent, or 50 percent with compensating factors.
Fixed rates vs variable rates
Interest rates play a huge role in how much money you end up paying for your home and how long it takes to pay off your mortgage. When choosing a mortgage, you will have to decide between fixed rates or variable rates, with both options offering advantages depending on personal finances and wider economic conditions. Fixed interest rates are locked down for the entire term of the loan, which means you're at an advantage if rates go up in the future and at a disadvantage if they go down.
In contrast, variable interest rates change according to wider economic trends, which means you're at a disadvantage if rates go up in the future and at an advantage if they go down. Each person needs to make their own decision by balancing the flexibility and efficiency of variable rates with the stability and security of fixed rates. It's also important to be aware of adjustable rate structures, with some fixed rates available for a certain period of time before they become variable.
Open mortgage vs closed mortgage
Interest rate structures aren't the only thing that influences the flexibility and stability of your home loan. It's also important to consider the difference between open and closed mortgages. An open mortgage allows you to make early and lump sum repayments in order to pay off your mortgage principal sooner. In contrast, a closed mortgage includes a fixed payment schedule that can't be changed over time. There are pros and cons of each approach, with open loans often including higher interest rates and mortgage fees.
Mortgage lenders vs mortgage brokers
When taking out a home loan, you have the choice between working directly with lenders or working with mortgage brokers. While most people obtain a mortgage from a bank, there are a wide range of individual lenders to choose from, from banks and credit unions through to private and hard money lenders, investment corporations, insurance companies, and trusts. It's important to do your homework, with these lenders known to differ widely in terms of their interest rates, fee structures, and terms and conditions.
If you want a professional in your corner to help you compare and contrast lenders, you also have the choice to work with a mortgage broker. While brokers don't actually lend any money themselves, they have ongoing relationships with multiple lenders and can help you to track down a good deal.
It's free to use the services of a mortgage broker, with their business model generating capital from commissions when their clients sign a mortgage deal. While this is mostly a good thing, it's important to be careful of conflicting interests. For example, some brokers are more likely to refer you to lenders who offer them the biggest pay-out.
Assembling a team
Getting a mortgage can be incredibly complicated, especially if you're doing it for the first time. Assembling a team of professionals can help to make the process simpler and more transparent. While setting up relationships with multiple parties can seem costly initially, it's important to remember that both brokers and realtors generally work off commission and have no upfront costs. While the same thing can't be said for lawyers, they can save you money, time, and lots of stress in the long-run.
A mortgage broker can be a great asset, with experienced brokers able to connect you with multiple lenders and help you compare loan agreements.
A realtor is also crucial, with agents who specialize in particular types of property and specific neighborhoods worth their weight in gold.
Legal assistance will be required at some stage during the mortgage process, either at closing or earlier during house hunting and negotiation.
Additional help is also likely, including a property inspector, appraiser, builder, and moving company.
Finding the perfect property
Once you have received pre-qualification or pre-approval from a lender, you can start hunting for your new home. While lots of people start looking for a home straight away, without a working budget, this can quickly lead to disappointment and frustration. Finding the perfect property is part art and part science, with your personal preferences and expectations needing to be weighed up against property prices and wider market forces.
Condos vs houses
What type of property do you want to buy? Have you thought about your current and future needs? Will you be able to maintain your current lifestyle if you buy a large house? While buying a detached home in the suburbs is still the dream of many, condos have become an increasingly attractive alternative in many US and Canadian cities. Not only is it cheaper to buy a condo, you can also save time and money on maintenance and enjoy a different kind of lifestyle than you would get living in a house.
The condo lifestyle is all about location and community. Most buildings are located in desirable inner-city locations, and most communities offer a range of sporting and recreational amenities. For example, while few people can afford to live in a trendy suburb and have access to their own swimming pool and gym, this is a common scenario for people who live in condos. While you do have to pay monthly condo fees and abide by the rules and regulations of the board, it's important to at least consider this option if you’re a first home buyer.
Comparing locations and properties
Along with the type of property, the location of your new home has a huge effect on the purchase price and lifestyle available. Once you have a working budget, you can sit down and compare average prices in different neighborhoods to get a good idea of what you can afford. It's important to leave your options open at this stage, with where you want to live not always aligning with the reality of your finances. What is your option B? What are you prepared to compromise? Are you more concerned about the property's location or condition?
In order to compare neighborhoods effectively, you need to write down a list of all the things that are important to you. How close do you want to be to public transportation? What about schools? Are you looking for somewhere with restaurants and cafes on your doorstep? While no-one has a crystal ball, try to anticipate your future needs regarding employment, education, and children. Once you have a short list of properties, it's important to compare them based on the same criteria and carry out a detailed property inspection to avoid any nasty surprises.
Understanding the market
Whether you're buying a condo or a house, a property purchase is one of the biggest financial decisions that you'll ever make. Anyone in the market for a new home should have a basic understanding of the data that drives the property market. While you don't have to be an expert, market analysis is just as important for owner-occupiers as it is for property investors.
In order to build equity and protect your investment, it's important to be aware of growth patterns and supply and demand in your location of choice. Take a look at how prices have changed over the years and months, and try to buy into a market that's on the way up without being over saturated.
Getting your first mortgage is an exciting time, but it can also be confronting and a little bit scary. While the shear size of the financial transaction is always going to create some anxiety, there are lots of things you can do to simplify the process and educate yourself along the way. From setting a budget and researching benefits through to understanding mortgage conditions and finding the perfect home, getting inside the mortgage process will help you make the right decisions for your future.