First-Time Homebuyer’s Guide to Mortgages

If you’re in the market for a new home, chances are high you’re shopping for a mortgage too. Homeownership is the biggest purchase you’ll make in your lifetime, so even with a hefty down payment saved up, securing financing is a necessity for most first-time homebuyers.

Eighty-five percent of first-time homebuyers take out a mortgage rather than paying for their first property with cash, according to the U.S. Chamber of Commerce. Mortgages also are a valuable tool for people moving up the property ladder, with 69 percent of repeat homebuyers requiring a home loan.

There’s a lot to wade through when it comes to mortgages, including shopping for interest rates, saving for a down payment and getting preapproved.

If you’re ready to obtain a loan to pay for your first home, here’s everything you need to know about mortgages and the loan process.

What Is a Mortgage?

A mortgage is a loan that homebuyers take out with their bank or mortgage lender to help them pay for their home purchase. The details of your mortgage are ironed out in a legal contract that outlines how much you owe your lender, how much interest you’ll pay on your loan along with how much you’ll pay each month over a set period of time.

Your home acts as collateral to secure your loan. If you start missing payments and default on your mortgage, your lender could put your home into foreclosure.

What Types of Home Loans Are There?

Home financing options vary from government-backed loans to conventional mortgages offered through private lenders like banks, mortgage companies and credit unions.

Government loan programs

If you qualify, you should consider taking out a government-backed loan, which comes with major benefits. Federal Housing Administration (FHA) loans, for example, are designed to help low- and moderate-income homebuyers, offering a low down payment. They are also easier to qualify for if you don’t have a perfect credit history. 

Veterans Affairs (VA) home loans are offered to veterans and active military homebuyers, and a down payment and private mortgage insurance (see below) are not required. Because the U.S. Department of Veterans Affairs acts as a guarantor on the loan, homebuyers can secure better terms and lower interest rates than through other loan programs.

Conventional loans

Most homebuyers opt for a conventional home loan via a bank or mortgage company. You can shop around for competitive interest rates and better terms, but you’ll need at least 5 to 10 percent saved up for a down payment, a solid credit history and stable income.

Research first-time homebuyer programs that your state or county may provide. These programs come with big advantages like low interest rate mortgages, tax credits and closing cost assistance.

What Are My Loan Options?

You need to make two key decisions about your mortgage — the term of your loan and whether your want a fixed or adjustable interest rate.

The term of your loan is the period over which you repay your mortgage. Terms can range from 10 years up to 30 years. Twenty-five- to 30-year terms are the most common — shorter terms come with larger monthly payments, which may be harder for homeowners to budget for.

With a fixed-rate mortgage, your interest rate is locked in and won’t fluctuate for the entirety of your loan. The principal and interest you’ll pay each month will vary as you chip away at your loan, but the total payment you’ll make will stay the same.

With adjustable rate mortgages (ARMs) — also called variable rate mortgages — your interest rate and your monthly payments will fluctuate. ARMs typically come with lower interest rates in the first few years, and the interest rate will reset over the course of your loan. ARMs also limit or cap how much your interest rate can increase and how often it can change.

Do I Need a Down Payment?

Unless you qualify for a VA home loan, you’re on the hook for a down payment. Your down payment is the lump sum payment you make when you purchase your home. 

You can get away with a down payment of about 5 to 10 percent of your purchase if you’re on a tight budget. In 2017, the average down payment for a newly purchased home was $20,000 or 7.3 percent of the average home’s purchase price. Americans who fit the criteria for an FHA loan can get away with only 3.5 percent down, as of 2020.

If you’re trying to qualify for a conventional loan, most lenders require you to put down 20 percent. If that isn’t feasible, you can take out private mortgage insurance.

What Is Private Mortgage Insurance?

Private mortgage insurance, or PMI, allows borrowers to qualify for a conventional loan when they put down 5 percent up to 19.99 percent. It’s typically arranged by the lender and issued by private insurance companies.

While you’re paying for PMI, the coverage isn’t for you. It serves to lower a loan’s risk to lenders. If you can’t put 20 percent down, lenders may see you as a high-risk client. The PMI is to protect lenders in case you default on your loan. PMI costs range from about 0.25 percent to as high as 2.25 percent of your outstanding loan balance each year. 

The bigger the down payment and the smaller the loan, the less risk your lender needs to take, so if you can save 20 percent of your home’s purchase price, you can avoid this extra expense.

What Are the Components of a Mortgage Payment?

Four components make up your mortgage payments. They come with a catchy nickname: PITI, or principal, interest, taxes and insurance.

The principal is how much of your payment goes toward chipping away at your mortgage, while the interest is how much you’re paying your lender for your loan. Taxes cover your real estate and property taxes, and your insurance covers your homeowners insurance and PMI. 

Not all homeowners follow PITI. You can opt to pay for your taxes and insurance separately instead of as part of your mortgage payment.

How Much Home Can I Afford?

Figuring out how much house you can responsibly afford is an important step for first-time homebuyers. With some number-crunching, you’ll have a ballpark estimate of how much you can spend on your first home and narrow your search accordingly. You don’t want to waste your time visiting open houses and model homes that are out of your price range.

As a rule, lenders typically suggest that homebuyers can finance a loan that’s about 2 to 2.5 times their gross income. If you’re a couple earning $200,000 together, your mortgage could be about $400,000, for example.

You can run your own numbers by tallying up your monthly income, your debt repayments from credit cards and student loans, and your monthly expenses like day care, car payments, utilities and subscriptions. Subtract your debts and expenses from your monthly income and look at what’s leftover. This is the amount that can go toward your mortgage payment. Don’t stretch your budget too thin, though. Include some wiggle room so you can keep saving for a rainy-day fund, investments, holiday planning and other financial goals you might have.

Online mortgage calculators can help you with this step. You simply plug in your income, your down payment, your monthly debts and your loan term length and the calculators will formulate different mortgages you can afford. It’s a great exercise to help you understand what lenders are considering when they determine how much they’ll qualify you for.

How Do I Qualify for a Mortgage?

Criteria for qualifying for a mortgage differs depending on your lender and your loan type. Government-backed loans, for example, come with fewer checkpoints for you to meet compared to conventional loans.

Generally, lenders will consider the following:

• Your gross income, including your employment, rental income, Social Security benefits and investments
• Your liabilities, including your credit card debt, student loans, lines of credit and car loans
• Your monthly expenses, including utilities, subscriptions and memberships
• Your debt-to-income ratio
• Your credit score

A strong credit score is critical for your loan application. Your lender will scan your credit report to see if you’ve defaulted on loans before. They want to see that have a lengthy history of paying your lenders back on time.

Stay one step ahead by pulling your credit reports from Equifax, TransUnion and Experian to make sure there aren’t any surprises and you can address any issues. (You can request your free credit reports at annualcreditreport.com. Applicants with a low credit score could end up paying higher interest rates on their loans.

With a conventional loan, you’d need a credit score of about 620, while for an FHA loan, your credit score can be between 500 and 579. The average credit score for mortgages taken out in 2019 was 759, according to the Federal Reserve.

Your lender will ask for pay stubs, tax returns, a letter of employment, bank statements and a list of your assets and debts. 

If servicing your debt takes up more than 36 percent of your gross income, your lender may be wary that your income is insufficient to cover all of your debts. Clear your outstanding debts as much as you can before you approach lenders for a home loan.

Should I Get Preapproved or Prequalified?

Getting preapproved is useful for first-time homebuyers. A preapproval letter from your lender states how much you’ve been preapproved to borrow and helps you gain insight into how much lenders think you can shoulder and shows builders you’re serious about buying.

Shop around with different lenders to see what loan options they have on offer, how much you can get preapproved for and at what interest rates.

Seventy-one percent of first-time homebuyers are approved for a mortgage on their first try without any issues. The Chamber of Commerce suggests it may be because first-time buyers are a savvy bunch —54 percent consulted with two or more lenders compared to just 37 percent of second-time buyers.

Your preapproval letter isn’t set in stone though. If you quit your job or you take on new debt, your lender could refuse your financing. Mortgage preapproval letters typically expire in about four to six weeks.

Prequalification doesn’t hold as much clout and is more of a first step to get an estimate of what you could borrow — which can be helpful in establishing your home-buying budget. They’re typically done online by providing your credit score, income, debts and assets, while preapproval letters require your lender to confirm your financial information through a full underwrite.