If you didn’t already know this from personal experience, you’ve undoubtedly picked up on it quickly in your new career: Most home buyers finance their home purchases.
Recent years have seen a marked increase in the percentage of cash offers as the housing market has heated up — with NAR reporting a one-year rise from 16% to a peak of 25% in July 2021. That still leaves three-quarters of buyers depending on mortgage loans to make their dreams of homeownership a reality.
And that being the case, you need a foundational understanding of the world of mortgage lending, which is just what this article hopes to provide you.
Mortgages 101
The purpose of a mortgage is to allow the home buyer the immediate benefits of homeownership while they spend up to three decades paying off the purchase. And mortgage lenders are willing partners in this venture as long as their financial rewards match the risks inherent in extending the loan.
How they manage all of that will become apparent as we look at the components of a mortgage loan and the variety of mortgage loan products on offer.
Components of a Mortgage Loan
The three main components of a mortgage loan are:
Down payment: This refers to the cash put down at the start of a loan. The traditional down payment lenders like to see is 20%. Come in with a higher down payment, and the borrower will likely enjoy a lower interest rate. The opposite is also true. This is because a down payment reduces the lender’s risk by ensuring that the property, which serves as collateral, is greater than the loan amount.
Loan amount: Purchase price - Down payment = Loan amount. Said another way, the loan amount is the remainder of the purchase price. It’s the balance that will be spread out over the life of the loan, paid in monthly installments. With a traditional fully amortized loan, the last monthly payment will pay off the loan in full.
Interest rate: This is where most of the lender’s reward can be found. The interest rate is the cost that the borrower pays for the privilege of the loan. Again, the higher the perceived risk, the higher the interest rate.
Loan Programs
If a lender chooses to extend a loan to a borrower, they will seek to match that borrower with the appropriate loan program. Here’s a quick list of the most common loan programs:
Conventional Loans: A conventional loan is not backed by a government agency. While they require mortgage insurance if the down payment is less than 20%, their interest rates are usually competitive.
FHA Loans: Federal Housing Administration loans are easier to qualify for, particularly for borrowers with lower credit scores, often used for first-time home buyers.
VA Loans: A Veterans Affairs loan is guaranteed by the United States Department of Veterans Affairs and offers veterans several benefits, including lower interest rates, no required down payment, and no mortgage insurance costs.
USDA Loans: United States Department of Agriculture loans require no down payment, making them ideal for those without savings who would otherwise meet the program's guidelines.
Qualifying for a Mortgage
Two questions your buyer-clients will need answers to early on are:
Can I qualify for a loan?
How much can I afford?
While a lender will be the one to provide them with definite answers, you can help them understand what goes into answering those questions.
Lender Considerations
When a lender evaluates a borrower for loan eligibility, they gather the information needed to make a sound financial decision. They will first determine whether or not the borrower is a risk they want to take on under any circumstances. And if so, they decide what loan products and terms they are willing to offer.
Here are the three primary factors lenders look at when considering a loan applicant:
Credit Score as provided by the three major credit bureaus
Debt-to-income ratio as calculated using verified financial documentation gathered from W-2s, pay stubs, tax returns, credit reports, etc.
Down payment as a percentage of the sales price or property value
By looking at these factors together, a lender can get a sense of how well a borrower has fulfilled their loan obligations in the past, how well are they set up to take on the additional loan obligation a home purchase will bring, and how risky will the loan be to the lender relative to the value of the property securing the loan.
Minimum Qualifications
As far as most lenders are concerned, the perfect borrower is someone who doesn’t need the loan. But the perfect borrower isn’t walking through that door anytime soon, and most lenders understand that. So, while they might prefer a 20% down payment, they can work with borrowers who come to the table with less than that or whose credit score and debt-to-income ratio might leave a little to be desired.
That said, there IS a limit to their compassion and understanding. Here are some of the limits (minimums or maximums) for the most common loan programs lenders work with:
Credit Score Minimums
FHA: 580
VA: 580 - 660
Conventional: 620
USDA: 640
Debt-to-Income Maximums
FHA: 50%
VA: 41%
Conventional: 43%
USDA: 41%
Down payment Minimums
FHA: 3.5%
VA: None
Conventional: 3.0%
USDA: None
The good news is that the underwriting of mortgage loans is a blend of art and science. The qualifications and limits shown above can be fudged a bit when considering the whole financial picture of the loan. But they represent the boundaries that have been set as starting points.
Other Factors Affecting Loan Costs
Interest rates and finance charges are examples of factors unrelated to the borrower’s financial profile that can affect loan costs. And these can vary significantly from lender to lender.
Long-term Interest Rates
Long-term interest rates are impacted by investor demand for 10- and 30-year U.S. Treasury notes and bonds. The greater the demand for these notes and bonds, the lower the interest rates for long-term fixed-rate loans — like mortgages.
While the borrower’s credit history and financial status can significantly influence the interest rate they will pay on their mortgage loan, the prevailing rate is established before they even walk into the lender’s office.
And, after years of being at historic lows, mortgage loans interest rates are starting to tick upward once again. So, whatever your buyer-clients can do to improve their credit profile, the better off they will be.
Annual Percentage Rate (APR)
APR is the annual cost of a loan to a borrower, including fees, expressed as a percentage. Unlike an interest rate, however, APR includes other charges or fees attached to the loan, such as mortgage insurance, many closing costs, discount points, and origination fees.
The moral of the story here is that the actual cost of a loan from one lender to the next can vary significantly even if the interest rate being offered is the same. So, make sure you educate your clients as to how to compare loan offers that appear to be similar. Pay attention to that APR!
What Can You Do?
For buyer-clients in need of financing, your role is to educate and prepare them for what is to come. Here are some steps you can take:
Be aware of the prevailing interest rates — easily found online from sources like NerdWallet.
Have a frank conversation about your client’s financial profile, advising them of the financial information that will be verified by any lender considering them for a loan.
Walk the client through the math of debt-to-income ratio to see what kind of monthly mortgage payment they could manage.
Find out what kind of down payment they expect to bring to the purchase.
Educate the client about APR and how to compare loan offers.
Support their dreams by being respectful while providing them with a reality check as needed.
Do these things, and you will be the professional expert and guide your clients deserve!