Mortgages explained: A first-time buyer’s guide

What should you look for in a mortgage? How do you go about getting one? What down payment should you make? And what’s a debt-to-income ratio, anyway? As a first-time homebuyer, it’s little wonder you might need some of the basics of mortgages explained, so we’ve put together this guide to help.

What is a mortgage?

A mortgage is a legal contract, usually between you, the homebuyer, and the lender that’s bankrolling your home purchase. In exchange for regular and timely payments, the lender provides you with the funds for the property. 

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

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

Without the funds to buy a home outright, you’ll need a mortgage to buy your first home – and you’re not alone. A record share of homeowners, just over 60%, currently have a mortgage.

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)

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 of 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% of the purchase price 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%. 

If you use the FHA program, you will have to pay for private mortgage insurance (PMI) until you’ve accumulated about 20% of equity in the home. 

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 need 3% down for a fixed-rate mortgage or 5% for an adjustable-rate mortgage. (Read the difference between these in our article How does mortgage interest work?)

Freddie Mac

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

No-money-down loans

There are two programs for first-time homebuyers where you can actually buy a home without making a down payment. Both programs are backed by federal funds to lessen the risk to lenders and encourage new purchases:

• US Department of Veterans Affairs (VA) home loans: VA loans are reserved for active-duty service members, members of the National guard, and veterans or their spouses, and eligibility depends on the applicant’s time in the military. The VA does not set a minimum credit score, but the lenders who make the loans may. 

• US Department of Agriculture (USDA) home loans: USDA loans are designed to encourage property ownership in designated rural and suburban areas. In addition to having a home in one of these locations, you also have to meet certain financial requirements.

Credit score requirements by the mortgage

Before you start shopping for lenders, check your credit score. There are several apps that allow you to monitor your TransUnion and Equifax credit scores, often for free. You may also be able to get your credit score from your credit card company or bank.

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.

Understanding your debt-to-income ratio

Your debt-to-income ratio (DTI) is another big factor in whether you qualify for a mortgage. A DTI ratio is the percentage of your monthly income that’s 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%.

What is the 28/36 rule?

The 28/36 rule is a formula for determining how much debt an individual or household should take on. Basically, it states that a household should spend no more than 28% of its gross monthly income on total housing costs and 36% on debt, like credit card and auto loan payments. 

Most traditional lenders set a maximum household expense-to-income ratio of 28% and a maximum overall debt-to-income ratio of 36% when evaluating your creditworthiness. Each lender creates their own standards for housing debt and total debt as part of its underwriting program, but often limit a borrower’s housing expenses to 28% of their monthly or yearly income. The borrower’s entire debt obligation usually can’t be higher than 36% of income.

Mortgage prequalification vs. preapproval

It’s important to understand the difference between a prequalification and preapproval because it can affect your ability to win a bid on a home: 

• Prequalification is when a lender estimates how much you can borrow based on your finances and a credit check. 

• Preapproval letters are an offer to lend you a specific amount of money, and it’s typically good for 30 to 60 days.

Preapproval 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. Every preapproval process is different, but having a preapproval letter indicates 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 for a mortgage

Getting a mortgage starts when you apply 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 gathers information about your finances, like 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.