One of the first things to investigate when you’re thinking about buying a home is financing, unless you intend to be a cash buyer. It will determine your ability to buy, what you can afford to pay and few agents will be interested in representing you unless you are “pre-qualified”. In a multi-offer situation, sellers may lose interest unless you’re able to provide some proof that you can pay the price on closing. You should talk to your bank or mortgage broker about this, but as a primer here’s my take.

The first thing to determine is what you can realistically put toward a down payment in the context of your savings and on-going income potential. You should also consider any anticipated expenses such as closing costs, remodeling costs and new on-going expenses like maintenance costs, property tax and utilities. Many mortgages have a reserve requirement, meaning you have to hold enough savings after closing to pay for x months (usually 6) of mortgage payments. Usually this can be covered by a percentage of 401(k) holdings, provided the terms allow them to be cashed out in event of hardship.

Traditional mortgages require 20% down, that is 20% of the purchase price (excluding closing costs) in cash as a down-payment. There are other products out there that also allow for a 10% down-payment and in some cases even lower. One factor that determines the products available to you is whether your mortgage is considered “conventional” or “jumbo”. Conventional loans are those that fall below (for the loan amount, not the purchase price) a set threshold defined by the government based on geographic regions. Those that exceed the limit are considered “jumbo” loans and topping up your down-payment might change your category.

Credit Score

Another factor that determines your eligibility or approval for mortgage products and the rates you are subsequently offered is your credit score. This is a complicated topic and there is a whole industry built around credit scoring and helping individuals improve their scores. That said, the main factors that have a positive effect on your score are:

Income to Debt Ratio

Your income is obviously an important factor in determining the size of mortgage you can afford to pay. Most banks use a 43% debt-to-income ratio to calculate affordability. That is, 43% of your net monthly income should cover your monthly mortgage payment. If you have other debt obligations that will also have an affect on affordability. The interest rate you are offered also has an effect on the monthly mortgage payment, so ideally you want to have a buffer in case interest rates rise between getting pre-approved and locking your rate once you get an offer accepted.

Getting Pre-approved

Getting pre-approved typically involves running through your income, down-payment, existing debts and ideal mortgage amount with a lender. They’ll then run your credit check and hopefully give you a provisional approval up to a certain mortgage amount and with options on certain rates. Congratulations, this is the first step and means you’re fairly likely to be able to draw down the mortgage. It is however different to a fully underwritten mortgage, where they check all of your documents and verify income

Property types and requirements

It is also worth considering that mortgage lenders may have different requirements based on the property type. For example, you might be looking at a single family home or a condominium with HOA fees, or a duplex, or quadplex with existing tenants, or a fixer upper that is currently uninhabitable. Some lenders will not underwrite for certain types of property, for example we ended up bidding on a fixer-upper that was in barely livable condition - we later found our that their underwriting department requires that there be no broken glass or obvious safety hazards and that there is a working stove. These issues can be discovered by the lender on the appraisal and could come back to bite you if not dealt with proactively. In the case of rental properties or for example, a duplex with an owner-occupier unit and a sitting tenant, the mortgage lender may consider the tenants rent as income which may count in your favor.

Fixed Rate or ARM

fixed rate mortgages offer a fixed interest rate over a given period of time, normally 30 or 15 years. This may also be the term of the mortgage, which will determine how much you pay each month so that the balance is 0 at the end of the term. Fixed rates offer certainty and lock in a monthly repayment amount for the term of the mortgage. Interest rates are almost certain to change in the future and locking in an interest rate for the long term removes the risk of your payments sky-rocketing in the future if they were to rise.

Many would argue that interest rates are about as low as they will ever get so locking in now for a long period makes a lot of sense. In the current environment you will find that shorter term fixed rates come with a lower interest amount, given the expectation that interest rates will be higher in the future, thus incentivizing you to opt for a shorter low rate and pay more later.

Adjustable Rate Mortgages (ARMs)