How to Shop for a Mortgage Today

enders grow more conservative after the housing bust.

By Pat Mertz Esswein

From Kiplinger's Personal Finance magazine, September 2007

The troubles in the subprime-mortgage market have led to tighter standards for all borrowers. Buyers and refinancers with sterling credit records won't feel the pinch. But lenders have reined in their underwriting rules for borrowers with less-than-perfect credit and for those seeking nontraditional loans that require a low initial payment or little verification of income. Now, rising home prices can no longer serve as the ultimate guarantor of a home loan.

How will tighter underwriting standards affect me? Buyers stretching to afford their first home will be hit hardest. The days of heroic efforts to help first-time buyers "afford" a home are over, says Bill Hampel, chief economist for the Credit Union National Association. When borrowers apply for an adjustable-rate mortgage, lenders will approve or reject them based on the fully indexed interest rate and higher monthly payment, not a "teaser" rate and low initial monthly payments. New disclosures may also add to the pile of paperwork you sign at closing.

Can I still get 100% financing? The availability and pricing of 100%- financing and piggyback loans -- for example, the 80/20, with an 80% first mortgage and a 20% second, designed to avoid the cost of private mortgage insurance -- are largely driven by your credit score. (Based on the FICO model used by most mortgage lenders, scores range from 300 to 850.) As credit scores start to dip below 700, loan options begin to disappear. For example, an applicant with a score below 700 would not qualify for an 80/20 mortgage but could get 100% financing with PMI. With a score of 620 or lower, you probably wouldn't be able to get 100% financing.

Is it better to make a down payment? You're almost always better off making a down payment, says Chicago mortgage broker Karl Banach. "I lean toward putting at least 5% down," he says. "You'll be eligible for many more loan programs, so you can compete on rate." Lenders also want you to have at least two months of PITI (principal, interest, taxes and insurance) in reserve. Financial assets, such as 401(k) accounts or IRAs -- from which you could withdraw funds to make a mortgage payment in an emergency -- qualify, but lenders count only 70% of their value because of the taxes and penalties you'd pay if you were to withdraw the money. On the bright side, the outlook for prices is that they'll remain soft for the next several years and you'll have time to save for a down payment without worrying that home prices will soon be out of reach.

Before I shop, should I pay down debt? Debt is not as important to lenders as your down payment and credit score when it comes to assessing risk, but it's still important. The standard debt-to-income ratio used by lenders is 28/36. Under that guideline, your monthly mortgage payment can't exceed 28% of your monthly household income, and your total debt payments may not exceed 36%. (Federal Housing Administration loans and loans backed by the Department of Veteran Affairs allow a higher ratio of 29/41.) Banach says he has seen the debt limit hit 60% for a borrower with a 30% down payment and a credit score of 800. He says he hasn't seen lenders pull back on the ratios yet, but he wouldn't be surprised if they did.

Is it worth waiting to buy until I can improve my credit score? Probably. The average rate on a 30-year fixed-rate mortgage is typically at least 1.5 percentage points lower for someone with a credit score of 760 to 850 than for someone with a score of 620 to 639. On a $216,000 loan, a borrower with a top-tier score would pay $232 less per month -- a saving of $2,784 per year -- than a borrower near the bottom, according to MyFICO.com.

You're entitled to one free credit report a year from each of the three major credit-reporting agencies (go to www.annualcreditreport.com). At least six months before you apply for a mortgage, request your report, correct any errors, and take action, such as paying down debt, to improve your score. (To estimate your FICO score and learn how to improve it, see Ask Kim Your Credit Score Questions and More Credit Score Answers.)

How high will mortgage rates go? In mid July, the average 30-year fixed rate was 6.63% nationwide, according to Freddie Mac, which is forecasting it to end the year at 6.5%. Kiplinger's is forecasting a 6.75% rate by year-end. The increase may be just enough to make buying tougher for borrowers who are skating the edge of affordability, says Hampel.

Adjustable-rate mortgages are still a good deal for borrowers who are confident that they will sell before rates adjust upward or who want to enjoy interest savings up front and can afford to refinance into a fixed-rate mortgage later. In mid July, the average rate on one-year ARMs was 5.71%, and the rate on the 5/1 hybrid ARM (a fixed rate for five years followed by annual adjustments) was 6.29%.

Use the mortgage calculators at Kiplinger.com to try out various scenarios, such as a bigger down payment or a higher interest rate.

Could the appraisal derail my deal? Lenders may require more-thorough appraisal -- perhaps a full interior and exterior inspection and measurement, instead of a drive-by -- or even two appraisals in markets where prices have been the most volatile. Mike Evans, an appraiser in Chico, Cal., and a spokesman for the American Society of Appraisers, says that the less money you put down, the more the home's market value will be scrutinized. You needn't fear the appraiser if you and your agent have done your homework. A good agent will provide a comparative market analysis of recently sold properties so that you can make a realistic offer. And if you include an appraisal contingency in your offer, you'll get your earnest money back if the price you've negotiated fails to match the appraisal.

Where to find the best rates

A new online tool, Freeratesearch.com, can help you evaluate your mortgage-loan choices and expand your search beyond the lender who preapproves you. Developed by Gerri Detweiler, a longtime consumer advocate in the credit field, the tool compiles and updates data daily from lenders' rate sheets using software originally developed for mortgage brokers.

Unlike other online rate-comparison services, Freeratesearch.com discloses the best-available "par rate" in your area for the type of loan you're seeking. The par rate is roughly equivalent to a carmaker's dealer-invoice price, exclusive of any commissions or rebates. You can then provide your contact information and Freeratesearch.com will forward it to the local lender offering the best rate, who will contact you about negotiating a loan.