A 20-Something’s Guide to Getting a Mortgage
Your apartment manager’s a jerk, your neighbor won’t stop slamming their door, and maybe you’ve even seen closets larger than your kitchen. Any way you slice it, buying a home sounds … appealing.
But before you go calling up real estate agents and running around to open houses, it’s important to understand how the financial component works. After all, this will be one of the largest purchases of your life, and mistakes can cost you thousands of dollars.
We’ll walk you through everything you need to know about getting a mortgage in your 20s: how mortgages work, how you can find a good one and whether buying a house now is even right for you in the first place.
In this guide, we’ll cover:
- Mortgage basics
- First-time homebuyer programs
- Getting a mortgage with student debt
- What it takes to qualify for your first mortgage
- How to start shopping for a mortgage
- Mistakes that can hurt your mortgage application
- Is it better to rent or buy?
A mortgage is a special type of loan made to buy a house. Since houses cost much more than most things you might buy with a loan, mortgage loans are extra large and are paid off over a long period of time, often 30 years.
How mortgage payments work
Your one mortgage payment actually includes up to five components:
- Principal: This goes toward paying down your loan.
- Interest: This is the finance charge for the loan.
- Property taxes: Your bank will make this payment for you.
- Homeowners insurance: Your bank will also make this payment for you.
- Mortgage insurance: If you put down less than 20% of your home’s value, your loan may have this cost, which protects the lender from losses if you default on the loan.
Over time, you’ll pay down your loan balance until it’s gone. The house then officially becomes yours, and you won’t have to make any more principal, interest or mortgage insurance payments. After that, you’ll be on the hook for making property tax and homeowners insurance payments.
Types of mortgages
You may choose from a variety of mortgage types. You can get a mortgage as a part of a special government loan program, such as a VA loan, USDA loan or FHA loan. Loans that aren’t part of a government loan program are called conventional loans.
Lenders typically sell conventional loans to one of two government-sponsored entities (GSEs), Fannie Mae and Freddie Mac, and if so, they’re also known as conforming loans because they conform to the guidelines of these two companies. Conversely, loans of any size that do not adhere to the guidelines of the Fannie Mae and Freddie Mac are called non-conforming loans.
Types of interest
Whether you get a loan in a government program or a conventional loan, you may be able to choose from different types of interest rates.
In 2016, about 96% of homebuyers chose a fixed-rate mortgage, which carries a single interest rate for the entire length of the loan. Variable or adjustable-rate mortgages (ARMs), on the other hand, offer you a trade: you can get a lower interest rate today, but banks can increase it at periodic intervals in the future if they so desire. These intervals are called adjustment periods and are often for periods of three to five years. With a five-year ARM, for example, the lender can change the interest rate once every five years.
First-time homebuyer programs
There are many assistance programs available for first-time homebuyers, including federal, state and local governments, as well as some from nonprofit organizations. These first-time homebuyer programs also take many shapes, such as cash grants or special loans, so it’s a good idea to read the fine print and know what you’re signing up for.
Many of these national loan programs aren’t exclusively for first-time homebuyers, but they are popular among that population:
- FHA loans require as little as 3.5% down and don’t require a high credit score
- USDA loans require zero down payment for rural homes
- VA loans also require zero down payment for military members and veterans
- Freddie Mac’s Home Possible and Fannie Mae’s HomeReady loans let you put as little as 3% down on certain homes
- HUD’s Good Neighbor Next Door program gives firefighters, teachers, EMTs and police officers a 50% discount off qualified homes
- VA’s Native American Direct loans offer no down payment and low closing costs to Native American veterans
Many more programs are available at the state and local levels. Because of this piecemeal approach, these programs aren’t standardized like at the national level, and tend to vary depending on where you live.
For example, the state of Alaska offers an assistance program that will pay closing costs on up to 4% of the loan amount if you qualify, and Washington state offers up to $40,000 in down payment assistance for qualified buyers in the city of Bellingham. The best place to find out what first-time homebuyer programs are available in your area is to check out your state’s housing finance agency.
Getting a mortgage with student debt
You might think your student loan debt will prevent you from getting a mortgage, but think again. “Student loans in and of themselves aren’t a problem,” said Noel Bennett, branch manager at Premier Mortgage Group in Boulder, Colo. “What can be a problem for young people is what we call the debt-to-income ratio.”
Here’s how it works: A mortgage lender needs to take into account how much money you have each month after paying your debt obligations. There are two kinds of DTI: the front-end ratio and the back-end ratio. The difference is the back-end ratio includes your potential mortgage payment, and the front-end ratio does not. This is to make sure you have plenty of room in your budget for big-ticket items like a mortgage payment.
It’s a ratio of your total monthly debt payments to your total income. For example, if you make $2,000 in monthly debt payments, including housing, and earn $5,000 per month, your debt-to-income ratio is 40% ($2,000/$5,000). In most cases, you can have a back-end debt-to-income ratio of up to 43% before you can no longer get a qualified mortgage (of course, the lower it is, the better). You can calculate your debt-to-income ratio here.
How student loans are calculated in your debt-to-income ratio
Calculating student loan payments into your debt-to-income ratio can be tricky, especially if your loans are currently in deferment, forbearance or if you’re on an income-based repayment plan, according to Bennett. Different types of loans factor your student loan payment into account in different ways.
“We use Fannie Mae for most of our loans. Fannie Mae [allows us to use] income-based repayment payments, even if it shows zero dollars,” said Bennett. “With other types of loans, like FHA loans, they will make us use the greater of 1% of the balance, or the monthly payment shown on the credit report, or we have to document the payment from the student loan company themselves with some sort of statement or something.”
The moral of the story? Which type of mortgage you choose dictates how your student loan payments are taken into account. If you aren’t currently making payments on your student loan, or if they’re less than they would be under the standard repayment plan, it can make sense to choose a mortgage such as a Fannie Mae loan that will take into account your current payment amount. Ask a loan officer to help you choose the best mortgage given your student loan situation.
What it takes to qualify for your first mortgage
Solid credit score
Some mortgages allow you to qualify for a home without a stellar credit score, such as an FHA loan. However, it’s in your best interest to work to increase your credit score as much as possible before you apply for a mortgage, for two reasons:
- You may qualify for more types of mortgages that could fit you better
- You may qualify for lower interest rates that will save you a ton of money
Typically, however, you’ll need a credit score of at least 620 to qualify for most conventional loans.
It’s possible that you might not even have a credit score yet, especially if you haven’t taken out student loans or credit cards. In this case, it might be possible to qualify for a loan using an alternative or nontraditional credit report like PRBC that builds a profile based on payments that aren’t often reported to the traditional credit bureaus, such as utility bills and rent, according to Arielle Minicozzi, a former mortgage loan officer and current executive financial planner of Arizona-based Sphynx Financial Planning. “When I was a loan officer, I would say about 30% of my younger buyers would need to use nontraditional credit. It’s not as common.”
Going the alternative-credit route is possible, but it may limit your options, says to Bennett. “Even having a credit score from using a couple different small credit cards, that will potentially open up options that will be more limited if we have to build an alternative credit report.”
A reasonable budget
The first thing that’s good to look at is how big of a monthly mortgage payment you can afford. “A good rule of thumb is to take your current monthly income, multiply it by 40%, and then subtract the total of your debt obligations,” said Minicozzi.
For example, if you make $5,000 and have $800 worth of debt payments each month, you might be able to afford a monthly mortgage payment of $1,200. (40% of $5,000 is $2,000, and $2,000 – $800 is $1,200.)
Using that figure and what you have available for a down payment, you can figure out how expensive a home you can afford. Your loan officer or a mortgage calculator can help you do the math.
A fair warning: After preapproving you for a loan, banks may offer you a seemingly huge amount of money toward a mortgage. That doesn’t mean you have to take it. “I tell my clients, ‘This is the most you can qualify for on paper. It’s not the most money that you may feel comfortable spending,’” said Minicozzi. “‘It’s way more important that you feel comfortable making that payment on a monthly basis.’”
A down payment
The gold standard down payment size for most mortgages is 20% of the purchase price. That may seem like a huge number, and it is, but if you can swing it, a 20% down payment has a lot of benefits.
However, it’s understandable that most young people might not have enough cash saved up for such a pricey purchase. If this is the case, you have two options: a) use a mortgage that allows a smaller down payment (and potentially pay higher costs), or b) wait and save up the money.
Minicozzi is a firm advocate in the savings camp. She advises people to simulate their proposed mortgage cost and save for it in a unique way. It works like this: Take the monthly mortgage amount you calculated earlier ($1,200 in our example), and multiply it by 110% to get a target mortgage payment ($1,200 * 1.10 = $1,320). Why a higher amount? “I like to have my clients leave wiggle room for unexpected interest rate increases, higher property taxes, etc.”
If you’re not currently making a rent payment, save this entire amount each month toward a down payment. If you are renting, then subtract your monthly rent payment from this target mortgage payment. So, if you’re making a $995 monthly rent payment, you should save at least $325 per month toward a home down payment ($1,320 – $995 = $325).
Following this approach has three advantages, according to Minicozzi. First, “it’ll show you whether you’re comfortable making that payment.” You definitely do not want to buy a house and only then find out you can’t make the payment.
Second, it’ll also show the bank that you can make that payment. “The underwriter is going to want to see that you have the ability to make such a large payment every month. By saving the money instead of spending it, that’s a good way to prove that to the bank.”
Third, this approach will also just help you save up money really fast — especially if you can save more than 110% of your monthly target mortgage cost.
How to start shopping for a mortgage
Your mortgage rate
Every mortgage comes with a certain interest rate. This is the cost of borrowing the money you need to buy your house. In recent years, these mortgage rates have hovered between 3.5% and 4.5%.
Your mortgage rate is the single biggest influence on how much money you’ll pay over the life of your loan. The smaller the rate, the more money you’ll save. Even tiny differences in interest rates can have huge effects when you zoom out to a 30-year level.
For example, let’s say you buy a $250,000 house with a 20% down payment, so you can avoid private mortgage insurance payments. If your interest rate is 4.29%, you’ll end up paying $155,884 just in interest alone by the time you pay off the loan in 30 years. But if you can find a slightly lower interest rate — say 4.00% — you’ll only have to pay $143,739 in interest. That’s a savings of $12,14504!
While shopping around is crucial to finding a great interest rate, there are a few things you can do to get a lower rate as well. For example, you could buy discount points in exchange for a lower rate, or you could work on your credit score or save more for a down payment, which can help you qualify for a lower rate.
How to shop and compare mortgage offers
Step one: Collect loan estimates
You can easily compare multiple mortgage offers with our loan comparison tool, or find mortgage lenders in your local community.
However, you don’t need to wait until you’re ready to put in an offer to contact a mortgage lender to help you.
“My best advice is that the minute you consider buying a home, the first thing that you want to do is reach out to your financial planner or loan officer,” said Minicozzi. “They can help you crunch some numbers and advise you on how to improve your chances of being approved.”
From there, it’s time to shop around for rates. Each lender should be able to give you a loan estimate, complete with all of the details you need to know to make an informed decision, such as the monthly payment amount, an estimated interest rate, fees and taxes and insurance. It’s a good idea to collect at least three full loan estimates from lenders so you have a range of options.
“I always know there’s a hesitancy and a fear of contacting a lender, like it’s going to be super invasive and all that,” said Bennett. “It’s really not. It’s a very simple 10-15-minute conversation” about your financial situation. Bennett says the initial consultation shouldn’t cost anything.
Step two: Get preapproved
“I can’t stress this enough. I’ve said it a hundred times, and I’ll say it till I’m blue in the face, but don’t start looking at houses until you have a preapproval in place,” urged Minicozzi. “Because inevitably you will find a home faster than you think you will, and if your financing isn’t ready, it’s going to cause a delay in your closing.”
Going through the preapproval process requires a little bit more work than getting a loan estimate. First, select the best lender from the list you shopped around earlier, and ask to be preapproved. This means the lender hasn’t given you the money yet, but if and when you find the right house, they are willing to give you the money. It’s like an added layer of insurance to woo a potential home seller and make your offer look more attractive.
You’ll need to provide a few more documents to go through the preapproval process, like statements from banks, loans and investment accounts, or previous tax returns if you’re self-employed. At the end, the lender will give you a preapproval letter that you can show to potential home sellers to prove that you’ve already got your ducks in a row for financing. In fast-moving housing markets, this can make the difference between having an offer accepted or not.
Mistakes that can hurt your mortgage application
Don’t wait to get your documents in order. Most banks will want to see at least these documents:
- Most recent paycheck stubs
- Most recent bank account statements
- Most recent loan statements
- W-2s and/or tax returns from previous two years
- Proof of supplemental income (VA benefits, alimony etc.)
Don’t be surprised by the amount of paperwork you have to do. You’re applying for a loan for tens or hundreds of thousands of dollars. Banks just don’t hand out that kind of money.
Don’t make any big financial moves. The lender requires all of this paperwork to try and build up a complete picture of your finances. Big purchases, like taking out an auto loan, can increase your debt-to-income ratio and make it harder to qualify for a loan.
Even changing jobs in the few months before you apply for a mortgage can cause delays, according to Minicozzi. So can poor documentation of changes to your finances, according to Bennett. “If you get a large chunk of cash from someone, like from a parent, it’s better to make sure that you get a check instead of cash, make that deposit and keep a copy of the deposit slip,” she said, “because those are things we have to track.”
Don’t forget to make payments on all your obligations. You probably know you need to pay your bills on time, but have you considered absolutely everything?
“I’ve had a lot of people that didn’t return a library book, and they felt like, ‘Well, I’m not going to pay it. I did return it, and I don’t care what they say,’ and just let it go,” said Bennett. “The library turns them over to collection, and now you’ve got a credit score that’s really gone down. So you have to be super careful about those little pesky things.”
Don’t be afraid to ask questions. You can do as much research as you want, but there will probably still be things that come up that might confuse you. Don’t feel stupid for asking questions, says Minicozzi. “It’s an expensive and really stressful process for a lot of people, and you have a team of professionals that are willing and ready to help you.”
When buying a home, there are closing costs that you’ll need to pay for, such as a loan origination fee, appraisal fees, and home inspection fees. Then, when you go to sell your house eventually, you get slapped again. This time, you’ll probably be expected to pay the real estate agent fee for both your agent and the agent for the person who’s buying your house.
It takes time to build enough equity in a home so you can at least cover the real estate agent’s fees and break even on a sale. After that, you still have to worry about homeowners association (HOA) fees and costs for home repairs and maintenance — costs you generally don’t have when renting.
Sound confusing? It can be, but you can actually generate a rough estimate of whether it’s cheaper to buy or rent — and how long it’ll take to break even — by using our rent vs. buy calculator.
“There’s another opportunity cost that a lot of loan officers and financial planners don’t really consider. If you’re moving to another state or another city, what does the job market look like?” Minicozzi asked. It’s no secret that 20-somethings are more mobile than their gray-haired neighbors. “Sometimes people can take into consideration that the cost of living is lower in another place, but don’t think about what kind of money they’d be earning to upkeep those costs.”
“The other category that I think a lot of financial professionals ignore but I think is very important to consider is the emotional considerations about buying a home,” added Minicozzi. You might be able to afford a home, but is it actually a home you want to live in? Is it the nice single-family home with a yard like you’d prefer, or is it a shack? Is it in a good school district, or within a reasonable drive to work? These are things you need to factor into your lifestyle and happiness, both today and well into the future.
Buying a home while in your 20s comes with a lot of difficulties. Student loans and low (or no) credit scores all pose obstacles to people in their 20s wanting to buy a home. But, if you educate yourself on the process, speak with a loan mortgage officer early on and shop around for the best rates, you’re setting yourself up for a successful home buying experience.