How To Get A House Loan
Understanding how banks in the USA evaluate potential homebuyers and determine house loan conditions is crucial for navigating the home-buying process. Let’s break it down into five more manageable parts, using clear explanations and analogies to make the complex financial principles involved more accessible. This series can help you avoid mistakes many make, when looking for a cheap house loan.
Here are the links to this 5 part house loan explainer:
House Loan 101 – Part 1 (this one here)
House Loan 101 – Part 2
House Loan 101 – Part 3
House Loan 101 – Part 4
House Loan 101 – Part 5
1. Evaluation of a Future House Owner
Banks look at several key factors before deciding to lend money for a mortgage. Think of the bank as a meticulous chef evaluating ingredients before preparing a meal; they want to ensure everything combines well to produce a satisfactory outcome.
a. Credit Score:
– What it is: A numerical expression based on an analysis of a person’s credit files, to represent the creditworthiness of an individual.
– Analogy: Consider your credit score like a grade in school that shows how well you’ve managed your borrowing habits. Just like a report card, a higher score (grade) makes you a more appealing candidate.
b. Income:
– What it is: Regular income ensures you have the means to repay the loan.
– Analogy: Think of your income as the fuel in your car; without enough fuel, you won’t be able to complete the journey (repay the loan).
c. Employment History:
– What it is: A stable job history indicates reliability in maintaining income.
– Analogy: Like a reliable recipe that always tastes good because of consistent ingredients, a stable job history shows you’re a dependable borrower.
d. Debt-to-Income Ratio (DTI):
– What it is: A personal finance measure that compares an individual’s debt payment to his or her overall income.
– Analogy: Imagine you’re carrying a backpack. The more items (debt) you add compared to the strength you have (income), the harder it is to walk comfortably. A lower DTI means a lighter backpack.
e. Down Payment:
– What it is: The initial, upfront portion of the total amount. This affects the loan-to-value ratio.
– Analogy: Think of the down payment as the foundation of a house; a strong, larger foundation (down payment) makes for a more stable structure (loan).
2. Calculating and Evaluating the House Loan and Interest
a. Loan Amount:
The loan amount is the total sum borrowed. It’s determined by the price of the house minus the down payment.
b. Interest Rate:
– What it is: The cost of borrowing money, expressed as a percentage of the total loan amount.
– Analogy: Consider the interest rate as the rental fee for borrowing money; the higher the rate, the more you pay to use the lender’s money.
c. House Loan Term:
– What it is: The amount of time you have to repay the loan.
– Analogy: Like a library book loan period; longer terms mean more time to read (repay), but potentially more late fees (interest).
d. Amortization:
– What it is: The process of spreading out a loan into a series of fixed payments over time.
– Analogy: Imagine paying off a large meal in smaller, manageable bites until it’s all gone.
Banks use these factors to calculate monthly payments, which include both the principal (the original loan amount) and interest. The interest rate and loan term will directly affect these payments. Additionally, banks often use risk-based pricing, meaning the interest rate offered reflects the perceived risk of lending to the borrower. A higher risk (e.g., lower credit score) generally means a higher interest rate.
Understanding Prerequisites
Before diving deeper into the calculation specifics, like how exactly monthly payments are calculated or the impact of different types of interest rates (fixed vs. adjustable), let’s ensure you’re comfortable with some of the foundational concepts we’ve just discussed:
– Do you have a basic understanding of what a credit score is and how it’s determined?
– Are you familiar with the concept of debt-to-income ratio and why it’s important?
– How comfortable are you with the idea of compound interest and amortization schedules?
All clear? OK, then let’s move on to House Loan 101 – Part 2.