If you’re ready to stop paying rent to a third party and start putting your money towards establishing equity in a home you can call your own, getting your financial ducks in a row is of prime importance. After all, you don’t want to fall head over heels for a house only to find out you can’t qualify for a mortgage.
So what does it actually take for a lender to find you mortgage-worthy? As you might imagine, there are multiple factors that go into qualifying and, past that, determining what your terms and payments might be.
Here are a few basics to help you sort through the confusion.
Your credit score
Credit helps lenders decide how risky of a loan candidate you are based on past behavior. They want to see on-time payments, multiple types of credit (i.e. revolving credit like credit cards and installment credit like a car loan), and a low credit utilization ratio (the amount of credit currently in use as a percentage of the amount available to you). They also want to ensure you haven’t recently applied for new lines of credit, which could negatively impact the length of your credit history and indicate current financial trouble.
Each of these areas can have an impact on your credit score, another determining factor lenders pay careful attention to. The minimum credit score required depends on both the type of loan and the lender. For instance, an FHA loan has a minimum score requirement of 580 while many lenders will look for a score of 620 for a conventional loan.
Your debt load
Another good indication of your ability to repay a loan is the amount of debt you currently have and how well your finances could shoulder the costs associated with a mortgage.
They will look at two debt-to-income ratios: the front-end ratio and the back-end ratio. The front-end ratio is all of your home-related expenses, including insurance, taxes, etc., divided by your gross monthly income. A good mortgage candidate would have a number at or below 28%.
The back-end ratio, on the other hand, is all of your housing expenses plus all of your other debt obligations (think student loans, car payment, etc.), divided by your gross monthly income. Ideally, this number should be at or below 36%.
While it’s possible to still land a loan if your numbers are higher, these numbers will make the approval process easier.
Your down payment
While the 20% down payment rule is still touted as a rule of thumb, bringing less to the table doesn’t necessarily mean you will be turned down for a mortgage. In fact, you could land a FHA loan with 3.5% down or a VA loan with zero down. You might even be approved for a conventional loan for 5% down — or less.
However if your credit score and overall financial picture is less than stellar, you might need a larger down payment to convince a lender you are still a viable loan candidate.
It’s important to note, if you don’t bring 20% to the table, you will likely be required to pay for Private Mortgage Insurance (PMI) on a conventional loan, until you owe 80% or less on your loan. FHA loans require payment of a Mortgage Insurance Premium, but canceling it can be a much trickier process.
Can your finances shoulder all of the costs associated with securing a mortgage? Not only do lenders want to see that you are able to pay for the down payment and the required closing costs, but they want to ensure you won’t wipe out all of your liquid assets in the process. After all, you need to be able to continue to pay for the mortgage once it’s in your name.
It’s also important to have these funds remain in tact throughout the entire mortgage process. Lenders will reconfirm assets before closing and if available funds have moved or changed, you could be denied a loan or your original terms could change.
The bottom line
While looking good in the eyes of a lender is certainly important, the key is to make sure your financial foundation is in good standing before taking on the added responsibility of a mortgage. It’s also important to keep your mortgage at a level you can comfortably handle, not just reach the top of what a lender might be willing to give you. Keep these things in mind and not only will you be able to land the home of your dreams, but you’ll be able to stay financially stable in the process– and what could be better than that?