How to Qualify for a Mortgage – Credit Score and Debt-To-Income Ratio
Your credit score and debt-to-income ratio are two essential elements lenders use when determining whether you can afford a mortgage. By understanding what these numbers signify and taking steps to improve them, you may be able to secure the home loan of your dreams!
Your debt-to-income ratio, or DTI, is the amount of monthly income that goes toward paying off outstanding debts. Lenders generally require a DTI of no more than 43% for approval.
Credit Score
When applying for a mortgage, your credit score is an integral factor that your lender will take into account. It helps them assess your risk and what loan terms you can afford.
Your credit score, which ranges from 300 to 850, measures how well you manage your financial accounts and debts. It’s based on information about your payment and account-opening habits and calculated by one or more of the three major credit reporting agencies (CRAs).
A good credit score indicates to lenders that you’re likely to repay the money borrowed. It also shows lenders that you aren’t a high-risk borrower.
An excellent credit score can help you receive the lowest interest rate on a home loan or other type of credit. However, your score may differ from lender to lender due to their unique scoring formula.
FICO Scores, created by Fair Isaac Corporation and based on data in your credit reports, are the most widely-used credit scores. 90% of top lenders use these scores when deciding whether or not to offer you a loan and at what interest rates and conditions.
These scores are calculated using an algorithm based on information in your credit report from one of the three major CRAs — Equifax, Experian and TransUnion. This algorithm compares that data to patterns found in hundreds of thousands of other credit reports.
This score also takes into account your credit utilization, or how much of available credit you’re using. Maintaining low balances and paying bills on time can raise your score; conversely, having high credit card limits or maxed-out cards may lower it.
Another factor to consider when applying for credit is how recently you’ve applied, as new credit inquiries account for 10% of your overall score. Too many applications in a short period can temporarily lower your score, so it’s wise to space out applications to avoid this problem.
Your credit score is determined by a variety of factors, including payment history (35%) and types of credit held (35%), plus how recently new lines were opened (15%). While not necessary, having various types of accounts can show lenders you are an experienced borrower with knowledge on using debt responsibly.
Debt-To-Income Ratio
As a first-time homeowner, lenders will consider your debt-to-income ratio when approving your mortgage application. This measure is calculated by dividing all monthly debt payments (rent/mortgage, auto loans, student loans or minimum credit card payments) by your gross income before taxes.
As you can see, the higher your debt-to-income ratio is, the more difficult it will be for you to qualify for a loan. That is why it is so important to work on decreasing debt and increasing income.
A low debt-to-income ratio shows lenders you’re financially responsible and capable of meeting your current obligations. Conversely, a high ratio may indicate too much debt relative to income, potentially making you appear risky to lenders.
Most lenders prefer a debt-to-income ratio of less than 36%, although exact figures may vary. A higher DTI indicates you pose greater financial risk and could possibly require the lender to increase your interest rate if the mortgage is approved.
Lenders will also consider your other debt and expenses when assessing your ability to make mortgage payments. This includes student loans, child support payments, and any other debt you might be responsible for repaying.
Calculating your debt-to-income ratio requires adding up all current monthly obligations – rent/mortgage, auto loans, credit cards, student loans, alimony or child support payments – then dividing that amount by gross monthly income (pretax total of earnings).
Generally, it’s best to keep your debt-to-income ratio (DTI) below 30%. Doing so will give you the best chances for getting a mortgage loan.
A lower debt-to-income ratio (DTI) increases your purchasing power, enabling you to get a better house for your money. If you have significant debt, making a significant down payment on a new home can reduce your mortgage payment and improve your debt-to-income ratio.
Saving for a rainy-day fund is also recommended, since lenders usually require that you have enough cash reserves (or rainy-day funds) in case you can’t make your mortgage payments. This could amount to up to six months’ worth of monthly payments depending on the loan type and other factors.
Down Payment
When taking out a mortgage loan, the down payment you contribute determines how much is borrowed from the lender and at what interest rate you’ll be charged. It’s an essential factor for many homebuyers – particularly those with limited savings.
Your down payment should be sufficient to cover the cost of purchasing your property plus an extra cushion to help meet other financial obligations. Typically, a down payment should amount to at least 5% of the purchase price.
It may be easier to qualify for a loan with a higher down payment than one with a lower one, but some lenders offer programs that enable buyers to make smaller deposits without losing their eligibility for certain loans. Ultimately, it’s up to you and your lender to determine which option is best suited to your individual financial situation.
In addition to decreasing your monthly mortgage payment, making a larger down payment can help you forgo private mortgage insurance (PMI) and other fees. Doing so could save you thousands of dollars over the life of the loan, increasing the likelihood that foreclosure will not occur.
A down payment shows your lenders that you’re committed to owning the property. A larger down payment may even enable you to break even in case of market decline, since there will be more equity if circumstances such as job loss or other hardships make it difficult for you to keep up with payments.
Depending on the loan you select, lenders may require that you make a down payment of anywhere from 3% to 20% of your home’s sale price. On the other hand, some government-backed loan programs don’t even require a deposit – like FHA loans – are completely debt free!
A down payment is an invaluable asset that can assist in buying your first home, making improvements to your current residence or financing a second property. It also serves as an opportunity to build savings and boost credit score. A housing counselor or lender can assist you in deciding on an amount for down payment that works best for your budget.
Other Requirements
Mortgages are loans secured by real estate, such as a home. This means the lender has a legal claim on the property and can foreclose on it if the borrower doesn’t make their payments on time.
In conclusion, the primary requirement for getting a mortgage loan is having good credit score. A high score will enable you to qualify for lower interest rates on your loan and may increase the likelihood of approval for larger loans.
Other major requirements for mortgage financing include a substantial down payment and an adequate debt-to-income ratio. Furthermore, borrowers must demonstrate they are capable of fulfilling the added responsibility of repaying their new mortgage.
Mortgage payments typically consist of four components: principal, interest, taxes and insurance. The principal portion pays off the majority of your loan balance while the others cover interest costs and local government assessments on your property.
You may need to set aside money in an escrow account to pay the local government’s property tax on a newly purchased home. Furthermore, it could be necessary for you to obtain homeowners insurance for this same property.
Mortgages may seem like a major decision, but it doesn’t need to be. Your credit score may take a dip during the process, though that should return to normal after 5 months. But don’t fret too much; making timely payments and following other credit rules will help restore your score. Our best tip? Keep other debts under control and don’t let your new mortgage consume too much of your monthly budget.