After years of planning and saving, you are now ready to buy a house. With interest rates still relatively low, you want to make sure you don't run into any snags in the mortgage approval process that could delay or derail your plans. Consider these five primary factors as you check your preparedness for a mortgage application:
- Credit Score – There's no nastier surprise than finding out you have a bad credit score. If it doesn't cost you an approval, it is likely to raise your interest rate. Mid-700 scores are the typical minimum for best rates, but some loans can handle scores in the 600's.
Check all three major credit agencies (Experian, Equifax and TransUnion) – a good score on one does not necessarily translate to the others. By law, you are entitled to a free one from each agency within every twelve-month period, through www.annualcreditreport.com or 877-FACTACT. Check them months in advance of your mortgage shopping so you have time to fix any issues.
Address any errors in your report immediately. However, if there is a valid reason for a low score, such as recent missed payments, you may need to scale your home purchase plans back until your credit issue has been addressed.
- Existing Debt – Lenders will look at your debt-to-income ratio (DTI) in two ways – a front-end DTI that compares all housing expenses to your income, and a back-end DTI which includes all monthly expenses such as credit cards, car payments, child support, etc. Conventional loans have an upper limit of 28% and 36% for front-end and back-end DTI respectively. FHA/VA programs can accept higher numbers, if you qualify.
You can keep the back-end DTI low by keeping credit card balances low – balances over 35% of the credit limit are considered dangerous by most lenders. Don't open any other credit accounts while you are in the mortgage application and approval process.
If the front-end DTI is too high, you may be trying to buy too much house for your income. Which leads us to….
- Size of Home – If you don't have the money to handle the down payment, closing costs, and running expenses of the house you want, either continue to save and wait, or scale back your housing ambitions.
Lenders will be looking at the Loan-to-Value ratio, which measures your equity (in this case, your down payment) compared to the value of the house. It is possible to put down less than the standard 20% down payment, but that increases your monthly expenses (through required private mortgage insurance and increased interest rates) and increases your chance of rejection.
You can consider program loans such as FHA/VA loans to extend your purchasing power, if you meet the qualifications.
- Document Income – Banks are sensitive to gifts that could be interpreted as back door loans, increasing your debt and thus your risk of default. Any down payment gifts from parents (or anyone) must have a clear paper trail with a signed letter verifying that it is a gift and not a loan. Large deposits, such as contractor payments for the self-employed, will also raise suspicion.
- Paperwork Preparation – Understand the loan process and what is needed and required from pre-approval through closing. Have your paperwork compiled in advance, such as tax records, W-2/1099 forms, proof of account balances and retirement programs, and similar documents. If there is paperwork you need that you cannot find or access, you can rectify it before making your application.
Remember to consider things from the lender's point of view. They look at your income and debts (can you pay your mortgage?), credit history (are you likely to pay your mortgage?) and your equity (have you invested enough to make repayment likely?). Think like a lender, and you should have no problem getting through the approval process on time – and with your sanity intact.