Would you like to move from renting a home or apartment to owning your own? The first step is to apply for a mortgage, but how do you know ahead of time if you’ll qualify?
If you are interested in buying a home or business, you must first qualify for a mortgage to afford the real estate you want to purchase. Affordability and pre-qualification for a mortgage loan are important considerations. You must consider your income, expenses, and credit history when determining whether you can afford a mortgage.
To determine whether you qualify for a mortgage, you must first determine how much debt you can handle. You should take your monthly income into account since you will be paying your mortgage monthly. According to conventional wisdom, you should apply one-third of your monthly income to your mortgage.
The Importance of Your Credit Score
45% of your monthly income applied to a mortgage is acceptable for some potential buyers and lenders, but those who are more cautious would prefer a mortgage payment that is less than 25%.
If you are applying for a mortgage, keep in mind that your lender will first check your credit score, or FICO score, from the three major credit reporting agencies: Equifax, Experian, and TransUnion. You are more likely to get a loan with a high credit score, and your interest rates are likely lower.
Factors that Determine Your Credit Score
A higher score implies that banks will perceive you as less of a risk. Thus you will be offered more favorable terms for the loan. The following factors determine a credit score:
- Your outstanding debt
- Your ability to make timely payments
As long as you do not have a lot of outstanding debt and make your payments on time, you will likely have a higher credit score. On the other hand, if you have a lot of debt and always make late payments, your credit score is likely to be lower.
Lenders look at your household income as one of the first things they consider when considering your loan application. To buy a home, you do not have to earn a minimum amount. Nonetheless, your lender needs to know that you will be able to pay your mortgage and all your other bills.
It would be best to keep in mind that lenders won’t only consider your salary when calculating your total income. They will also consider:
- Benefits and allowances for military personnel
- Any extra income you earn from a side job
- Child support or alimony
- Investment income
- Social Security payments
Your income must be consistent for lenders to approve your loan. If the income stream isn’t expected to continue for at least 2 more years, they won’t consider it. If your child support payments expire in 6 months, your lender probably won’t consider these as income.
Also, the type of property you want to buy will influence your ability to get a loan. A primary residence is the easiest to purchase. When you purchase a primary residence, you purchase a home you plan to live in for most of the year.
Lenders can lend more money to more people by lending to primary residences because they are less risky. What would happen, for instance, if you lost a source of income or received an unexpected bill? You would prioritize your mortgage payments more. Some government-backed loans are only available for primary residence purchases.
Imagine you want to buy a secondary property instead. Because these properties are riskier for lenders, you’ll need to meet higher credit, down payment, and debt standards. Investment properties are no exception.
If you run into a financial emergency, your lender wants to know that you can continue paying your premiums. Assets can help. Assets are valuable things you own. Examples include:
- Savings and checking accounts
- CDs (certificates of deposit)
- Mutual funds, stocks, and bonds
- IRAs, 401(k)s, or any other type of retirement account
Documentation verifying these types of assets, such as bank statements, may be required by your lender.
The Debt-to-Income Ratio
Your mortgage lender needs to know that you have enough income to cover your bills. Since it is difficult to determine this by looking only at your income, most lenders emphasize your debt-to-income ratio (DTI).
The DTI ratio is a percentage that shows lenders how much of your gross monthly income goes towards required bills each month.
Calculating your DTI ratio is easy. Just add up all of your fixed payments each month. Do not include variable expenses. You can include rent, credit card minimums, and student loan payments.
Do you have recurring debt you pay each month? Only include the minimum payment you must make each month. If you have $15,000 in student loans but only need to pay $150 a month, then only include $150 in your calculations. Utilities, entertainment costs, and health insurance premiums should not be included.
Divide your household’s total monthly expenses by your total pre-tax household income. Include all regular and reliable income from all sources in your calculation. To calculate your DTI ratio, multiply your number by 100.
As a borrower, a lower DTI ratio makes you more attractive. Most loans require a DTI ratio of 50% or less.
Your DTI ratio and your housing expense ratio are often used to determine your mortgage qualification.
PITI stands for principal, interest, taxes, and insurance. It is a rough estimate of the amount you can afford to purchase a home. A lender will use your PITI estimate to determine whether you qualify for a mortgage because it gives them an idea of whether you can afford to repay the loan.
When you know what you’ll owe in each category, you can calculate your PITI yourself. You’ll know if a house is within your reach before you get too enamored with it.
Private Mortgage Insurance
Most people believe they can’t buy a home unless they have at least 20% down. However, this isn’t the case. Depending on your loan type, you can put as little as 3% down on a home. You can even buy a home with no down payment using some government-backed loans. If you want to avoid paying for private mortgage insurance (PMI), you will need at least 20% down payment.
PMI insurance aims to protect your lender if you default on your loan.
PMI offers no protections to you as the buyer, but most mortgage lenders require you to pay it if you bring less than 20% down at closing. By paying down your principal each month, you can cancel your PMI once you reach 20% equity in your home.
When you apply for a mortgage, you should also consider closing costs. Your lender will charge you these fees in exchange for finalizing your loan. You’ll have to pay closing costs based on where you live and your mortgage type.
Closing costs include appraisal fees, attorney fees, and escrow fees. Closing costs will typically equal 3 – 6% of the loan amount. Make sure you have enough money to cover these costs before applying for a loan.
Loan Pre-Qualification and Pre-Approval
You can obtain a pre-qualification letter from your lender once you determine your loan type. An application letter does not guarantee you will be approved for a loan, but it gives you a loan amount for which you are likely to be approved, so you can start looking for a property with that in mind. A lender may decide to grant you a loan for a certain amount after checking your credit and considering your financial situation.
A pre-approval of a loan does not guarantee you will be approved. The lender must also consider other factors before granting you a loan, such as:
- An appraisal of the property,
- A purchase contract, and
- A title report.
Should I Consult an Attorney?
If you have any questions or concerns regarding legal issues during your home purchase, you should consult a mortgage attorney, who can advise you on which course of action to take should any legal problems arise.
Even though most states do not require you to hire a mortgage attorney, it would be beneficial to have legal representation if there are liens or other encumbrances on the property.