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Buying a home is an exciting process in which choosing the right loan is as important as choosing the right home. There are a few factors to be considered before buying a home and starting the mortgage application process. There are certain steps that you may take to make your mortgage application look stronger and get the desired loan terms. Lenders carry out a comprehensive process in determining your loan eligibility and affordability based on your income, credit history, credit score, employment, down payment etc to determine your interest rate and other loan terms.
Saving for a Down payment and Closing Costs
First step in home buying process is figuring out a rough estimate on your affordability and saving for a Down payment. The affordability usually depends on your income, current monthly expenses, interest rate etc. The amount of down payment needed may vary from 3% - 25% or more depending on the loan type unless you are eligible for a VA loan where no down payment is needed. Generally.
With a conventional loan, you will need at least 3% down payment with Private Mortgage Insurance.
With FHA loan, you will need at least 3% down payment
With VA (Veterans) loan, you can obtain with 0% down payment.
Private mortgage insurance is a special type of insurance that protects the lender until the equity reaches 20%, then it is usually removed. These low down payment percentages are only possible if you meet certain standards. Everyone's financial situation, credit score, debt to income ratio, Type of lender etc are different. So, the loan terms and interest rate, down payment differ accordingly. Gift funds from family and friends may be used as the down payment. At least 2 years of employment history in a same profession is preferred for the eligibility of loan by many lenders.
Debt to income ratio
The ability to repay the loan cannot be decided by considering only the income. There are also other expenses to be considered while deciding the debt to income ratio. Lenders calculate other expenses that are obligated to be paid by you. These are some of the fixed payments that may have to be paid every month.
Auto loan
Student loan
Credit card payments
Alimony or child support payments
Mortgage, Property Tax, HOA
They also take into account other income factors while calculating the ratio. These are considered as the fixed income received every month. So, if there are only 6 months left in the child support payments, they may not be taken into consideration. Only payments that are known to last at least for 2 years are usually taken into consideration.
Alimony or child support payments
Rental income
Extra income from side hustle
commissions or overtime
Social security payment benefits
Benefits for the disabled
Military benefits.
Debt to income ratio is calculated by the lenders to make sure that you have the ability to repay the loan in a timely manner. By including your other income sources and excluding your other payment obligations from your original monthly income, Gross monthly income is calculated. The monthly payments doesn't include household expenses like utilities, gas, cable, cell phone plans etc. The lower the debt to income ratio, you are considered as an efficient borrower by the lender.
There are two types of Debt to income ratio, Front end and Back end.
Front end = Percentage of your income that will go towards your mortgage payment each month.
Back end = Percentage of monthly income that will go towards all the monthly expenses along with your mortgage.
The ratios max allowed vary depending on the type of loan and lender.
Improving your Credit Score
A credit score consists of three digits and they typically range from 300 - 850. This helps as an estimate of how likely are you able to repay your debt, how likely are you to pay your bills on time, credit risk, etc... The score is calculated from the transactions of your credit accounts. These transactional data are collected by the Credit Reporting agencies, which are also called as Credit Bureaus. The 3 major Credit Bureaus are Experian, TransUnion and Equifax.
Typically, credit score ranges from 300 - 850. This number helps show how Creditworthy an individual is. This score is based on the credit history. Lenders use this score to evaluate the credit risk, how likely is the individual capable to repay the debt on time. Everyone's financial situation is different and the lender's criteria for granting the credit also varies.
Conventional Loan - Usually if you maintain a credit score 740+, you may be eligible for the conventional loan with good interest rate. However, most of the conventional loan providers accept a credit score of 620 and above, but the interest rate is decided accordingly.
FHA Loan - You may be eligible for a FHA loan with a credit score of 580 and above. Some lenders may give you loan for as low as 500 credit score, if you are able to increase the down payment from 3% to 10%.
VA Loan - You may be eligible for VA loan with a credit score of 620 and above.
Credit monitoring services are a good way to track the changes in your credit report. It may also help you in protecting against Identity theft and fraud. You may receive updates regarding the loan that has been paid off or new account opened etc. If you receive an alert for an activity that hasn't been done by you, you may report to the credit bureaus immediately for a suspected fraud. Experian, Credit wise etc provide credit monitoring services.
Choosing a Longer Tenure
Another way to increase the eligibility for the loan is choosing a loan term with longer tenure as they tend to have lower EMI compared to the short term loans. From the lender's point of view, you are more likely to pay loan on time if your monthly payment is lower. But, it may in turn cause you to pay higher interest rate and higher total interest payments on the life of the loan.
Getting Pre-approval beforehand
If you decide to house hunt soon, it is a good idea to get pre-approval beforehand. This is a letter from the bank / lender who verifies your credit score, overall monthly expenses, figure out DTI, financial stability etc to come to a decision about your affordability and the maximum amount the bank is willing to lend you for your home purchase. Once, you get a pre-approval, you may start looking for homes within that range.