At first glance, mortgages may look like an endless, rolling sea of numbers. And truth be told, understanding how to qualify for a home loan is enough to make most home buyers feel like they’re melting in a Dali painting.
But that doesn’t mean the math has to be surreal—all you need is our handy primer to help you decipher the main figures that you really should understand. A basic understanding of how a home loan works can save you major money and ultimately afford you more house.
So be sure to find a lender and Realtor® who are happy to answer all your questions. We’re here to help you avoid a meltdown. Let’s paint the big picture on the core mortgage qualification elements: Credit score, debt-to-income ratio, and down payment.
CREDIT / FICO SCORE
What’s Really Required:
Fannie Mae recently released their survey, “What do Consumers Know About Their Mortgage Qualification Criteria?” The study revealed that Americans are misinformed about what is really required to qualify for a mortgage when purchasing a home.
To help correct the misunderstandings, let’s take a look at the survey results compared to the latest Ellie Mae Origination Insight Report, which focuses on recently approved loans.
- 59% of Americans either don’t know (53%) or are misinformed (6%) about what credit / FICO score is necessary to qualify.
- Many Americans believe a ‘good’ credit score is 780 or higher– It’s typically what you need to qualify for the best interest rates on a mortgage. Yet over half of approved mortgages had a credit score of 600 – 749.
Not sure if your own credit is in such good shape? Go to AnnualCreditReport.com, where you can get a free copy of your report every 12 months from each credit-reporting company. There are three major U.S. credit bureaus (Experian, Equifax, and TransUnion), and each releases its own credit scores and reports (that are used to determine your score). Their scores should be roughly equivalent, although they do pull from different sources. Your report is a detailed list of all debts and liabilities and payment history. The actual numeric score isn’t included though—you’ll have to pay a small fee for that.
There are steps you can take to boost your score, including getting errors on your credit report removed, pay off some debt (no brainer!) and increasing (no, that’s not a typo) the spending limits on your credit cards. A cool loophole is to ask your credit card companies to increase your credit limit.
Having $1,000 of credit card debt is bad if you have a limit of $1,500. It isn’t nearly as bad if your limit is $5,000. The simple math: Although you owe the same amount, you’re using a much smaller percentage of your available credit, which makes you look like you have conservative borrowing practices– not a maxed-out free spender.
DEBT TO INCOME RATIO
Your debt-to-income ratio is the big picture of what a lender looks at to determine how much house you can afford. Getting a ballpark estimate of how much home you can afford boils down to how much money you’re pulling in. The general rule of thumb is that you can purchase a home that costs roughly three times your annual salary.
So if you’re making $72,000 per year (and you have a reasonable amount of job security), that means you can afford a house that costs $216,000. That said, this is only an estimate and does not account for your monthly bills. So let’s dive into more specifics…
The standard, 36% debt-to-income-ratio rule compares how much money you owe (for long-term debts like credit cards, college loans, car loans, child support and—hopefully soon—a home loan) to your income. Conservative experts say this ratio should be no more than 36%.
Think about it in terms of your monthly expenses… Once you know the numbers, as well as how much of a down payment you plan to contribute, you can plug them into realtor.com’s Home Affordability Calculator to find out the maximum monthly mortgage payment you can afford—and by extension, the priciest house you should buy.
From the above example, the $72K salary equates to $6K monthly. If you pay $500 in debts (pre-house), and can make a down payment of $40,000, if you get a 30-year fixed mortgage at 3.5% interest you can afford a house worth $255,700 (almost $40K more than the general rule of thumb).
A word of optimism…
These “rules” and calculators are a good guide, but many other things can come into play during the loan qualification process– in your favor. Firstly, geographically-variable things like the actual property taxes and homeowners insurance tab for a specific house can differ greatly even in the same metro area. (For instance, when we lived in hurricane-prone Florida, our homeowners insurance cost $6400 a year! Our current insurance is $1100 in Texas, but in another neighborhood that we considered living in across town, the insurance would’ve been $900 more.) These all tally into your total ‘mortgage payment’: PITI or Principal, Interest, Taxes and Insurance.
Having other savings /financial assets or a car loan that is not far from payoff can sway conventional lenders’ willingness to nudge up the debt-to-income ratio percentage too. There are also VA (Veteran’s Administration) loans and FHA loans that allow up to 43% DTI ratio.
According to the same studies, 76% of Americans either don’t know (40%) or are misinformed (36%) about the minimum down payment required. Many believe that they need at least 20% down to buy their dream home. New programs actually let buyers put down as little as 3%. Below, the chart shows that all types of buyers typically put less than twenty percent down.
Whether buying your first home or moving up to your dream home, knowing your options will definitely make the mortgage process easier. Your dream home may already be within your reach! Call me anytime with questions. I can also get you pointed in the right direction for a vetted, expert mortgage consultant that fits your needs. 512.676.0824 ~ Gina