Whether you’re in a buyer’s or a seller’s market, you'll want to buy a home as soon as you come across the right one. But it's not always that simple. There are many financial issues that will determine whether you'll be able to purchase the house, as well as the terms of your mortgage.

Understanding this information well in advance may help you make better decisions and will make your mortgage approval process to go smoothly and quickly.

Read on to find out more about how you'll need to be positioned financially before you sign your real estate contract.

Key Takeaways

  • Make sure you have a sizeable down payment to put down on your new home.
  • Shop around for an affordable interest rate.
  • Ensure you have an acceptable credit score and a debt-to-income ratio below 43% before you apply for a mortgage loan.
  • Pay your closing costs immediately.
  • Ask the lender what documents you'll need to ensure there are no problems with your application.

A Sufficient Down Payment

Make sure you have enough liquid capital saved up to put down on your new home. Your dream of homeownership can quickly get dashed if you can’t provide an adequate amount of money for your down payment.

Lenders have tightened the requirements since the economic crisis in 2008,” says Karen R. Jenkins, president and CEO of KRJ Consulting. “As a result, prospective borrowers seeking to purchase a home must have some ‘skin in the game’ to qualify for a home.” According to Jenkins, most loan programs, including an FHA mortgage, require a minimum down payment of 3.5% of the purchase price.

You may have known people who purchased homes in the past without a down payment or you may have even been one of those people. That's a much less likely scenario today, as banks are trying to limit the risk of borrowers defaulting.

For example, when real estate values go down, a borrower who puts their life savings into that property is more likely to hang on and ride out the storm, waiting for property values to rise again. “A borrower with skin in the game is less likely to default when the going gets tough,” according to Stacey Alcorn, owner and Chief Happiness Officer at LAER Realty Partners.

An Affordable Interest Rate

There's a very good chance that you'll pay tens of thousands of dollars in interest alone over the life of your mortgage. That's why it's so important to find a loan with a low-interest rate. This can save you thousands of dollars in the long-term.

Make sure you shop around. Don't sign with the first lender that gives you a quote. Start off by checking with your own financial institution. You may be able to get a competitive rate because you already do business with them. And don't rule out credit unions, small community banks, and even online lenders. The more lenders you check, the more likely it is that you'll get a really good rate.

A great tool for researching and comparing interest rates is a mortgage calculator. This tool gives you an idea of your potential costs before you even meet with a mortgage broker.

A Minimum Acceptable Credit Score

Your FICO score reflects your ability to repay your debts. Maxing out your credit cards and paying your bills late can be another financial stumbling block for potential homeowners who need a mortgage. If you have a bad credit score or, even worse, no credit history at all, there's no way you'll qualify for a mortgage.

FICO scores offer the bank insight into your ability to pay your monthly bills and how much overall debt that could potentially impact mortgage payments down the line. But what is considered an acceptable FICO score? It can often be difficult to assess because it varies based on which lender you ask.

Amy Tierce, a senior loan officer with Radius Financial Group, notes that although the Federal Housing Administration (FHA) offers financing options to borrowers with a credit score as low as 500, most lenders have their own requirements. So it will be a challenge to find a lender who'll work with a borrower with a credit score below 640.

However, maxed-out credit cards aren’t your only concern. “If you are consistently 30, 60, or 90 days late on your other bills, your credit scores will again be low, and banks don't want to lend money to someone they will have to beg for their money constantly,” Alcorn says.

Your Debt-to-Income Ratio

Homeowners who overextend themselves may end up eating ramen noodles every day in a house they may eventually lose. This is why it's important to be realistic about what you can afford. You can figure this out by adding up all your monthly debt payments and dividing that figure by your gross income each month.

You can calculate your debt-to-income ratio by dividing the total amount of your monthly debt payments by your gross monthly income.

"Banks use a debt-to-income ratio (DTI) to determine if a borrower can afford to purchase a home,” Alcorn says. “For example, let's say a borrower earns $5,000 per month. The bank doesn't want your total debt, including new mortgage payment, plus your car payments, credit card payments, and other monthly obligations, to exceed a certain percentage of that income.”

The Consumer Financial Protection Bureau has rules stating that the debt-to-income ratio cannot exceed 43%.

But Alcorn warns that just because the bank feels you can afford a particular mortgage payment doesn't mean you actually can. “For example, the bank doesn't know that you have a large family, or childcare costs, or aging parents that you’re caring for. It's important to have a candid conversation about your monthly payments with your mortgage team so that you don't get in over your head," says Alcorn.

Being Able to Pay Closing Costs

There are a number of fees associated with a home mortgage, and you could be in for a rude financial awakening if you don’t know what to expect in advance.

Although closing costs vary from lender to lender and from state to state, “borrowers pay for the appraisal, credit report, attorney/closing agent fees, recording fees, and processing/underwriting fees,” Alcorn says, adding that closing costs are usually 1% of the loan amount.

However, the fees could account for as much as 3%, and lenders must provide borrowers with a comprehensive good faith estimate of the fees you may incur on a specific type of loan.

The Required Financial Documentation

Making sure you have all your ducks in a row before you apply for your mortgage will help the process go much smoother. Insufficient documentation can delay or even stop the loan approval process altogether, so you need to find out what you have to bring to the table.

“Your lender should have a full and complete checklist of required documentation to support your loan application depending on your employment and income situation,” Tierce says. “If you are starting with a pre-approval, be sure that the lender asks for all documentation for the process since a pre-approval without thorough documentation review is useless. Something can be missed that could result in your loan being declined later if the pre-approval process is not extremely well documented.” 

What is pre-approval? According to Jenkins, it's "preliminary approval based on what the borrower stated on the application—income, debt, assets, employment, etc. The actual approval process validates the income, assets, and debt using various methods such as pay stubs, tax returns, bank statements, W2s, and employment verifications.”

Tierce adds that “in competitive markets, sellers and realtors won’t even consider an offer without knowing that the buyer is pre-approved.” Additional documents could be requested at a later date or throughout the process. “The underwriting process is exhaustive, and some documents may bring up questions or concerns that require additional documentation. Just take a deep breath and give the lender everything they ask for, as quickly as possible, to get your approval completed.”

The Bottom Line

Before you can think about buying your dream home, you need to be sure that your finances are in order and that you've prepared wisely and thoroughly before the mortgage-approval process even begins.