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. Knowing this information well in advance will 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.
- 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 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.
“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.
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. “ (But) a borrower who has put zero money down is likely just to walk away from the property and let the bank take it through foreclosure,” says Alcorn.
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 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 tell the bank your ability to pay your bills monthly and how much overall debt you have. If you are maxed out on all your credit cards, your FICO score will be low, and this will hurt your chances of getting financing because banks don't want to lend to someone who is living off credit cards,” Alcorn says.
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, 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. “Collections, bankruptcy, or foreclosure on your credit tells the bank that you have no problem reneging on your debt commitments and, to put it simply, they don’t want to be next.”
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.”
Jenkins agrees, adding that "there are additional expenses involved with owning a home that you may not incur while renting. Be sure to calculate all monthly expenses and debts and let your budget make the final decision regarding what you can comfortably afford to pay.”
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, Jenkins says that fees could be as much as 3%. “Lenders are now required to provide you with a comprehensive good faith estimate of the fees you will incur on a specific loan. The rules are also more stringent on lender’s estimates, and there is very little room for the fees quoted to change at the closing table.” She advises homebuyers to review the good faith estimate and ask questions if they're unsure what a specific fee represents.
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? As per 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.