The Golden Rule in the world of loans is pretty simple: "He who has the gold, makes the rules."
The bank has the gold, and you need it to buy your first home. The bank literally holds the keys to your castle. So what does it take to get your loan approved? As a first-time homebuyer, it's probably a lot simpler than you may think.
Part 1: Income
Your income is the primary tool you have to repay your loan. That's why the bank cares so much about it. The bank wants to see that you have stable and reliable income. It wants to understand where your income comes from and how likely it is to continue.
That means the bank wants to see proof that your primary job, part-time jobs, overtime, bonuses, commissions, and any other sources of income you may have add up to a level that can easily cover your monthly payments. Generally speaking, the bank will ask to see tax returns, W-2 forms, or sometimes even pay stubs to verify all that income.
Working consistently at the same job is also a plus to banks. It shows that your income is stable and continuous. It also indicates your commitment to your responsibilities, which will will soon include paying a mortgage on time every month.
Part 2: Your debts and debt history
Having strong income is the first half of the equation. The second half is how much debt you have now and your history of paying debts in the past. Why does the bank care about your past payment history? Because, like it or not, history does tend to repeat itself.
The bank will ask you to disclose all of your existing debts. Don't hold anything back, because the bank will also review your credit report to double-check. If you always pay your bills on time and you don't have an excessive level of debt, then you should be fine.
Knowing that the bank will be checking your credit report, it's a really smart move to check your credit report in advance for any possible mistakes. You can do that for free at AnnualCreditReport.com.
Part 3: With your income and debts, how much can you afford?
The bank uses two primary calculations to analyze the relationship between your income and your debt, and to then determine whether you can afford the loan.
The first is the debt-to-income ratio. This is the percentage of your monthly income before taxes that is spent on all of your monthly debt -- including your new mortgage loan. Generally speaking, banks require this ratio to be at or below 40%.
The second ratio is the housing-to-income ratio. This is similar to the debt-to-income ratio, except it only shows the percentage of your monthly income that is spent on your housing. In this case, that would be your new mortgage payment. Guidelines vary from bank to bank, but a ratio of 28% or below is usually considered satisfactory.
Part 4: The backup plans
In life, things sometimes go wrong. There could be layoffs at work, an illness in the family, or hundreds of other problems that could arise that could cause you and your family financial hardship.
The bank also needs to establish the backup plan in case one of these unforeseen and unfortunate events occurs. The backup plan is twofold.
First, the bank wants to see if you have the financial resources to continue making payments if your income were to temporarily stop. It will want to see how much money you have in your checking and savings accounts, any retirement savings you may have, other brokerage accounts, and any other assets you have that could be easily sold to make your mortgage payment.
Don't forget, some of these funds will be required for a down payment on your home and to pay closing costs. So the bank will review your assets net of those costs. For example, if you have $35,000 in cash and want to make a down payment of $30,000, that only leaves you $5,000 in rainy day money and for closing costs. That's cutting it pretty close.
And the final backup plan is, of course, to sell the home. The bank will require a professional appraiser to determine the value of the house before your loan is approved, and any loan the bank does approve will be capped by the home's value. Traditional mortgages are limited to 80% of the home's value, but special programs exist that allow for smaller down payments.
The reason is simple -- if the home is sold, the bank wants to make sure it will sell for enough cash to pay off the debt in full.
As a first-time homebuyer, remember to keep it simple
If you ever begin to feel overwhelmed by the process, try to remember to take a step back and consider the big picture. In that light, the entire process is very logical.
The bank wants to give you a loan -- lending is how the business makes money. But the business only succeeds so long as loans are paid back. Every step in the mortgage application process is designed to make sure that you are capable of paying back the loan. As long as there are no red flags, your mortgage will most likely be approved.
So what's the best way to make sure your loan will be approved? Ask yourself the same questions the bank is asking: Do you have sufficient income without excessive debt? What's the backup plan? And finally, if the backup plan fails, can you sell the house for enough to pay off the debt?