Before you go shopping for a new home, you should be reasonably certain of what you can afford, as well as whether or not you'll qualify for a mortgage. When evaluating your loan application, a lender will look at several categories of information. And, here is what you need to know about how that information is used.
How a lender uses your credit report and score
When a mortgage lender checks your credit, your score is just one piece of the puzzle. They will generally look at all three of your FICO credit scores (usually more than once during the process), and use them all in their decision in one way or another.
Most lenders use the middle of the three scores, and others average them together or use the lowest. And, the actual score needed varies depending on your lender's preferences and the type of loan you're applying for.
Even if your score is sufficient, you can expect the lender to go through your credit report very closely, especially if you have any derogatory information. You'll probably have to pay any outstanding collection accounts, even if they are several years old, and you may need to provide a written explanation of any issues, such as "I missed a student loan payment in 2011 because..."
And, you'll be expected to explain any recent credit inquiries and whether or not any new credit resulted from them. As you'll see in a minute, your other debts will play a role in the decision process, so lenders want to know if you have been attempting to borrow any more money recently.
Do you make enough?
Most people are aware when applying for a loan that your income needs to be high enough to justify the loan. But how much is enough?
Lenders look at two income-related numbers when making decisions. The first is known as the "front-end ratio." Basically, this is the amount of your expected mortgage payment (including taxes and insurance) divided by your income. So, if you make $5,000 per month and your mortgage payment is expected to be $1,500, your front-end ratio is 30%.
Generally, lenders want this ratio to be 28% or less, but there are exceptions. For instance, if the home you want to buy is in a high cost-of-living area like New York or Hawaii, it's usually expected that a greater percentage of your income will go toward your housing payment.
The front-end ratio can also be bent in some cases if your other qualifications are extremely high. So, if you have an excellent credit score, flawless employment history, or don't have much other debt, chances are good that this limit can be stretched.
Who else do you owe money to?
The other income and debt-related metric is called the "back-end ratio", which is the total of all of your debts, including your expected mortgage payment, relative to your income. So, if you make $5,000 per month, owe $500 per month on your other debts, and expect your new mortgage payment to be $1,500, your back-end ratio is 40%.
As a rule of thumb, lenders like to see a back-end ratio of 36% or less. However, just like the front-end ratio, this can possibly be stretched for high cost-of-living areas or excellent qualifications.
Your lender will calculate both ratios to determine the maximum mortgage payment you can afford and will take the lower of the two payment amounts into consideration. For example, if you have no other debts whatsoever and make $5,000 per month, 36% of your income is $1,800. However, because the front-end ratio's 28% guideline limits you to $1,400, that's the number your lender will use.
How's your history?
As far as employment histories go, the basic guideline is that lenders want two years at your job. And, just like the previous topics, there is some "wiggle room" here as well.
For example, if you left one job to accept another in the same field, you should be OK as long as there are no significant gaps in your work history. However, if you left a job and it took you a few months to start another, it can be a problem.
And, if you were in school when the two-year period started, that should be OK too. In other words, if you graduated college a year and a half ago and have been steadily employed since then, the two-year requirement shouldn't apply to you.
How much do you want?
One other consideration is the size of your loan. Loans for under $417,000 (more in high-cost areas) are called "conforming" loans, meaning they are eligible to be purchased by Fannie Mae and Freddie Mac. Since this means a lot less risk for the lender, approval standards are generally lower for conforming loans than for larger, or "jumbo" mortgages.
If you are applying for a large mortgage, expect to be held to a slightly higher standard in terms of credit and employment, and for the debt-to-income ratios to be adhered to more closely.
Know where you stand
These categories of information should give you a pretty good indication of whether or not you'll qualify for the mortgage you want. And, as I've noted previously, weakness in one area can be overcome by exceptionally good qualifications in other areas.
Finally, every lender is different, so talk to yours if you have any concerns. However, if you meet the qualifications listed here, you shouldn't have too much of a problem.
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