So you've finally decided you're ready to become a homeowner, or maybe upgrade from your starter home. When you've made the choice to look for property, your first step should be to get preapproved for a loan by a mortgage lender.
Mortgage lenders have specific criteria they consider when determining whether to grant someone a loan and when deciding the terms of the loan, including the interest rate. You'll want to make sure your finances are in order so you don't get rejected by your lender. The best way to set yourself up for preapproval is to focus on the five key financial metrics lenders value most.
1. How does your income compare to the amount you want to borrow?
Lenders worry about providing mortgage loans that will make you "house poor," which means you'll spend too large a percentage of your income on your home loan. A good rule of thumb lenders apply is that your total housing cost -- including your mortgage, property taxes, and homeowners insurance -- should be less than 28% of your income.
If you're not already carrying much debt, mortgage lenders will sometimes allow your housing costs to account for a slightly larger percentage of your income. But the bottom line is that a lender won't let you overextend yourself to the point where a minor financial setback could cause you to miss payments.
2. What's your total debt load?
Your mortgage debt isn't the only concern lenders have about your financial situation. If you've maxed out your credit cards or are otherwise in over your head with debt, don't expect a lender to approve you for a mortgage. For most lenders, the maximum allowable debt-to-income ratio is between 36% and 43%. If your total debts -- including the mortgage you're applying for, other housing costs, and all other owed funds -- exceed this amount, you may be unable to get a loan.
3. Do you have good credit?
Lenders want to know that you're not drowning in debt and that you've been responsible with your debts over the course of your life. Your credit score is the key indicator mortgage lenders use to determine whether you're a responsible borrower who will pay the bills on time.
A credit score above 740 will have banks competing to lend to you and offering the best mortgage terms. However, if your credit score is below 620, you'll likely be denied a mortgage loan. While some subprime lenders may be willing to lend at a high interest rate, it's far better to take steps to improve your credit -- like establishing a positive history of on-time payments -- than to struggle to find a loan with disadvantageous terms.
4. Can you prove you've been steadily employed?
The likelihood that you'll stay employed is a big concern to lenders, who worry the mortgage bills won't be paid if you leave your job. Mortgage lenders again look to your past behavior as a predictor of the future. If you've been employed for just a month when applying for a loan, or if you have a history of repeatedly bouncing from one job to the next, this raises red flags that could result in a loan denial.
Most mortgage lenders want to see two years of steady income. If your income increased dramatically in the past year, the mortgage lender may not give you full credit for your newly generous earnings. For instance, if you made $50,000 last year and $100,000 this year, the lender may treat your income as if it's just $50,000 -- especially if you are self-employed.
5. How big a down payment can you make?
Some mortgages allow you to put just 3% down. However, if you borrow more than 80% of the value of your home, you must pay private mortgage insurance (PMI). This unnecessary expense can cost you more than $100 per month. PMI is meant to protect the bank in the event you need to sell your home and can't get a high enough price to pay off the mortgage. Note that PMI does not protect you in this event.
If you buy a home with a low down payment, not only will you waste cash on PMI, but you'll also be in trouble if home values fall and you need to refinance or move. If you owe more than your home is worth, you could be trapped in your house unless you can bring cash to your closing to make up the difference between what you owe and what a buyer is willing to pay.
Yes, there are some circumstances in which you could justify buying a home with a small down payment and paying for PMI. If you believe interest rates or property values are likely to increase substantially before you save up for a down payment, then buying without one can make sense. You may have family reasons to need a home as well, although you're taking a big risk with your financial stability unless you're confident you'll be staying in the home for a while and will have cash to bring to the closing if necessary. However, if you can wait until you've saved at least 20% of the value of the home, you can reduce your risk and get a lower-cost loan with more advantageous terms. Many good things in life are worth waiting for, including the right home at the right cost.
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