Applying for a mortgage can be a daunting process for new homebuyers. The best way to prepare for it is to know exactly what lenders want from you -- as well as what they don't want. With that in mind, here are nine of the most common reasons mortgage applications are rejected.
1. Your credit score
Any prospective lender will run a credit check, and all lending programs have minimum credit score requirements that depend on how much you're putting down, how much you have in savings, and other factors.
Conventional mortgages require a bare minimum FICO credit score of 620, and FHA mortgages require a 580 if you're only putting 3.5% down. Some lenders impose higher standards than these minimums. It's certainly worth checking your FICO scores before applying, and if your score isn't stellar, check with your lender to find out their minimum requirements. If you don't meet them, then it's time to start working to improve your credit score. Even if you do qualify for a mortgage, it may be worth waiting a year or two while you raise your credit score; this will allow you to qualify for a lower interest rate, which could save you thousands of dollars throughout the life of the loan.
Be sure to check your FICO score from all three credit bureaus. Lenders typically pull all three and use the middle score. I've bought three homes in my life, one with an FHA mortgage and two with conventional loans, and this method was used all three times.
2. Black marks on your credit report
In addition to your FICO score itself, lenders take a closer look at the information on your credit report. If you have collection accounts or unpaid legal judgements, for example, your lender may require that you pay these off, or at least document a valid reason why they exist.
The same goes for things like foreclosures, bankruptcies, short sales, previous late mortgage payments, and any other information suggesting that you haven't always kept up with your debts. Even if you qualify based on your FICO score, these things could get in the way of a smooth mortgage approval process.
3. Your income
As you might expect, lenders want to know that you earn enough money to afford your mortgage payments. Lenders will divide your expected mortgage payment -- including principal, interest, taxes, and insurance -- by your income. The result is known as the front-end ratio, and the industry standard is 28% or less, although many lenders will approve applicants with higher housing costs, especially in high-cost-of-living areas. If a mortgage would put your front-end ratio above 28%, then you should probably apply for a lower amount -- or spend some time working to raise your income.
4. Excessive debt
In addition to your income, lenders will consider your other debts as well. Specifically, any monthly obligations, such as car loan payments, student loan payments, and the minimum payments on your credit cards will be considered, just to name a few.
This is added to your expected mortgage payment, and the sum is divided by your income to calculate your back-end ratio, a.k.a. your debt-to-income ratio. Lenders traditionally like to see a DTI ratio of 36% or less, but it's possible to get approved with much higher DTI ratios. In fact, a recent rule change allows for DTI ratios of up to 50% in certain cases, specifically to allow consumers with high student loan debt to buy homes.
5. Your employment history
Your lender wants to know that you have a steady stream of income to make your payments with, and they also want to see a consistent employment history. Generally, a lender will want to see at least two years of continuous employment, preferably in the same field. In other words, if you've hopped between several different jobs over the past couple of years, or if there are significant gaps in employment (think a few months or more), then it could work against you.
Also, if you were in school more recently than two years ago, you're typically exempt from this requirement, although your lender will want to see a steady employment history since you graduated.
6. New debts after you apply
This is one of the most common reasons you could be denied a mortgage after you've already been approved.
When you get a mortgage, your lender will typically pull your credit report and score at least twice -- once when you initially apply for the loan, and again shortly before closing. Any significant discrepancies between the two can create a problem, especially if the recheck shows that you've opened new credit cards, charged large purchases, or done anything else that could significantly raise your debt-to-income ratio or lower your credit score.
There are several big expenses that typically come with buying a new house, such as furniture. Wait until after closing to finance any of them.
7. A too-small down payment
It's a common myth that you need 20% down to buy a home. However, although you can qualify with a tiny down payment, paying 20% down can certainly make things easier for you in the long run. You can obtain a conventional mortgage loan with as little as 3% down or an FHA loan with as little as 3.5% down. However, unless you are planning to get a VA loan, USDA mortgage, or some other type of special loan, you'll probably need to put something down.
Closing costs are another upfront expense that will typically cost anywhere from 2% to 5% of the home's selling price, and a lender will want to see that you'll have enough money for your required down payment and any closing costs. In addition, you may be required to show that you have some money in reserves -- six months' worth of mortgage payments is a common threshold.
8. A lack of documentation
Even if you have more than enough income, a rock-solid employment history, and tons of money in savings, none of those will help you obtain a mortgage unless you can adequately document them. If you work for an employer, and you keep your money in a savings account, this shouldn't be an issue, but for self-employed individuals (especially who deal in cash often) and in certain other situations, it can be tough to thoroughly document everything.
9. Issues with the home itself
Finally, another common reason for mortgage denial is a problem with the home itself. Lenders want to make sure the home is actually worth what you're paying for it so that in the unlikely event that you fall into foreclosure, the lender has an asset it can easily sell to recoup its money. Therefore, if the home doesn't appraise for enough, it can create a problem. You may need to put more money down or try to negotiate a lower selling price that's in line with the appraisal.
Condo buyers can be denied because of HOA concerns -- specifically, when not enough of the units are owner-occupied. And if the property you plan to buy is simply in poor condition, it could be a cause for denial.
The bottom line here is that there are several potential roadblocks you can face when applying for a mortgage. Some of these can be dealt with fairly easily, while others could be immediate deal-breakers.
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