Step 3: Get a Loan Pre-Approval
Home buyers should contact a lender before they start looking for a home. This way they know how much they can afford to spend. When you are ready to make an offer on a home, a loan pre-approval can also demonstrate to the seller you are serious about buying a home. Be sure to shop around for a reputable lender and a loan product with rates and terms that work best for you.
Factors included in the mortgage approval process:
Capital: This is the amount of cash you have available. The more cash you have in savings accounts or other places, the more comfortable a lender is that you can afford homeownership.
You will need to show that you have enough capital to pay for the following:
- Down payment
- Loan fees
- Closing costs
- Escrow impounds (advance payments for property taxes and insurance)
- Reserves (money set aside for repairs and maintenance)
- Moving expenses
Capacity: This is your ability to earn enough income to make your mortgage payments and still pay all of your other living expenses. Lenders look at several things to determine capacity including your current income, your income history, your earning potential, and your debts. They compare these to determine your debt-to-income (DTI) ratios. Debt to Income ratios are also referred to as the back-end ratio. It shows how much of your gross monthly income is needed to cover all your debt obligations. Follow these steps to determine your approximate DTI:
- Add up all your debt (including your mortgage, car loans, child support and alimony, credit card bills, student loans, etc.)
- Divide this amount by your monthly gross income.
- Then multiply this amount by 100. This percentage is your DTI.
Current Income: Lenders look at your total household income to see that you earn enough to pay the new house payment and other expenses and still live comfortably. The lender is going to use your gross income to qualify you; however, to be safe you may want to consider what you can afford based on your net income (or take-home pay) instead.
Income History and Earning Potential: Lenders want to know if you have stable income or held stable jobs for the past two years. They also want to know how long you have held your current job and how likely you are to continue to earn comparable or better income.
Amount Owed: The lender will consider your creditor debts, such as monthly payments on loans, credit cards, child support or alimony. These include car payments, furniture payments, and student loan payments. Other monthly expenses such as utility bills, auto or life insurance and groceries will NOT be included in your total debt.
Credit: To check your credit history, the lender will get a copy of your credit report and credit score from the three major credit bureaus: Experian, TransUnion, and Equifax. This is how the lender determines how you have handled other debts and how likely you are to repay your home loan.
What is a Credit Score? The credit score is a number grade attached to your credit report. This is a factor that creditors consider to decide whether to approve your application for a loan or credit card as well as how much credit to extend and at what interest rate. The higher your score, the better. Scores range from 300-850.
What Determines Your Credit Score?
- Your payment history - What is your track record?
- The amount of outstanding debt - How much is too much?
- The length of your credit history - The longer the better.
- The types of credit you use – Is it a healthy mix of installment, credit cards, etc.?
- New Credit - How many new accounts have been opened lately? Too many in a short period of time can be trouble.
No Credit or Bad Credit? Beware of “Quick Credit Fixes”. Most of the companies that make these claims charge you money for things you can do on your own. Nonprofit financial counselors are available to help you for little to no cost. Find a financial counselor near you.
Requesting Your Credit Report. To order a copy of your own credit report, which is a great idea to review and correct errors, you can visit www.annualcreditreport.com. A free copy is made available once every 12 months. It will not include your FICO score.
Reviewing Your Credit Report. Check your identifying information (name, current address, social security number, date of birth) to ensure it is correct. Details about your credit card accounts, car loans, etc. should be reviewed for errors. Public information such as bankruptcies, foreclosures, tax liens and judgments will be listed on your report under the public record section. Inquiries that you have initiated will be listed on the report as well. These include companies that obtained a copy of your credit report within the past two years because you applied for credit.
Ordering Your Credit Score. Home buyers can obtain a copy of their credit report and FICO score by visiting www.myfico.com. There is a charge for obtaining your FICO score. Housing Counselors working for a non-profit, government entity, or community based organization can also provide you a copy of your credit report as well as guidance when reading through it.
Collateral: Your new home will be collateral for your loan. The lender will look carefully at the value and condition of the house to ensure it is worth as much money as you are borrowing. This is done through an appraisal.
- The appraiser uses his or her professional training to estimate the fair market value of the house you want to buy. Because lenders want you to invest some of your own money in the house, they will generally lend less than the fair market value. The fair market value is used to calculate your loan-to-value ratio (usually described as a percentage), which is the loan balance you owe, compared to the appraised value of the house.
- Lenders review the appraisal and inspection report to determine fair market value and to make sure the house is in decent condition. If the appraisal or inspection report shows that any of the major parts of the house are not in good shape (for instance, the house needs a new roof), the lender may only agree to make the loan if the roof is replaced first. This is called a property contingency. It is for your protection as well as the lender’s.