Your credit score, debt-to-income ratio, loan to value ratio, down payment amount and assets all factor into determining whether or not you qualify for a mortgage. By understanding how these elements interact, you can build up your credit and increase your chances of approval.
When applying for a loan, lenders will pull your credit report from all three major bureaus. This determines the interest rate you qualify for and other details of the loan.
Your Credit Score
Your credit score is a number that assesses your financial health and helps lenders decide whether you’re an appropriate risk for borrowing money. It ranges from 300 to 850 and is calculated based on information from your credit report. Your score plays an integral role in determining mortgage eligibility and can save money over the life of the loan.
Your score is calculated based on a mathematical formula that analyzes the information in your credit report. Each lender may use different scoring models, so be sure to know which one they utilize before applying.
Credit scores take into account factors like payment history, amounts owed and length of credit. Keeping debt balances low, paying off old bills and avoiding new credit applications are all effective strategies for raising your credit score.
A lower credit score can result in higher interest rates and payments on a home loan, as well as restricting your borrowing power and necessitating you to purchase mortgage insurance policy, which is mandatory when making down payments of less than 20%.
Lenders will also consider your debt-to-income ratio (DTI), which is the amount of monthly payments on debt compared to your income. Ideally, this should be below 36 percent; however, some lenders may accept more with a higher down payment.
Your credit score can make lenders more lenient when considering other aspects of your application. Plus, having a high credit score may enable you to qualify for lower down payments on loans, saving thousands in interest over the life of the loan.
Another factor that could influence mortgage approval is your employment history and income level. Lenders use these figures to assess both your likelihood of repaying the loan as well as whether or not you pose a risky borrower overall.
You can improve your credit score by paying off existing debt and making timely payments. This is especially beneficial if there are credit issues preventing you from obtaining new lines of credit.
Your Debt-to-Income Ratio
Your debt-to-income ratio is one of the key elements mortgage lenders use to determine whether you’ll be able to afford your new home. It’s calculated by adding together all recurring monthly debt payments such as your mortgage, student loans, credit cards and minimum payments plus any other loans you may have and dividing them by your gross income.
The greater your monthly debt payments, the higher your debt-to-income ratio will be. Aim to keep this as low as possible in order to boost your chances of qualifying for a mortgage loan with advantageous terms.
There are several ways to reduce your debt-to-income ratio (DTI), including paying down debt and increasing income. Furthermore, avoid taking on new loans before and during the mortgage application process.
As a general guideline, having a debt-to-income ratio below 36 percent will increase your chances of approval for a mortgage loan with favorable terms. However, your DTI is only one factor lenders consider when considering whether to offer you the loan; other aspects like credit score, employment status and savings must also be taken into account.
On the front-end debt-to-income ratio (DTI), lenders generally require housing expenses such as your future mortgage payment, property taxes and homeowners association fees to not exceed 28% of your total income. At the back-end DTI (revolving debts such as credit card or car payments, student loans and child support payments) to not exceed 36% of total income.
In general, a high front-end debt to income ratio indicates you may be more at risk for defaulting on your mortgage loan than what the lender would prefer. This could result in an increased interest rate or worse yet, the loss of your home.
Another way to reduce your debt-to-income ratio (DTI) is by making payments more affordable, such as refinancing existing loans. Doing this can save you interest and enable you to pay off the debt more quickly.
Ideally, your debt-to-income ratio (DTI) should not exceed 40%. A high DTI may indicate to lenders that you may be in financial difficulty and will have difficulty repaying your mortgage or other loans. Fortunately, there are ways to lower your DTI and improve the likelihood of qualifying for a mortgage loan with favorable terms.
Your Loan-to-Value Ratio
When a lender approves your mortgage loan, one of the first things they will consider is your loan-to-value ratio. This ratio measures how much you owe against the value of your home (or vehicle, for instance).
Lenders tend to view a lower loan-to-value ratio as more reliable than a higher one, signaling that you are an efficient borrower who could potentially qualify for better interest rates on mortgage or refinance loans.
Lenders typically require an LTV of 80% or lower for conventional mortgages and those insured by the Federal Housing Administration, or FHA. This percentage can vary for various reasons but generally represents a reasonable ratio in most cases.
Some borrowers may be eligible for higher loan-to-value ratios (LTV) than this, however it will usually lead to higher monthly payments and ultimately cost you more in the long run. Therefore, always aim for a lower LTV than what the lender requires when applying for a loan.
Your down payment is another important factor when it comes to calculating your loan-to-value ratio. A larger deposit will lower your LTV, as will having equity in the property.
Paying down your mortgage principal quickly is a wise idea, especially if you have a high interest rate; doing so will save you money in the long run on interest charges.
Maintaining your home in good condition is another way to reduce LTV, as it helps boost its value. You could even utilize a home equity line of credit (HELOC) to pay down your mortgage balance faster and reduce overall loan-to-value ratio.
In order to avoid private mortgage insurance, which is charged to borrowers with low down payments, your LTV must be at least 80%. However, if there is a second lien against your home such as a home equity line of credit, then there is no requirement for such a high LTV since this lien isn’t attached to the value of the property itself.
Your Down Payment
When purchasing a home, the amount you put down can have an impact on how much you pay each month for your mortgage loan. When calculating this amount, take into account both how much you plan to spend on the new residence and any financial objectives you may have.
Your down payment amount is determined by both your debt-to-income ratio and available savings. Lenders want to ensure you have enough money left over after paying closing costs (usually 2-5% of the purchase price) for unexpected expenses or emergencies, such as repairing your roof or replacing appliances.
You can use a mortgage calculator to estimate the maximum down payment you should be able to afford. This will help determine whether it makes sense for you to save extra or wait until all of your debts have been cleared in order to make larger deposits.
When applying for a loan, one thing to consider is the type you qualify for. Some mortgage programs, like FHA loans, require you to make a down payment of at least 3.5% of the purchase price.
A larger down payment can help you bypass private mortgage insurance (PMI), a type of insurance that safeguards the lender in case you default on your loan.
Furthermore, making a larger down payment on your home may result in lower interest rates since lenders are less likely to risk losing their investment when you put down more money for it.
Home equity can also help you build home equity, which could reduce your overall debt and provide you with a substantial sum to save for other financial goals.
If you’re uncertain which down payment size is ideal for you, a trusted mortgage professional can assist. They will also guide and answer any questions along the way.
Generally, a larger down payment is preferable when purchasing a more expensive home or property with better location. However, smaller deposits can also be advantageous if your debt-to-income ratio is low and you have enough saved to cover monthly mortgage payments. Furthermore, having a small down payment also helps avoid having to pay private mortgage insurance, or PMI.