Ready to start your home search? You want to be a homeowner in the next year but are not sure where to start. You’re ready to get out of the rental market. Here are the steps to take.
Get your credit in order
Your credit score is designed to be a predictor of how you will pay your debts in the future. Mortgage lenders will use your credit score as a major factor in loan approval. The exact ins and outs of how your score is determined is a closely guarded secret. The three major credit agencies: Experian, TransUnion & Equifax all use slightly different algorithms to calculate a score.
In theory, your score from each of these agencies should be very similar. With a limited credit history or with derogatory items in the past scores can vary significantly. A mortgage lender will take the middle of all three scores. They will use your middle score for approval and pricing purposes.
What is a good credit score?
A long-term credit goal should be to consistently achieve a score of 760+. With a score in the 760+ range, you are in the top tier for any type of credit. Although the ultimate goal should be a score of 760+ it is not needed for mortgage approval.
Mortgage guidelines will change from time to time. The minimum required scores will sometimes decrease or increase depending on market conditions. Minimum required scores also vary depending on mortgage type (conventional, FHA, VA, etc.).
Typically with a score in the 620+ range, minimum guidelines are met. Currently, there are programs available with scores down to 580. At the lower score, a larger down payment may be required. In addition, the lender may require you to have a lower debt-to-income ratio to qualify.
Why should I check my credit early in the process?
A credit score is an important factor in mortgage approval. It also plays a factor in the pricing of your loan. Pricing is a term that refers to the combination of interest rate and lender cost. A lower rate will to a higher interest rate and monthly payment.
A credit score check early in the process will allow time to make improvements if needed. If above the minimum approval guideline but below the top tier, use this time to boost your score. Your goal should be approved on the best possible terms.
With a credit score below the minimum guideline for any possible mortgages, there is time to improve your score. Depending how far below the guideline at the start, will determine how long will be needed to boost the score. There are times with a score just below guidelines, revolving account balances can be paid down to get the needed increase.
There are times when more work, and time, will be required to get a credit score over the line. In addition to paying balances down, there may be old accounts or false information that needs to be removed. It is always best to have your mortgage broker review your credit report. The broker can often assist you or steer you in the right direction needed to improve your credit score. They will also be able to provide you with a reasonable estimate of the length of time needed to bump up a score.
Credit is on track! Now what?
After credit, the next important factor is verifiable income. It is best to have your income reviewed by your broker to determine your maximum housing payment. If you are employed, the documents needed are the most recent 30 days of paystubs and the previous two years W2’s.
The lender will use your income, estimated monthly housing payment, and debts listed on your credit report to calculate your debt ratio. The debt ratio will determine your maximum monthly housing payment. Keep in mind that it is important to stick with a monthly payment in your comfort range regardless of the maximum calculation.
The third piece of the puzzle ‘Funds-to-Close’
After you have determined that your credit and the debt ratio are in line the next step in your funds needed to close. The lender will want to verify your bank statements. To start you will need to provide the most recent two months’ statements for any accounts needed to close. Be prepared to provide an updated statement right up until closing.
You may not have all the funds needed when you start your process. That is fine. The lender will need to verify all assets before closing. You may have deposits from upcoming paystubs or receive a gift of funds from a family member. These allowable deposits can be used as long as they can be documented before closing.
Income
What is Debt To Income Ratio?
In addition to credit score and funds for closing, the lender will review your income. Total monthly income is compared to monthly liability payments. This calculation is referred to as the Debt-To-Income Ratio (or DTI). The allowable DTI varies somewhat based on the mortgage type (conventional, FHA, VA, or jumbo). A good rule of thumb for DTI is 47%.
What Does the 47% Mean? How is It Calculated?
The debt-To-Income Ratio is calculated by looking at your total monthly verifiable income compared to monthly liabilities. The monthly liabilities include the new total housing payment. Total monthly housing payment includes loan principal & interest, property taxes, and homeowners insurance. The total monthly housing payment also includes any homeowners association dues or other insurances such as flood insurance.
In addition to the total monthly housing payment, the lender will look at other monthly liabilities. Those other monthly liabilities include (but are not limited to) minimum credit card payments, auto payments, student loans, personal loans, and recreational loans.
The Calculation
A client has a total verifiable monthly income of $10,000. Their new total monthly housing payment will be $3,675. They also have total monthly liability payments of $875. Their debt-to-income ratio is calculated as:
$3,675 (housing payment) + $875 (monthly liabilities) / $10,000 (income) = 45.5% Debt-To-Income Ratio
The Bottom Line
When you have your credit score, funds to close, and debt-to-income ratio in line – you are ready to purchase a home. If you do not have these things in order, the sooner you get started the better. Some steps can be taken on each of these items to make improvements.