What You’ll Get From This Guide
The purpose of this guide is three-fold:
- To help you understand the mortgage process you will be entering
- To help you to get approved for the mortgage you need to purchase the home you want
- To get your mortgage at the lowest interest rate and fees possible
In this regard we will cover how the mortgage application process works, how to prepare yourself to successfully navigate that process, and how to maximize your personal financial profile to increase your chance of loan approval while simultaneously enabling you to get the best pricing available.
We will do this by presenting mortgage loan requirements, and offering strategies, suggestions and tips that will enable you to successfully meet and even exceed those requirements. Strategies will also be provided to help you to shore up or compensate for any “weak spots” that you may have in your financial profile.
By the time you finish reading this guide, you will be prepared to apply for a mortgage, be ready with the necessary supporting documentation, and overcome any hurdles along the way. It is our intention to help you to enter your mortgage application process from a full position of strength, to maximize your options and lower your costs.
How Much Home Can You Afford?
Determining how much house you can afford is based on several factors. These can include the amount of your down payment, the stability of your employment, your income, your debt-to-income ratio, and of course your credit history.
When you apply for a mortgage, the lender will qualify you based on each of these factors. Let’s take a look at each.
Down Payment Requirements
Except for VA mortgages (which provide 100% financing to eligible veterans), most all mortgage types require that you make some sort of down payment on the house that you are purchasing.
For conventional mortgages the minimum down payment is generally 5% of the purchase price. However, there are special conventional mortgage programs that will allow you to put down as little as 3%, though the qualification for these loans is typically more difficult.
But where conventional mortgages are concerned, you are generally better off if you can put down at least 20% of the purchase price. This not only makes your mortgage application more likely to be approved, but it also eliminates the need for costly private mortgage insurance, better known as PMI (we’ll discuss PMI in some detail later in this program).
FHA mortgages, which generally have more lenient underwriting criteria, typically require a minimum downpayment of 3.5%. However, FHA loans may require as much as 10% down if your credit score is below 580.
The lender will document your down payment funds either by sending a Verification of Deposit form to your lender or investment broker, or by requiring you to furnish statements verifying each account for at least the past two months.
As a general rule, lenders will look for a two-year employment history, regardless of the type of mortgage that you apply for. Naturally, they will want to see that you have been consistently employed, either in the same job or in the same line of work.
There is some flexibility in this regard. For example, if you are a recent college graduate and have only been on the job for a few months, the lender may still accept your employment and income. There may also be exceptions for seasonal employment, as long as your income fully supports the loan amount that you are applying for.
The lender will also want to know that your current employment is likely to continue, though for legal reasons most employers today are reluctant to provide that information. If the employer indicates that your job status is “on probation”, perhaps as a result of your being new on the job, the lender may not accept your employment and income.
Employment Verification. The lender will typically verify your employment by calling your employer, and performing what is known as a verbal verification of employment. In doing so, they will request your date of hire, your position, and your probability of continued employment.
If you’re self-employed, the lender will also require that you have been in business for a minimum of two years. They will verify this through a copy of a business license or a verification from your CPA.
Second job – If you have a part-time second job, and you want to use the income to qualify for a mortgage, you will generally have to show that you held both your full-time position and a second job for the past two years. Income documentation for the second job will be virtually the same as it will be for the first job.
The lender will also verify your employment income by requiring the following documents:
- A copy of your most recent pay stub
- W2’s for the past one or two years,
- Income tax returns for the previous two years, if 25% or more of your compensation comes from commissions or bonuses
If you do receive commissions or bonuses, the lender will typically average these income sources over the past two years. If they require tax returns, they will also look to see if you incur any expenses in connection with the production of that income. If you do, those expenses will also be averaged over the past two years, and deducted from your average commission income.
Second job income – Generally speaking, any income from a part-time job will also be averaged over the past two years due to the fact that hours on such jobs often vary widely.
Self-employment income – The lender will average your income over the past two years, based on the results provided by your income tax returns. They will use the net income from your business, and not your gross income.
The calculation will look something like this:
$50,000 (2015 business income) + $70,000 (2016 income) = $120,000
$120,000 divided by 24 months = $5,000 per month
They will also want to see that your earnings have been either level or increasing over that time frame. For example, if your business net income was $70,000 in 2015, and $50,000 in 2016, they will average your 2016 income over 12 months. That will result in a reduced income of $4,167 per month.
The lender will do this in order to take a more conservative view of your income. Since the 2016 income is more recent, it will be considered to be the more reliable income figure.
Unfortunately, if your net income declined from one year to the next, there is a very real possibility that the lender will reject your income completely, and decline the loan. They may make the assumption that the business itself has a questionable future, and cannot be relied upon to provide a stable income.
TIP: In a situation like this, there may be a solution by adding a cosigner to your mortgage application. The cosigner will have to be someone who is related to you, even though they will not occupy the property. And naturally, that person will have to have a stable income that will offset the weakness in your business income.
Documentation of self-employment income. You should be prepared to provide tax returns covering the past two years. This will include your personal income tax returns, and if you are a corporation or partnership, business income tax returns as well. The returns should be signed by you, and include all schedules.
The lender will also ask you for a year-to-date profit and loss statement – prepared by an accountant – for the current tax year, since it cannot be documented by a filed tax return.
WARNING: Virtually every lender will have you sign an IRS Form 4506, which will be sent to the IRS to verify that the income tax returns you have provided to the lender are accurate. Be as accurate possible with regard to your income, as wide variances could draw unexpected attention.
Debt-to-Income (DTI) Ratio Guidelines
DTI is an important qualification when you apply for a mortgage. It represents the new house payment, plus your recurring non-housing debts, divided by your stable monthly income.
Before we go any further, you should be aware that your new house payment, according to the lender, is comprised of the following payments:
- Principal and interest on the new mortgage
- Principal and interest on any secondary financing
- Real estate taxes (apportioned on a monthly basis)
- Monthly private mortgage insurance (compensates the lender if you default on your loan)
- Homeowner’s insurance (also known as hazard insurance) prorated on a monthly basis
- Flood or earthquake insurance, prorated on a monthly basis
- Homeowner’s Association (HOA) fees, prorated on a monthly basis
Now let’s work a DTI example.
Your stable monthly income is determined to be $6,000. The proposed new housing payment is $1,500. You also have non-housing debts of $900 per month, comprised of:
- Car payment, $300 per month
- Student loan payment, of $400 per month, and
- Credit card payments, $200 per month
Your total monthly obligations are $2,400. Your DTI is calculated as follows:
$2,400 in total obligations divided by $6,000 in stable monthly income = 40%
For VA and FHA mortgages, the maximum DTI is typically 41%. However, lenders may exceed that ratio by a few points if your overall application profile is strong.
Conventional mortgages generally limit your DTI to 36%. But once again, if you’re overall loan profile is strong, that percentage can be exceeded. Since conventional mortgages are typically underwritten using “automated underwriting” – which is a computer-driven underwriting application that uses certain algorithms – a loan may be approved even if the DTI is well above 36%.
We’ll get more into when the DTI requirement can be exceeded under “Compensating Factors” below.
Credit History Requirements
In the typical course of events, mortgage lenders will require a credit report that reflects at least three active credit lines. The longer your credit history is the better, but they will generally be looking at a credit history that is at least one year in length, or at least sufficient to generate credit scores from each of the three major credit repositories, Equifax, Transunion and Experian.
Alternative Credit. If you do not use traditional credit, you can still qualify for a loan using what is known as alternative credit. This can include recurring payments, such as utility payments, insurance payments, and even private debts. But be aware that the lender may require that you provide copies of canceled checks for the past 24 months as evidence that you actually make those payments, and made them on time.
WARNING! You can only use alternative credit if you have no history of using traditional credit. You can never use alternative credit as a substitute for traditional credit. If you have a credit history and credit score showing with one or more credit bureaus, then that is the credit that will be used for qualification purposes.
Let’s get back to credit scores…
On FHA loans, the minimum credit score is 580, however your loan may be approved if you make a downpayment of at least 10%, even if your score is below this level. However be advised that even though FHA guidelines permit credit scores down to 580 and below, not all lenders will accept such scores. Since there are ramifications for lenders who originate FHA mortgages that go into default, many lenders establish higher minimums, such as 620 or higher.
For conventional financing, you are generally required to have a minimum credit score of 620. For the most part, conventional financing is less flexible in regard to credit scores than FHA is. In addition, the interest rate you will pay on your mortgage is closely tied to the level of your credit score. We will discuss that in some detail under “Maximizing Your Credit Score” below.
Apart from credit scores, lenders will also look closely at certain items on your credit report. A late payment here and there on consumer debt generally won’t be a problem, though the lender will likely request that you provide a letter of explanation for the circumstances that led to the late payments. If they do, it’s important that your letter explains why the situation is unlikely to be repeated.
There are four other areas of concern in regard your credit:
Mortgage/rent payment history – Since you are applying for a new mortgage, any late payments on these will receive close attention. This is especially true if the late payments have occurred within the past one or two years. A pattern of late housing payments will not bode well for your application.
Collections, charge-offs and judgments – The age of these events will be important. If they are more than two or three years old, it may not hurt your application. Even so, in most cases, the lender will require that these balances be paid off prior to closing. This is especially important in regard to judgments and tax liens. Since they are court ordered, they can have an effect on the lender’s lien position on the property that you are purchasing.
Bankruptcy – You will need to wait until at least two years has passed since the bankruptcy was discharged. In addition, the lender will want you to document that the reason for the bankruptcy was due to circumstances beyond your control. This can include an extended time of unemployment, a business failure, or a serious medical event. You’ll have to provide a letter of explanation, supported by documentation of the circumstances that took place. You will also have to demonstrate that you have successfully re-established credit since the bankruptcy.
Foreclosure – The rules here are similar to bankruptcy. At least two years will have to have passed since the foreclosure, and you’ll have to provide similar documentation to prove that it was the result of circumstances beyond your control.
In the case of bankruptcy or foreclosure, if you cannot prove that the cause was from circumstances beyond your control, you’ll have to wait at least four years in order to be eligible for a mortgage.
It’s also important to consider that even though any of the above events may be deemed acceptable to the mortgage lender, each will have a strong negative effect on your credit score. For example, if you’re applying for a conventional mortgage, and have bankruptcy two years ago that’s keeping your credit score below 580, your loan application will be declined based on a credit score. (You may then want to consider using an FHA mortgage with a 10% down payment.
Mortgage Loan Types
There are three basic types of mortgage loans – fixed rate mortgages (FRM), adjustable rate mortgages (ARM) and balloon mortgages. ARMs and balloons typically have lower interest rates than fixed rate mortgages, but you should also be aware that underwriting guidelines for these loans is more strict than it is for the fixed. While the lender may offer some leniency on the guidelines for a fixed rate mortgage, they’re much more likely to stay strictly within guidelines with ARMs and balloons.
Here is a brief explanation of the three mortgage loan types:
Fixed Rate Mortgage (FRM) – This loan is exactly what the name implies. Both the interest rate and the monthly payment are fixed for the life of the loan. For this reason, FRMs are considered safer than the other loan types, and may offer more relaxed guidelines. The term can run from 10 years to as long as 40 years, but 15 and 30 years are by far the most common. At the end of the term, the loan is completely paid.
Adjustable Rate Mortgage (ARM) – These are set up and amortized as 30 year mortgages, but the interest rate adjusts at predetermined points during that term. They typically have an initial fixed rate period, which is generally five, seven or 10 years. After that they adjust annually.
They do have interest rate caps to limit upside increases. For example, an ARM may have caps of “2/2/5”. That means that an initial interest rate increase is limited to 2% above the original rate; any subsequent increases are limited to no more than 2% above the previous rate; and the highest rate you will pay over the life of the loan is capped at 5% above the starting rate.
For example, if your initial rate is 3.00%, the first adjustment can increase the rate to as high as 5% (3% + 2%). And over the life of the loan, the rate can go no higher than 8% (3% + 5%).
ARMs are best used if you plan to live in the house no longer than the fixed rate term of the loan. After that, the payment shock can be substantial.
Balloon Mortgage – Balloon loans are also amortized over 30 years. But they offer a limited term of five, seven or 10 years, at a fixed rate of interest. After that term the loan must be paid off completely, either through refinancing it, selling the property, or paying off the loan with other assets.
Some balloons offer a one time adjustment, in which the rate is adjusted to then-prevailing interest rates at the end of the initial term. For example, if you have a seven year balloon at 3.75%, the rate will reset to say, 5.25% (if that’s what prevailing rates by then), and will remain at that level for the remaining 23 years of the loan term.
Like ARMs, balloon mortgages are best used if you plan to live in the house no longer than the balloon term itself, which will be between five and 10 years.
Preparing Your Finances to Apply For Your Mortgage
Now that you have a general idea as to what the requirements are that mortgage lenders look for, it’s time to begin preparing your finances to apply for your mortgage.
The best way to start is by getting pre-qualified by a representative from a mortgage lender. They will take all of the above into consideration, and provide you with a maximum loan amount that you are likely to be qualified for. That will enable you to determine the maximum price of a home that you want to purchase.
It’s important to understand that when you get a pre-qualification letter, sometimes referred to as a pre-approval, that it is a conditional approval. That means that it is subject to certain documentation being provided, and all of the information that you supply being verified as correct.
It will help if you work to prepare each area of your financial profile, to both increase the size of the mortgage that you will qualify for, as well as the likelihood of final approval. It’s all about putting you in the best position to get the mortgage that you need, at the best possible rate and terms, for the home that you want to buy.
Getting Your Down Payment Ready
Earlier we discussed that you can make a down payment of as little as 3% or 5% on a conventional mortgage. We also noted that a down payment of at least 20% of the purchase price is generally preferred.
If you are not in the position to make a down payment of at least 20%, the lender will require that at least 3% or 5% of the purchase price must come from your own funds. That means money that you have had in a bank account or brokerage account for at least 60 days.
This is referred to as the “seasoning requirement”, and it is used to satisfy the “own funds” guideline. It’s basically to make sure that you as the occupying homeowner will have a financial investment in the property. You are generally permitted to get a gift from a family member or secondary financing for the balance of the down payment.
TIP: If you can get a gift of 20% of the purchase price to cover the down payment, the own funds requirement is waived.
Let’s look at all three components of your down payment individually.
Own funds – You should make sure that you have accumulated your necessary down payment contribution, whether it’s 3% or 5% of the purchase price. The funds need to be sitting in your bank account for at least 60 days prior to making application. If you make any large deposits into any accounts within that 60 day time frame, the lender will require you to document the source of the deposit. They will do that to make sure that this money does in fact constitute your own funds, and are not proceeds from an undisclosed loan.
BE AWARE! – A new credit report will be ordered just before closing to make sure that you have not taken or applied for any new loans since making application for the mortgage. If you have, you can jeopardize your mortgage approval.
Gift funds – You can obtain a gift from one or more family members for the amount of the down payment that exceeds the own funds requirement. There will be three requirements in connection with the gift:
- A gift letter executed by the donor, indicating that the funds transferred will be a gift requiring no repayment, as well as disclosing the amount and source of the gift funds, and the expected date of transfer (this will usually be completed on a standard lender supplied gift letter)
- Evidence (bank statements) proving that the donor has the ability to give the gift
- Evidence of the transfer of the funds from the donor’s account into your account before closing
Secondary financing – Home buyers often use first-second combinations. In order to avoid having to pay PMI, they will take an 80% first mortgage, and then either a second mortgage or a home equity line of credit (HELOC) for 10% or 15% of the purchase price, with the remaining amount being their down payment.
A typical arrangement is what is known as an “80/15/5”. That means that the first mortgage will be 80% of the purchase price of the home, a second mortgage will be 15%, and the actual down payment will be 5%.
Most lenders have the ability to provide both the first and second mortgage. It’s important to understand that the monthly payment on the second mortgage will also be included as part of your mortgage payment, as well as part of the calculation for your DTI.
Showing a Stable Employment History
Based on mortgage lending guidelines, you should make sure that you have been consistently employed for at least the past two years. Your income should also show either a level or increasing pattern. But once again, if you’re a new college graduate you can fully expect that the lender will accept less than a two-year employment history.
If you’re self-employed, you will almost certainly have to make sure that you have been in business for at least two years. Some lenders may accept less – though never less than one full tax year – but the loan requirements will be much more restricted. It will also be important that your self-employment income is rising, or at least level, from one year to the next.
Making Your New Home Fit Within an Acceptable DTI
If the pre-qualification that you receive is not sufficient to purchase the type of home that you want, you may have to work on lowering your DTI. For example, if purchasing a $400,000 home will result in a 45% DTI, you may have to pay off some debts in order to lower the DTI to an acceptable level.
TIP: It’s always best to pay off an installment loan, such as a car loan, since the payoff is both clean and final.
Paying off credit cards is more problematic. Lenders will recognize any credit card payments that appears on your credit report. For this reason, any credit cards that you plan to pay off should be paid at least 30 days before you apply for a mortgage. That will make sure that they will show up as paid. As a general rule, lenders will not allow you to pay off credit cards after you have applied for a mortgage. That’s because credit cards are revolving arrangements that can easily be borrowed against immediately after repayment.
Maximizing Your Credit Score
How important is your credit score? It can not only mean the difference between a loan approval and a decline, but it can also have a material effect on both your interest rate and your monthly payment.
Mortgage loans work using tiered pricing. This includes price adjustments for the size of your loan (or loan-to-value ratio), the use of secondary financing and your credit scores, among other factors.
The chart below shows how different credit score ranges affect your interest rate, monthly payment, and the amount of interest you will pay over the life of a 30 year mortgage for a home loan of $200,000.
|Credit Score Range||Interest Rate||Monthly Payment||Interest Paid on 30 year Loan|
Notice that in the top credit score range, 760 – 850, your monthly payment will be $959. That’s nearly $200 less per month than you will pay for the same mortgage with a credit score of between 620 – 639.
But it gets even worse over the life of the loan. At highest credit score range, you will pay $145,152 in interest. At lowest range you will pay $214,832.
That’s a difference of nearly $70,000. As I said, your credit score matters when you’re applying for a mortgage.
But it gets worse still…
The interest rate you’ll pay on your mortgage isn’t the only cost that will be negatively affected by your credit score. PMI is also based on your credit score, and the difference between credit score tiers is substantial.
Here are the annual PMI premium that you will pay for a $200,000 mortgage with a 5% down payment, based on different credit score tiers:
- Credit score: 760 or higher – $820 per year
- 740 – 759: $1,180
- 720 – 739: $1,460
- 700 – 719: $1,740
- 680 – 699: $2,160
- 660 – 679: $3,000
- 620 – 639: $3,220
(Source: MGIC Quickpick Rate Card)
At the highest credit score range you’ll pay $820 in PMI. At the lowest range you’ll pay $3,220. That’s a difference of $2,400 per year, or $200 per month.
Since PMI can remain in effect for up to 15 years (on a 30 year mortgage), you will pay upwards of an additional $36,000 in premiums if you are in the lowest score range, compared to the highest.
When you add the extra $70,000 you’ll pay in interest to the extra $36,000 in PMI premiums, you’ll pay well over $100,000 extra for the lowest credit score over the life of the loan. That’s more than 50% of the original loan balance of $200,000!
It’s worth repeating: your credit score matters when you apply for a mortgage.
Fixing Your Credit Score
As you can see from the chart and example above, improving your credit score by 50 to 100 points can save you tens of thousands of dollars. That should make improving your credit score a priority before applying for a mortgage. However this will not be an easy process.
Obtain a copy of your credit report and credit scores from all three credit bureaus – Equifax, Transunion, and Experian. You can get a free copy of each from AnnualCreditReport.com, which has been authorized to provide you with your federally mandated annual free credit report.
Carefully review your credit report, and note the credit score. If it’s not at the level you want, you’ll have some work to do. It can take some serious time and effort, especially if your scores are low. This is why you need to get working on this well before applying for a mortgage.
If there is any derogatory credit information on your credit report that has been reported in error, you must be prepared to dispute it and have it removed. Most people are neither aware of, nor comfortable with, this process. For this reason, you’re almost certainly better off getting professional help.
The best type of help to get is from a law firm that specializes in credit problems. Often, just the involvement by a law firm can make things happen – and this is critically important. As a rule, creditors are very reluctant to cooperate with consumers in repairing credit errors. In many cases, only the threat of legal action will get results.
Using a competent credit repair law firm from the beginning will be the most effective strategy, even though you will have to pay for the service. The alternative will be that the credit errors will remain on your credit report, dragging your credit score down, and either preventing you from getting a mortgage, or forcing you to pay a much higher interest rate on your mortgage, as well as a higher monthly premium for PMI.
Also realize that the fee you will pay to a credit attorney will often be more than offset by reductions in the payment of past due balances. You should look at it as a small investment with a huge return.
For example, if you have collections or charge-offs, creditors will often accept less than the full amount to satisfy the account. But you have to know how to negotiate such an arrangement with each creditor, as well as getting the creditor to report the payoff to the credit bureaus promptly. Using a credit attorney can not only make this process happen faster, but it can also save you thousands of dollars in the process, by lowering the settlement amounts.
Legitimate derogatory credit. If you have a bankruptcy or foreclosure, you must wait at least two years before applying for a mortgage. You must also do your best to document that the event was due to circumstances beyond your control.
If you have any unpaid balances, such as collections or charge-offs, pay them off before applying for a mortgage. Again, use an excellent credit repair firm to help you with this, especially if there are several open accounts. This goes doubly for judgments and tax liens. Though paying them off won’t make them disappear from your credit report, a paid account is always better than an open one. And the longer that it has been paid, the better it will be for your credit score.
Common Reasons Why Mortgage Applications Get Denied
The best way to avoid having your loan application declined is to know what the most common reasons for a denial are. By knowing what they are, you can prepare in advance to make sure that they don’t become a problem. And by doing that, you will also be improving your chances of getting a mortgage at the lowest cost possible.
Applying With Bad Credit
When you apply for a mortgage, most weaknesses in your financial profile can be overcome, one way or another. But the notable exception is credit. If you have bad credit, it’s highly likely that your loan will be declined. Your credit indicates both your willingness and your ability to pay your debts on time, and mortgage lenders give it more weight than other criteria.
Since the financial meltdown, most mortgage lenders have gotten more “gun shy” about lending to people with credit problems. This can include not only low credit scores, but also major derogatory credit, such as bankruptcy, foreclosure, late housing payments, and unpaid balances, like charge-offs and judgments.
For this reason, it’s critically important that you show at least two years of clean credit history. Make sure that you wait at least two years after a bankruptcy or foreclosure. In the meantime, do all that you can to improve your credit score based on the strategies given above.
Applying Too Soon After a Major Derogatory Credit Event
This point can’t be emphasized enough, but if you do have credit problems you need to get them fixed before even making application for a mortgage. This is especially true when it comes to dealing with charge-offs, collections, judgments and tax liens. Make sure each has been paid off, and then delay applying for as long as you can.
WARNING! Mortgage lenders expect that you will have re-established your credit since the major event happened. A pattern of continued credit problems will result in a loan decline.
The same is true if you had a recent late payment on a mortgage or rent payment. The passage of time is your friend when it comes to credit problems. The older the derogatory credit is, the less impact it will have on your credit score, and the less threatening it will seem to the mortgage lender.
The same is true in regard to bankruptcy and foreclosure. Though the two year rule was put in place (though only recently), you may have to wait three or four years to give your credit score a chance to improve.
When it comes to credit, delaying your mortgage application for a year or more could be the difference between an approval and a decline.
Having Too Much Debt
Run your own DTI calculation now. Add up all of your recurring debt payments, including car payments, student loan payments and credit card payments. If you are required to pay child support or alimony, include those payments as well.
Once you total of all those obligations, divide them by your stable monthly income. If the percentage that you get is much above 10% or 15%, then it might hurt your ability to apply for a mortgage.
Mortgage lenders generally allow your new house payment to consume 25% to 28% of your stable monthly income. If your non-housing debt is 20% of your income, then when combined with a new house payment, your DTI will be between 45% and 48%.
If you are making a minimum down payment loan, such as 5% or 10%, a DTI that high can be a problem. For this reason, you should make a plan to begin paying off some of your non-housing debt, to get that ratio down.
Once again, this should be done well in advance of applying for a mortgage.
Applying With an Unstable Employment History
If you have recently come out of a period of unemployment, that’s probably not the best time to apply for a mortgage. Make sure that you have re-established employment for at least a few months before making application – a full year or more is even better.
As well, review your employment history for the past two years. It should show a pattern of stability apart from your time in the unemployment line. You should be prepared to explain the unemployment, as well as why it is unlikely to happen again.
TIP: You might want to try to get some help from current employer. Mortgage lenders will typically ask employers what your probability of continued employment is – and most employers will refuse to provide that information. See if you can convince your employer to provide your lender with a supplemental letter assuring the lender that you have a high probability of continued employment (it is not necessary to imply any guarantee of continued employment). They may refuse to do so due to company policy, but it’s always worth asking for.
Applying Too Soon After Starting a New Business
Realistically, you should wait to apply for a mortgage until you have been self-employed for at least two full calendar years, which can be documented with income tax returns.
Remember that the lender will average your income over 24 months, so the net income your tax returns show must be sufficient to support the loan amount that you want to apply for.
The lender will base your income on the net income reported (not gross sales), but will add back non-cash expenses, such as depreciation and amortization.
TIP: It’s never well advised to apply for a mortgage until you have been in business for at least two years. Even if the lender accepts the income based on less time in business, you will enter the application process with one major strike against you.
Buying More House than You Can Afford
This is probably the single biggest mistake home buyers make. They get pre-qualified to purchase a $250,000 house, but then try to purchase one for $325,000.
If the lender approves you for a $250,000 property, that should be accepted as your absolute top price. To the degree that you exceed that number, the likelihood of a loan decline will increase.
Conversely, if you want to increase the likelihood of approval, give strong consideration to buying less house than you have been qualified to buy. If you have been pre-qualified to purchase a $250,000 home, but you buy a $200,000 house, your entire financial profile will look stronger in relation to the home that you are buying.
The other aspect of this point that you need to consider is how your life will be after you close on the house. If you buy above your means, you run the risk of becoming “house poor”. That an unfortunate situation in which your house payment takes up an unusually large percentage of your budget. That may get you into a nice house, but it can make the rest of your life very uncomfortable.
It’s always important to remember that there other expenses connected with a home purchase beyond just the basic monthly payment. That includes utilities, repairs and maintenance, periodic renovations, and even making major purchases, such as furniture. If your budget is to tightly stretched with the basic house payment, there will be little money left over to cover any of these additional expenses.
Lack of “Cash Reserves”
Most conventional mortgage programs require that you have cash reserves available after closing on the new home. Cash reserves are measured in terms of the new monthly payment. For example, if your new monthly house payment will be $2,000, and the lender requires two months cash reserves, you will need to show an extra $4,000 in liquid assets that will be available after the closing.
A typical requirement for cash reserves is anywhere from two months to six months. These funds must generally be verified in a liquid account, such as a bank account or investment account. Retirement plans generally are not allowed for this purpose, since withdrawing money from them on short notice is generally difficult to do, and creates an income tax liability.
The lender requires cash reserves so that borrowers will have some extra financial margin after they close on the new home. One of the biggest problems for mortgage lenders is what are known as early term defaults. That’s where the borrower defaults on their mortgage within the first few months of closing. The cash reserve requirement is designed to prevent that.
While you are calculating how much money you will need to close on your new home, make sure to figure in at least two months cash reserves. That means that you will have to have enough money to cover the down payment, any necessary closing costs, and the cash reserves.
TIP: To minimize the amount of money you will need to close, negotiate for the property seller to pay some or all of your closing costs. It’s common practice in some markets, but completely unknown in others. Alternatively, your lender can provide lender paid closing costs, in which you accept a higher interest rate in exchange for the lender covering your closing costs. This practice is very common in all markets.
You are unlikely to be declined for lack of cash reserves, but if you’re weak in one or more other areas, that could be the outcome.
BONUS TIP: If you really want to impress the lender, plan to have more than two months reserves. A strong cash position indicates a strong borrower.
“Compensating factors” is a mortgage industry term that describes factors in your financial profile that exceed minimum requirements. The more compensating factors that you have, the stronger your loan application will be.
Here is an example of some types of compensating factors:
- Making a large down payment – 20% or more
- Having excellent credit – evidenced by credit scores well in excess of 700
- Having substantially more than two months cash reserves (a healthy retirement plan balance will help here, as long as the minimum requirement is covered by bank funds)
- Having very stable employment – working with the same employer for several years
- Having a low DTI – a DTI of 30% or less can cover a lot of weaknesses elsewhere in your financial profile
- A small increase in your new house payment – an increase of less than 10% above your current house payment is viewed as a positive
Compensating factors give lenders more room to make accommodation for areas of your financial profile that may be weak. For example, a large down payment and a high credit score may allow the lender to approve your loan, even though you have a high DTI.
The more compensating factors you can bring to your mortgage application, the greater the likelihood that your loan will be approved.
How Much House Can You Afford to Buy?
In order to determine what mortgage amount you qualify for, and therefore how much house you can afford, you really need to contact a mortgage loan officer. You can usually do this by phone or even by email, though some may prefer a face-to-face meeting.
The loan officer can give you a good idea as to the maximum loan amount you can qualify for, based on actual mortgage lender guidelines. He or she will do this by running a credit report, reviewing your W2s and recent pay stubs, as well as asking you a series of important questions.
Being pre-qualified by a loan officer is the most reliable way to know how much of a mortgage you will likely qualify for, but if you’d like to get a quick idea you can use an online mortgage calculator. Just be careful however, as calculators are based only on the most basic information, which may be very different than what will be required when you actually apply for a loan. They also can’t tell you if your mortgage application would be approved or declined.
Bankrate offers their How Much House Can I Afford calculator that will provide you with a rough estimate. But please keep in mind that the calculator only considers the numbers that you input into it, and not other important factors, such as your credit profile, or the specific income a lender would include. It also uses a DTI of 36% on all calculations. If your financial profile is particularly strong, you may be able to exceed that DTI and qualify for a larger mortgage.
Applying for a mortgage is a process, and most of it involves a healthy dose of advanced planning. If you follow the the strategies in this guide, you should be well prepared to do just that.