Building credibility in the financial world is of the utmost importance before applying for a mortgage.
Having a high credit score, little existing debt, and a good chunk of cash for a down payment will impress lenders, and ultimately unlock the best loan terms and interest rates.
Lenders will use specific formulas to determine how good you are at managing money and the amount of risk associated with the potential loan.
They will pull your credit score and analyze any outstanding debt when considering your application. It can be quite invasive, so be prepared for that.
These are the main things they’ll consider:
- Credit Score
- Debt-to-Income Ratio
- Loan-to-Value Ratio
These factors will help them assess their level of exposure and your creditworthiness. Here’s what it all means…
1. Credit Score
Check Your Score
Before speaking with a lender or even starting your home search, it’s important to evaluate your financials and check your credit score. This will give you a chance to fix any errors or improve your score if needed.
The better your credit score, the better chance you’ll have to get approved for a higher loan amount and at a better interest rate.
You can check your credit score and history through a credit bureau company. Here are the three major ones:
Understanding Your Credit Report
Once you have access to your credit report, it’s time to read through it and get a better understanding of what’s going on.
Here are the main factors that contribute to your overall credit score:
- Credit Utilization: a percentage based on the sum of credit used compared to the sum of your credit limit. For example, let’s say I have a credit limit of $10,000 in total. I’ve charged $5,000 to my credit card. My credit utilization percentage would be 50%.
*Tip: you want to keep this around 10-20%. This will allow you to make payments on-time and build trust among creditors and lenders.
- Payment History: your ability to pay back debt on-time. Even one late payment can have a big impact on your score.
- Credit History Length: the age of your credit, or how long you’ve had a credit account. The longer your credit history, the higher your score.
- New Credit: how many credit accounts you’ve recently opened. An overload of new accounts will result in a hard inquiry on your report, which will lower your score.
- Credit Mix: how well you’ve managed the mix of credit accounts, loans, and other debts.
From a Lender’s Perspective
Lenders typically like to see a credit score of 750 or higher.
A lower credit score may prompt the lender to charge you a higher interest rate or request more of a down payment.
Typically, a score of at least 620 will be required for the consideration of a mortgage.
But there are workarounds depending on your loan type. Credit scores as low as 500 may qualify for an FHA loan (a type of federal assistance loan).
2. Debt-to-Income Ratio
Lenders want to know if you’ll be able to manage your current debt along with a monthly mortgage bill. They will determine this based on a debt-to-income ratio.
Overall, your total monthly debt, including your new mortgage, shouldn’t exceed 36% of your gross monthly income. If you’re able to stay below that margin, your lender should have no issue approving your mortgage.
That’s why it’s important to get your existing loans under control. Your debt-to-income ratio will play a major role when determining your loan amount and interest rate. Try to pay down any student loans, auto loans, etc. before contacting a mortgage lender.
3. Loan-to-Value Ratio
Your loan-to-value ratio refers to the amount of money you’re looking to borrow divided by the house’s appraised value. In simpler terms, the percentage you’ll own versus how much you’ll owe.
A mortgage lender will use this ratio to determine the level of risk associated with a particular borrower.
A big factor depends on how much the house gets appraised for.
Let’s say you’re in the process of buying a house. Before the lender gives final approval on the loan, they will require that the house is appraised. An appraisal will determine the home’s current market value.
If the requested loan amount is equal or higher than the appraised value, a lender will view this as a liability. Because of this, the loan may not be approved, or the interest rate may increase.
Here’s a good rule-of-thumb to follow:
A higher loan-to-value ratio = a higher risk loan = a higher interest rate. And vice versa.
The loan-to-value ratio can get confusing. At the end of the day, you want to make sure you have enough for a down payment and you’re not overpaying for the house. It’s a win-win for both parties.