If you’re a first-time homebuyer or re-entering the homebuying market, getting a home loan might seem mysterious and scary. You are probably asking yourself many questions: How will you qualify for a home loan? How much credit do you need to get a mortgage? What is a FICO score? What is credit utilization, and why does it matter? What is the debt-to-income ratio? The good news is that the mortgage professionals at On Q Financial are here to help you navigate this process. We believe the dream of homeownership is inclusive, and making the mortgage process simpler is our passion.
Here we’ll discuss what lenders look for when reviewing your finances to help you get a home loan and whether your credit is good enough for a home mortgage. We’ll explain some mortgage terminology you might not know. If you have questions, you can also schedule a free, no-obligation consultation with one of our expert mortgage consultants. They’ll help answer your questions about your unique situation and guide you through your homebuying journey.
What do lenders consider before offering a home loan?
A mortgage is simply a financial transaction. It’s a promise, with official documentation that complies with government regulations, that you will repay a debt. That promise is secured by real estate – your new home. Lenders want to feel secure that you’ll make your mortgage payments on time and in total. We’ll collect information about your finances to help them feel comfortable that you’re a good bet.
You might be surprised to learn that you don’t apply for a mortgage until a seller has accepted your offer on a home. When you meet with your mortgage consultant, they’ll try to get a broad picture of your financial situation. This information will help them match you with the best home loan program for your goals.
A variety of factors contribute to your financial situation, including:
- Income: Lenders will want to see a minimum of two years (2) employment and income history, usually in the form of your federal tax returns and W-2s, to help calculate your gross income (before taxes)
- Credit score: When you’re ready to apply, lenders will request and review your credit score from all three credit agencies (Equifax, Experian, and TransUnion)
- Debt payments: Any recurring expenses on debt are used when calculating your Debt-to-Income ratio (DTI) – these are car loan or lease payments, student loan payments, minimum credit card payments, personal loans, child support, and assets (but not lifestyle expenses like food, utilities, health insurance, etc.)
- Assets: These are the items you own that have monetary value, like cash, cash equivalents, and property, that will help your lender feel like you have a way to make your payments if you lose your job
What is a FICO score?
A FICO score is a three-digit number designed to summarize your credit reports. Lenders use this essential information to determine how likely you are to repay a loan. It is one of the vital factors in whether you’ll qualify for a mortgage and the interest rate you’ll pay on your home loan.
FICO Scores are used by most lenders when making lending decisions.1 You may know and track your credit score through an app from one of the major credit bureaus (Experian, TransUnion, and Equifax). Your FICO Score used by lenders may vary slightly from the reports you receive.
What makes up your FICO Score?
Credit agencies build your credit report using many different pieces of data, both positive and negative. Lenders use all this information to try and determine how likely you are to make payments on the money you borrow on time and in full. Ideally, you’ll have a long history of making on-time payments to various sources and have low balances with each of them. While the importance of these categories varies from person to person, in general, the information that makes up your FICO Scores include:
- Payment History The most important thing lenders want to know is whether you’ve paid your bills on time consistently in the past. Your payment history accounts for the most significant percentage of your credit score — 35%. A few late payments aren’t automatically a score killer, but you should work hard to pay your bills on time. May consider setting up automatic payments for your credit cards, retail accounts, car loans, etc.
- Amounts Owed Not only are lenders interested in whether you consistently pay your bills, but they also want to know how much debt you have overall. It may be better to have large available balances but low total balances on your credit cards and other accounts. Amounts owed makes up about 30% of a FICO Score.
- Length of Credit History Long credit history is good for your FICO Score, but it’s not required to have good credit. This category makes up 15% of your FICO Score. It includes the age of your oldest account, your newest account, and the average age of all your accounts. It also measures how recently you used each account.
- Credit Mix Your credit mix evaluates the type of credit accounts you have. A good credit mix includes revolving accounts (like credit cards, retail store cards, gas station cards, and home equity lines of credit) and installment accounts (like mortgages, auto loans, or student loans). Credit Mix makes up 10% of your credit scores.
- New Credit Opening several credit accounts in a short amount of time makes some lenders nervous — especially if you don’t have a long credit history. New credit inquiries make up 10% of your FICO Scores and consider inquiries from the previous 12 months.
FICO scores are essential in qualifying for a mortgage and getting a more affordable rate. Still, it’s not the only consideration lenders will make when deciding whether to offer you a home loan.
Why is Credit Utilization Important?
Credit Utilization (also called amounts owed) is so important to lenders that it makes up 30% of a FICO Score — nearly as much as payment history. Credit utilization is the percentage of available credit you’re using. Having a low credit utilization ratio will have a more positive impact on your FICO Scores than not using any of your available credit at all.2
Credit bureaus look at two types of credit, revolving accounts, and installment loans. Revolving accounts are credit cards, retail store cards, gas station cards, and home equity lines of credit. These are accounts where you have flexibility over how much you pay each month and how much you can access if you need to. Installment loans include mortgages, auto loans, and student loans. These are accounts with a fixed monthly payment and term.
Lenders care about credit utilization for two important reasons. Lenders want to know that you can pay your bills. Low amounts owed show your lenders that when you’ve borrowed money in the past, you’ve repaid it. It also shows that you don’t have large debts on which you make monthly payments. Also, a low Credit Utilization ratio (the amount you owe compared to the amount you can access) means you have a margin of liquidity. If anything happens to your regular sources of income, you can borrow from existing accounts to pay your monthly mortgage payment.
What is Available Credit?
Available credit is similar to credit utilization — the amount you have left to draw from your credit accounts. While credit limits are the maximum amount you can borrow, available credit takes your credit limit and removes amounts you’ve already spent.
There’s no ideal amount of available credit. Still, accepting as much credit as lenders are willing to offer is a good idea. A good guideline is to keep the amount of credit you use below 30%. You can do this in two ways: Pay the balances on your credit cards as much as possible each month (not just make the minimum payment). Ask your credit card companies from time to time to raise your credit limit.
As discussed above, credit utilization determines about 30% of your credit scores, so it pays to manage your available credit intentionally.
What is the Debt-to-income Ratio?
The debt-to-income ratio (DTI) measures your gross monthly income and monthly debt payments. Lenders use this measurement to help determine whether you have sufficient income to pay a new debt like a home loan or mortgage. A low DTI indicates that you have enough income to pay an additional debt, which makes you more attractive to lenders.
You can calculate your debt-to-income ratio by taking your recurring debts and dividing the total amount by your gross income. For example, let’s say you earn $6,000 each month, pay $1,400 monthly in rent, $120 each month in credit card bills, and your car payment is $675. Your debts total $2,087, and your income is $6,000, which makes your debt-to-income ratio 34.8%.
When you consider whether you can pay a mortgage, it’s good to consider your other monthly expenses like utilities, phone, and entertainment expenses. When lenders evaluate your DTI, they do not consider these expenses.
What is a Good Debt-to-income Ratio?
Generally, borrowers with low debt-to-income ratios are considered less risky than people with higher DTI ratios. Lenders want to know that you’re likely to manage your monthly debt payments effectively.
As a general guideline, 43% is the highest DTI ratio you can have and still get qualified for a mortgage. Ideally, lenders prefer borrowers to have a DTI lower than 36%.3 If you already own a home and are paying a mortgage, lenders would like to see your mortgage debt payment between 28% and 35% of your income. Lenders would like to see your DTI on all debts be 20% or less if you’re renting a home.
You may be able to improve your DTI ratio in a variety of ways. If you have a lot of high-interest credit card debt, you may want to consolidate that into a lower-interest personal loan. You can also make larger payments on your highest-interest accounts to pay the principal and reduce your average payment. You might also consider refinancing higher-interest car and student loans to reduce your monthly payment.
Conclusions
A home loan is one of your most significant financial commitments. It makes sense to take some time and consider how you can position yourself for the best possible mortgage. Find your current FICO or credit scores and start calculating your debt-to-income ratio now, and you can take concrete steps to improve these in the next few months and years. If you’d like help to make a plan to meet your particular needs, On Q Financial, LLC has the tools and expertise. Click here to find a mortgage consultant in your area and schedule a free initial consultation.
3 Source: Consumer Financial Bureau, 2018.