When my wife and I bought our first home we were one year out of college, both had good jobs and had a down payment in the bank. We had narrowed down our options to a two- or three-bedroom house or townhome because I definitely wanted a garage. We knew what we wanted and thought we were in good financial shape to buy our first home.
When it comes to deciding on a home to purchase, the list of things to consider can be lengthy. But while you are comparing square footage, number of bedrooms, and neighborhoods, mortgage lenders are looking at the specific numbers that make up your financial fitness. Unless you are among the few homebuyers that will pay cash, you need to understand 4 important numbers on how lenders assess your financial fitness.
These numbers not only impact your ability to buy your dream home, but also how much it costs you in terms of interest rate. The better your financial fitness, the lower interest rate you get, saving you thousands of dollars over the lifetime of your loan.
1. Credit score
Your credit score is one of the most basic ways a lender can determine your creditworthiness, or your ability to pay your loan on time every month. Five key factors impact your score, each varying in importance: payment history (35%), amounts owed (30%), length of credit history (15%), credit mix (10%), and new credit (10%).
While having a low credit score (think below 620) doesn’t necessarily mean being approved for a mortgage is outside the realm of possibility, it certainly makes the situation more challenging. In addition, interest rates for scores in the 580 to 699 range could be anywhere from 0.5% to 4% higher than the lowest rate available — and that will make your mortgage more expensive.
On the flip side, a score of 760 to 850 could land you the best possible rate, and a score of 700 to 760 could put you just 0.25% above the lowest rate.
The graph below shows the relative weight that each one of these categories has in the calculation of your credit score.
Category Possible Points
|Length of credit history||127.5|
|Types of credit||85.0|
2. Down Payment
Times have changed, but cash is still king in the home-buying game. This means the higher the down payment you put on the table upfront, the more overall buying power you can bank on in the end.
There are plenty of benefits to adhering to the often-repeated 20% rule of thumb, in which you come up with a down payment that’s 20% of the sale price of the home. Putting this much cash (or more) into a down payment can eliminate the need for private mortgage insurance (PMI), allow you to negotiate for a lower interest rate, and, in a seller’s market with multiple purchase offers, could place you above other competing offers to get your dream home!
It all boils down to looking committed and financially ready to make such a large purchase. In turn, you could significantly lower the amount you pay over the life of your loan.
3. Debt-to-Income Ratio
Making a nice, steady income is great, but that’s not everything when it comes to determining your mortgage eligibility.
Lenders want the reassurance that you will be able to pay your mortgage in addition to all other financial obligations you currently have. To do this, they will look first at your front-end ratio, or housing ratio — your monthly housing payment (including insurance, interest, taxes, and PMI, if applicable) divided by your monthly income. The general rule of thumb is to keep this at or below 28%.
Next, they will look at your back-end ratio or debt-to-income ratio, a calculation that determines how much of your monthly pay goes to service your existing debt (e.g., car loans, student loans, credit card payments, etc.). This calculation is your total monthly debt payments divided by your total monthly household income. The general rule of thumb for this calculation is to keep it at or below 45%. I personally like to encourage people to keep it below 36%. Although you may qualify, you don’t want to be ‘house poor’.
While landing above the suggested ratios won’t necessarily end your journey to homeownership, it can certainly negatively impact your loan terms.
A lender’s biggest concern is always whether the borrower will have the income coming in and the financial resources already on hand to stay up-to-date on payments, regardless of other financial storms they may be weathering.
Therefore, you will be required to provide a list of assets showing where money for the down payment is coming from (and whether the money is yours or a gift from elsewhere) and how healthy your savings and investments currently are. The bigger your cushion, the more likely lenders are to think you can pay for not only all necessary mortgage costs and fees, but also all home-related financial obligations afterward. A good way to assess this is understanding your Net Worth which is Assets – Liabilities.
At the end of the day…..
Paying careful attention to these numbers and making necessary changes before turning your attention to square footage and finishes can do wonders in ensuring your bank account will be ready when the time comes to make a purchase. As my wife and I learned, having a job and downpayment in the bank isn’t enough. Fortunately, we were still able to purchase our first home over 20 years ago, but not at the best loan terms. However, once we got our financial fitness in order, we refinanced a few years later with much lower interest rate and better terms!
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