At some point you’re going to likely want to buy a house. After all, buying a house can translate into price appreciation, independent living and tax benefits. Owning your own home is also a social symbol of financial success and maturity. It is the American Dream. Also, once you buy your own home, you can stop paying rent and use your money to build equity and wealth.
However, many potential buyers start home shopping before getting their financial affairs in order. As a result, many potential buyers become frustrated when lenders decline their loan applications, resulting in a halt to their home buying efforts. In real estate, especially in a seller’s market where there are plenty of qualified buyers, you need to be ready if you’re serious about buying.
How do you know how much house you can afford? Well, most lenders have clearly defined parameters to let you know what kind of loan you qualify for. In almost all cases, lenders are willing to provide you with a pre-approval letter, letting everyone know the size of the loan you qualify for. A pre-approval letter shows the sellers that you’ve done your due diligence and you can act fast once you’re in contract. Sellers and brokers don’t want to waste their time if they are dealing with a buyer who can’t afford the home they’re selling. In a sellers market, there are simply too many other qualified buyers that want the same house.
Criteria for Loan Approval:
1.) Sufficient Down Payment: A down payment is the amount of money you need to pay out of your pocket when buying a house. The size of the down payment varies greatly depending on individual circumstances, such as income and credit history. Generally, the more risky your situation is (i.e. past credit issues), the more you will probably be expected to make a larger down payment. Down payments generally range from 3.5% to 20% of a home’s appraised value. For anything under 20%, you will almost certainly be required to pay Private Mortgage Insurance (PMI), which is an insurance that protects lenders if the borrower defaults on the loan. This can add several hundreds of dollars to your monthly payment. You want to avoid paying PMI if at all possible. It’s a monthly expense that protects the lender. There is no benefit to the borrower. Basically, the lenders feel you are a greater risk of default if your initial financial stake in the property is less than 20%.
2.) Good Credit History: If you are serious about buying a home, or anything else that requires a loan, you absolutely need to maintain a clean credit history. You should avoid any delinquencies on your financial obligations, including credit card payments, car payments, medical bills, rent, etc. Any negative items or derogatory remarks on your credit history are red flags to lenders, indicating that you may not be trust-worthy of a loan. Therefore, it is critical that you’re aware of what’s on your credit history and try your best to remedy any issues, or mistakes. One of the major indicators about a person’s credit history is their credit score. The most often used credit scoring method is the Fair, Isaac, and Company (FICO) score, which analyzes your credit performance as per the three major credit bureaus in the United States, which are Equifax, Experian and TransUnion. FICO scores range from 300 to 850, with the average FICO score in the U.S. in 2016 being 695. The higher your FICO score, the better.
3.) Verifiable Income: In order to get any loan, you will likely need to show a consistent income stream, either through employment or having your own business. If you are employed , the lender will want to see pay-stubs and a W-2. If you own a business, they will likely want to see receipts or deposits made into your bank account. Either way, you will be expected to show your tax returns for the past 2-3 years and bank statements for the past 3-months.
4.) Debt-to-Income Ratio: This ratio is your monthly debt payments divided by your gross monthly income (debt payments/gross income). This ratio is very important, because lenders want to make sure you’re not already burdened with too much debt, relative to your income. Generally speaking, lenders want to see a maximum debt-to-income ratio of 36%, with a maximum of 28% going towards your mortgage. Some lenders might go higher, but you will probably pay for it in terms of higher interest rates and/or down payments. It is important to note, that you may have a high income, but a poor debt-to-income ratio, if you have a lot of debt. Conversely, you may have a lower income, but a good debt-to-income ratio, if you maintain low debt levels.
5.) Home Value: Even if you feel you found a home that you qualify for, the final say on value is up to a licensed appraiser. Basically, the appraiser must generate a value of opinion as to what the home is worth. This is the figure that the lender will use to decide on the loan size they will approve on the property. Generally speaking, lenders want to see an Loan-to-Value (LTV) of 80% or less. This means that if you find a home which is appraised for $250,000, the maximum loan the lender will approve for this property is $200,000. In this case the buyer must put a down payment of $50,000. Now, if the seller of this house is asking $275,000, then you must either negotiate the price down, or increase your down payment to $75,000. However, some lenders will offer loans for more than 80% LTV. Every situation is different.
The legwork involved in getting a loan is probably the most tedious and stressful part about buying a home. A lot of paperwork is required and you need to provide a lot of explanations regarding your credit history, income, taxes, etc. However, it is a necessary part of most real estate transactions and has a big impact on the success of your purchase. The key is to pay all your bills on time, keep a clean credit history, keep debt to a minimum and live within your means. Also, it is important that you shop around for the right house and the right loan.
Zillow’s Home Affordability Calculator