When David Inglis and his wife decided to move to San Diego last year, they were expecting a relatively smooth process. They'd keep the house they owned in Los Angeles and rent it out as a source of passive income, then they'd buy a new house in San Diego. They even had a 20% down payment ready to go.
"The problem was that we found renters and had to get out of our current house and close on the new house within 21 days," Inglis, 40, a yacht broker, tells MagnifyMoney. That gave them just 21 days to get a mortgage — easier said than done. As Inglis put it: "Getting approved for a mortgage is a process, to say the least."
With what felt like a moment's notice, the couple had to gather up and submit everything from tax returns to current income statements, and do mountains of paperwork in between to get pre-qualified for a loan. From there, their lender picked through their credit scores, debt-to-income ratio, employment history — you name it. They closed on their new house in the nick of time at the end of 2017, and it was anything but a stress-free experience.
If you're new to the whole buying-a-house thing, locking down a mortgage loan isn't something that happens overnight. That's not to say it isn't worth it though. One recent Value Insured survey found that the vast majority of younger folks—a whopping 83%, in fact—still associate buying a home with the American dream.
At the starting line? There are a number of important factors that go into determining if a lender will approve you for a home loan. Here's everything you need to know.
Getting approved for a mortgage — 5 things lenders are looking for
Remember: A mortgage is a type of loan. When you're applying for any type of financing, your credit score is perhaps the most important piece of the puzzle. This three-digit number essentially provides lenders with a general idea of your creditworthiness.
If you have accounts in collections or a history of making late payments, for example, you'll have a lower-than-average score, which directly affects your loan options. That means you could get hit with higher interest rates or bigger mortgage insurance premiums, or both.
"Your credit score is really important on conventional loans,” John Moran, founder of TheHomeMortgagePro.com, tells MagnifyMoney. “Some other loan programs are less credit-sensitive."
For conventional home loans, Moran says your credit score has to be at least 620, but for FHA or VA loans, you may be able to get away with a score in the 500s. But it’s not just about getting approved. The lower your score, the higher your mortgage rate will likely be — and that can add tens of thousands of dollars to the cost of your loan over time.
FICO, America's leading credit reporting agency, looks at several important factors when determining your score. Your payment history, amounts owed, and length of credit history are chief among them. If you’re aiming for a home in the next year or two, you’ve got time to improve your credit if you start now.
Trust us — it’ll be worth the effort. You can see below what estimated mortgage rate folks would get based on their credit score and how much it could cost them over time. For our purposes, we’ll assume they’re all getting a $250,000 30-year fixed rate loan.
Total interest paid
Source: Calculated using the MyFico Loan Savings Calculator
You can find a detailed breakdown of your credit score by pulling up your credit report for free. Your report unpacks your credit history for lenders, so it’s vital to know what’s on it. This is crucial because you could end up spotting an error that's weighing your score down.
If your credit score could use some work, don't fret—there are plenty of ways to give it a good boost before buying a home. Establishing credit history, keeping your credit utilization ratio below 30%, and making consistent on-time payments are all on the list.
Debt vs. income
Your credit score goes hand in hand with your current debt load. Lenders specifically zero in on how your debt relates to your income. Together, this determines what's known as your debt-to-income ratio (DTI)..
To calculate out your DTI, it’s fairly simple: Add up all your monthly debt obligations (not including your current housing payment unless you own the home and plan on keeping it), then divide that number by your gross monthly income. So if you pay, for example, $2,000 a month toward debt and you're grossing $4,500, your DTI comes in at about 44%.
What’s a good DTI? Strive for 36% or less.
Fannie Mae, which sets the lending standards for the vast majority of mortgage loans, generally requires a maximum total DTI of no more than 36%. However, if the borrower meets certain credit and reserve requirements, they can generally get away with 45%.
Why? A high DTI is a red flag to lenders that you may not be able to afford a new monthly loan payment. In a lot of ways, it's more telling than your credit score.
"The only thing that really matters to lenders is how this new monthly payment and your other debts relate to your income," said Moran. "One of the quickest ways people can turn things around is by paying down revolving debts like credit cards and lines of credit, which increases your available credit and decreases your credit utilization ratio."
He adds that making a smaller down payment in order to pay down revolving debt might improve your chances of qualifying since doing so will boost your credit score relatively quickly. Knocking those balances down also lowers your monthly minimum payment, so you may be able to qualify for a larger loan. In other words, your DTI isn't the end-all-be-all when applying for a mortgage loan, but it’s pretty important.
Lenders also look at how much of a down payment you can make, which ties directly back into your debt-to-income ratio. According to Bob McLaughlin, director of residential mortgage at financial services company Bryn Mawr Trust, putting down a higher down payment makes you more likely to get approved since it essentially decreases the risk for the lender. As a result, better loan terms and interest rates will likely be on the table.
"If you have the ability to put 20% down, you also avoid having to pay private mortgage insurance, which makes it easier to qualify," he said.
Another perk is that you'll have more equity in your home as well as a lower monthly mortgage payment. But for many, saving for a 20% down payment is a serious barrier to homeownership. Not surprisingly, a 2016 report put out by the National Association of Realtors found that the average down payment for first-time homebuyers has fallen in the 6% range for the last few years. The good news is that according to Moran, you can still get approved with a lower down payment.
"You can put 0% down for VA loans, 3.5% for FHA loans and even as little as 3% for conventional loans," he said.
"There are people all the time buying homes with these minimum down payments, but it really all boils down to what you're comfortable with and the kind of monthly payment you can handle."
FHA and VA loans are usually the first low down-payment loans that come to mind, but options like personal loans and USDA loans may also be worth considering. Just keep in mind that taking this shortcut could potentially translate to a financial burden — low down payments typically necessitate higher insurance rates and extra fees to protect the lender.
That said, lenders are really looking at your big financial picture, not just your down payment size. If you're putting down less, but have a good score and a steady source of income, you're much more likely to get approved for a mortgage loan than someone with a lower score and/or spotty employment status.
Our insiders say that your income and employment history are just as important as your credit score, DTI and down payment size. Again, it all comes down to lenders feeling confident that you can indeed repay your loan.
"You have to fit the underwriting guidelines per your profession, and there is little flexibility there," said McLaughlin.
Piggybacking on this insight, Moran says that the ideal situation is if you've worked for the same employer for two years and you're salaried. The second ideal way to get the green light is if you're an hourly worker who's been with the same company for at least two years.
But all this begs one obvious question: What about self-employed folks? The freelance economy is growing rapidly. According to the latest Freelancing in America survey conducted by Upwork and the Freelancers Union, these folks are predicted to make up the majority of the U.S. workforce within the next decade. Moran says that for these workers to qualify for a mortgage, they'll need to have a two-year work history.
Check out our guide on getting approved for a mortgage when you’re self-employed.
"It's a little bit of a kiss of death to start self-employment right before applying for a home loan," he said.
"Most lenders won't approve you because they want to be sure you'll be able to afford your new loan payment. The only way to really prove you have a steady income is with two years' worth of tax returns."
In rare cases, Moran adds, you may be able to get away with one year, but it’s not the norm. Things are different of course, for self-employed newbies who are applying with a spouse who works a steady 9-to-5, which could tip the scales in their favor. Again, it's all about the big picture. That said, a new salaried position will typically erase doubts stemming from a spotty employment history, as long as you have about two months’ worth of pay stubs, according to McLaughlin.
All the factors we're highlighting here are interwoven. The size of the loan you're applying for fits right in. The higher your loan amount, the higher your monthly payment, which impacts that all-important DTI.
This is why you may be more likely to get approved if you're seeking a lower amount. But whether you're looking for $100,000 or $400,000, it really boils down to how big of a monthly payment your budget can absorb. (Lending Tree, which is the parent company of MagnifyMoney, has a Home Affordability Calculator that can help you figure this out.)
The general rule of thumb here is to keep your mortgage loan (including principal, interest, taxes, and insurance) at or below 28% of your total income. Moran has worked with ultra-conservative folks who like to keep that number at 25%, but he says it really varies from person to person.
"Some people like to travel and don't want to be house poor; others are homebodies and just really want a nice house because that's where they're going to spend their time," he said.
"It's all a trade-off, but either way, lenders will only pre-qualify you for what they think you can actually afford."
How to get preapproved for a mortgage
Pre-approval is a term you're likely to hear in the home-buying process. This is when the lender takes into account everything from your credit score and debts to employment history and down payment size to offer you a maximum loan amount.
When you come to the table with a pre-approved offer of lending from a bank, you’re already way ahead of the competition. And this can really give you an edge. When you’re living in a metro where most people are coming with double-digit down payments and pre-approvals to boot, you’re competing with very attractive borrowers.
Pre-approvals will ding your credit score, but the hit won’t be too bad if you complete several mortgage applications over a short time period, like 30 to 45 days. Multiple inquiries should only count as one hard inquiry on your credit report.
A good rule of thumb is to get mortgage quotes before you apply for pre-approval. You can get quotes quickly from different lenders at LendingTree by filling out a short online form.
Included in a pre-approval letter will be the estimated loan amount you might qualify for and your estimated mortgage rate.
The pre-approval process is also meant to prevent you from making offers on homes you can't afford. But this doesn't mean you have to actually take out a loan for the full amount. Many choose to get preapproved for their top number, then dial back during negotiations.
When it comes to mortgage approval factors, there are a lot of moving parts. Far and away, your credit score and debt-to-income ratio carry the most weight for potential lenders. From there, your ability to prove that you're steadily and reliably employed is equally important.
At the end of the day, all that really matters is that you're applying for a loan that you'll actually be able to repay hiccup-free. The larger your down payment, the better your odds—especially if it eliminates the need for PMI. Either way, it's probably in your best interest to meet with lenders before you start house hunting.
"You don't want to put the cart before the horse by going with a realtor to look at houses, only to fall in love with something you can't afford," added McLaughlin. "Your emotions can definitely make the mortgage application process more stressful, which is why it's best to go through the prequalification process first."
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