When you begin looking for your dream home, it’s fun to fantasize about buying one of the largest and most extravagant properties in your city. In Nashville, that means drooling in front of the gated mansions of country music’s biggest stars. But in reality, your budget is probably closer to that country star’s assistant. Or possibly even their assistant’s assistant.
Also, you probably don’t have the funds to throw down and purchase a home without some type of financing. Unless you’re an investor, or have some wealthy and generous relatives, it’s unlikely you’re shopping with cash.
According to a Realtor Home Buyer and Seller Generational Trends Report, 88% of recent homebuyers financed their purchase. And almost all of Generation Y buyers (97%) have borrowed money. That means these buyers needed to be approved for a mortgage.
Do you know what keeps loan officers awake at night? It’s not your credit score.
It may surprise prospective homebuyers that debt-to-income ratio (DTI) is actually the most important factor in getting approved for a mortgage. Why? The ability to both afford and pay back a loan is critical. A FICO score may shed light on your past reliability, but it doesn’t indicate whether or not your present budget can handle a loan. However, a DTI ratio can help lenders measure your ability to afford a monthly mortgage payment.
A debt-to-income ratio is calculated by dividing total recurring monthly debt by gross monthly income. For example, if your monthly debts equal $1,000 and your gross monthly income is $4,000, your DTI ratio is $1,000 / $4,000 = .25 or 25%.
Lenders prefer for borrowers to have a debt-to-income ratio of less than 36%, with no more than 28% of that debt being paid toward the mortgage. Generally, it’s difficult for a borrower with a DTI ratio greater than 43% to be qualified for a loan.
If your debt-to-income ratio is more than 43%, you may want to consider working on reducing it before applying for a loan. The two main ways to achieve this are by reducing your monthly recurring debt, increasing your gross monthly income, or a combination of the two.
If you think your DTI is acceptable, you should shop around for the lowest interest rate. We recommend starting the mortgage shopping process with LendingTree, which is the parent company of MagnifyMoney. With one online form, over 400 mortgage lenders will compete for your business. Different lenders have different approaches, so only by shopping will you be able to determine if you can qualify.
What Paperwork is Required?
The effects of the financial crisis and The Great Recession have led to increased government regulation throughout the housing market. Lenders are now required to closely scrutinize potential borrowers to make sure they can afford the loans they’ve applied for. This includes verifying income and a complete picture of their finances.
Some lenders are stricter than others. Fannie Mae and Freddie Mac are government agencies with relatively standard income requirements (which we will outline below). However, if you don't fit the box of a standard 9-5 worker with a W2, you might want to consider a lender like SoFi, which even offers loans up to 90% LTV with no PMI requirements.
You should receive a list of what’s needed from the lender and these items may include:
- A purchase contract.
- Individual taxpayer identification and/or Social Security number.
- Your current home addresses and any previous residences from past two years.
- Names, account numbers, and current balances of checking, savings, retirement, and credit card accounts.
- Your bank’s address.
- The past three months’ checking and savings account statements.
- Income verification statements (pay stubs, W-2s, or other proof of employment).
- The past two years’ Federal income-tax returns.
- Documentation to prove any additional income you received.
- Balance sheets and tax returns if you are self-employed.
- Cancelled checks to show payment history for rent and utility bills.
- Documentation of any additional consumer debts.
- Gift letters. If family members or organizations are helping you cover the cost, you must have a gift letter stating the money is a gift and will not need to be repaid.
The mortgage underwriting process can take months, so it’s imperative to provide the lender with all paperwork they’ve requested as quickly as you can. They may reach out with questions and ask for further documentation, if needed.
Why You Need a Good Faith Estimate
Once you’ve handed over the mountains of required paperwork, you’ll want to make sure you have a complete understanding of the full cost of the loan.
Would you blindly agree to the financing for a new car or a new television? Of course not. And you shouldn’t for a mortgage, either. Expenses for credit reports, processing fees, appraisal fees, attorney’s fees, surveying, inspection fees, and title fees can add up quickly. In fact, closing costs can amount to 2-5% of the home’s sale price! The only way to know the true cost of a loan is through a Good Faith Estimate (GFE).
Lenders are required to provide you with a Good Faith Estimate within three days of receiving your mortgage application. Although a GFE can help you understand the full costs of the loan and monthly mortgage payments, legally it can change up to 10%. Be sure to closely compare your GFE with the HUD-1 settlement statement you receive the day before closing. Don’t be afraid to review each item, line-by-line, and ask questions if anything doesn’t look right.
How Much House Can I Really Afford?
Most prospective buyers want to know how much home they can afford. The exact payment for a property depends on the monthly debt payments and the current interest rate. Standard ratios from online calculators can give you a general idea, but ultimately, you’ll need to decide how much you can comfortably add to your budget.
Remember, your monthly mortgage payment can change based on your type of loan, interest rate, homeowner’s insurance, and property taxes. Have you planned for future increases?
It’s also important to consider the cost of home maintenance and repairs. Will a down payment, closing costs, and your new monthly mortgage payments leave you with a comfortable emergency fund?
Lastly, and perhaps most importantly, will taking on a monthly mortgage payment prevent you from saving for future goals like your child’s college education or retirement?
Don’t Go Into the Home Buying Process Blind
Buying a home is the largest purchase many of us will make, and diving into the process blind can make the entire process even more nerve-wracking. Avoid surprises by arming yourself with knowledge before approaching a lender for a pre-approval. That means knowing your credit score, how much you can afford, and what information you’ll be asked for to prove it.
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