Owning a home is a rite of passage for every American. At the end of 1999, the average sales price for a home in the United States was $202,000. Some 20-years later in 2019, the average cost of a home including the land has grown to $377,000 – Nearly doubling the cost of home ownership.
For aspiring homeowners, the thought of moving into a property is unachievable unless you can qualify for a mortgage. Applying for finance for your new home requires that you provide lenders with documentation, proving you can pay back the money you lend to purchase the property.
Unfortunately, not everybody can qualify for a home loan, and several factors determine whether or not a bank or financial institution will loan you the funds.
It’s essential to have your ducks in a row before you go into a bank and ask to speak to the loan officer.
Here’s everything you need to know about what’s involved with qualifying for a mortgage.
The Different Types of Home Loans
When it comes to applying for your home loan, there are two different types of loans available. government-backed mortgages are a standard option available to new home buyers, issued by private lenders and backed by the federal government.
Conventional loans are available from both government-backed lenders, as well as private lenders, but they do not feature any government guarantee.
There are a few differences between the two loan types. Should you default on your mortgage repayments under a government-backed loan, then the government will ensure that the lender is made whole.
With conventional loans, if you fail to repay the mortgage, then you are liable for the amount due, and the lender may repossess your property to cover the outstanding amount.
Government-Backed Home Loans
There are government agencies that insure mortgages to help new homeowners get approved for finance on their new property.
The Federal Housing Administration is one of the most accessible types of mortgages to qualify for, featuring down payments as little as 3.5-percent. If you take out a loan facility with the FHA, then you need to be aware that you have to pay for mortgage insurance. However, your insurance payments under an FHA loan may potentially be more expensive than most private mortgage insurance policies.
Mortgage insurance protects you from losing your home through default if you can no longer pay the mortgage. However, FHA loans require 1.75-percent of the total loan cost upfront for your initial insurance payment, and a further 0.8-percent per annum for the duration of the loan. Almost anyone can qualify for an FHA loan, and they are very popular with first-time homeowners.
If you are a veteran, then the Federal Department of Veterans Affairs issues guaranteed loans for retired and current service members. VA loans provide eligible borrowers with minimal qualifying requirements, as well as very favorable terms. It’s possible to get a VA loan with no down payment as long as a qualified estate agent correctly values the home.
VA loans are available with no minimum credit score criteria qualifying the candidate for a mortgage. VA loans do not require any mortgage insurance, and the only qualifying criteria for the mortgage is an upfront funding fee of between 0.5 and 3.5-percent of the total loan amount. Disabled veterans or widows of fallen servicemen or servicewomen, may qualify for a waiver of the upfront funding fee.
The Rural Housing Service operate under the United States Federal Department of Agriculture. The RHS guarantee loans for homebuyers in rural areas that cannot qualify for conventional financing methods due to income limitations.
USDA loans do not require any down payment. However, they may charge an upfront fee of 1-percent of the mortgage amount, as well as an annual fee of 0.35-percent of the total loan value.
Where to Source Your Government-Backed Mortgage
Various private lenders participate in these government-backed loan programs. You’ll need to visit one of these lenders to take out a mortgage, and it’s important to note that they are not directly available through the government.
Comparing government-backed loans to conventional loans, you’ll find that lending requirements of far more relaxed. However, you’ll need to have the home appraised and inspected to meet minimum health and safety standards.
Conventional Mortgage Loans
There are two types of conventional mortgage loans available to buyers – Conforming and non-conforming loans.
These loans adhere to specific guidelines set by Fannie Mae and Freddie Mac, which are government-sponsored entities, that purchase mortgages from the original lenders. Some lenders don’t like to expose their business to risk involved with mortgages.
Instead, they sell them to Freddie and Fannie Mae, or other private entities that buy mortgage debt from issuers. Both Freddie and Fannie do not buy non-conforming loans that fail to meet qualifying criteria and standards for a mortgage. Such examples of these criteria would be minimum credit scores and income-to-debt ratios.
These are mortgages issued by private entities that don’t adhere to the same guidelines set by Fannie Mae and Freddie Mac. Jumbo loans are the most common type of non-conforming loan used by individuals that want to buy a home of higher value than what Fannie and Freddie would typically take on.
In 2018, Fannie and Freddie would not issue mortgages for sums greater than $453,100, or $679,650 for properties in territories such as the U.S Virgin Islands, Guam, Hawaii, or Alaska. Therefore, a jumbo loan assists buyers with the additional finance required for purchasing the property.
Non-Qualified Vs. Qualified Loans
When applying for a mortgage, loans fall into two categories – unqualified and qualified. Both non-conforming and conventional loans should be either non-qualified or qualified, depending on whether you meet the qualifying criteria for the mortgage.
These loans meet established criteria set by the Consumer Financial Protection Bureau. These qualifying criteria ensure that lenders complete due diligence on the borrower before issuing the non-mortgage, minimizing the risk of default.
Qualifying loans also decrease predatory lending in the mortgage market, such as lenders that offer interest-only payments. Interest-only payments on your mortgage never reduce the principal amount, meaning that the lender is in a perpetual state of debt.
These mortgages do not meet CFPB qualifying criteria. This fact does not mean that every lender offering these types of loans are taking advantage of predatory finance. However, if you are thinking about taking out a non-qualified mortgage, then you should make sure that you do your due diligence on the lender.
This strategy ensures that you do not fall prey to unfair financing terms. In most situations, non-qualified loans have far more relaxed requirements for approval than qualified loans.
Qualifying Criteria for a Mortgage
The 2008 housing crisis changed the landscape in the mortgage market. Before the crisis, lenders issued “stated income loans,” which did not include any proof of income in qualifying for the mortgage.
Unfortunately, many people applying for a loan falsified their income, to be eligible for a larger mortgage on a house that they could not afford.
These “liar’s loans,” were at the epicenter of the crisis, and responsible for the most significant economic downturn in American History since the Great Depression. As a result of the financial onslaught that occurred after 2008, lenders tightened the qualifying criteria needed for acquiring a mortgage.
There are a few essential documents you need to receive approval for any type of home loan. Here is what you’ll need to have on hand before you go house-hunting.
Proof of Income
The primary concern of any mortgage lender is that you’ll be able to afford the loan repayments. Therefore, you’ll need to prove that you have a steady source of income that’s valid to the lender. If you work for a company, then you’ll need a payslip, as well as proof of bonuses and commissions, if you are in a sales position.
If you’re self-employed, then the lender will likely need to see 6 to 12-months of income statements. This criterion assures the lender that the business is viable, and can support your debt levels. Business owners may also require W2s or 1099 forms from companies or employers that do business with your company.
Other sources of income you can use when applying for your home loan include child support or alimony payments, as well as income from social security. Investors can you use the income from interest and dividends to qualify, as well as income from rental properties.
In the majority of cases, lenders will not allow you to use a financial windfall, such as a one-off bonus at work, an inheritance, or gambling winnings, for proof of income. The lender requires that you prove your income for up to 6 to 12-months before they consider it as verifiable income.
The Debt to Income Ratio
While income is possibly the most critical qualifying criteria when applying for a mortgage, lenders will also take a look at your debt-to-income ratio. This criterion shows the true financial health of the applicant. For instance, if you have an income of $50,000, and have zero debt, then you have a better income-to-debt ratio, than someone who earns $500,000 but has a million dollars in debt.
Lenders for use all outstanding sources of debt when accounting for your debt-to-income ratio. Credit cards, student loans, and business loans, all count towards your debt load. Lenders discount this from your income to determine the affordability of taking on mortgage debt.
Your Credit Score
When applying for a mortgage, lenders will look at your previous borrowing history, and take this into account to determine your risk profile.
If you have a history of making late payments on accounts, or you have any judgments for unpaid bills or charge-offs, this may damage your credit score. Foreclosures and bankruptcies are also taken into account when calculating your credit score.
Lenders will look at the amount of available credit to determine your credit utilization ratio. For example, if you have $20,000 in available credit, and debts totaling $4,000, then your credit utilization ratio is 20-percent. Lenders like to see a credit utilization ratio of less than 30-percent to qualify for a mortgage.
Lenders also like to see a mix of different types of credit facilities such as credit cards, auto loans, student loans, or a previous mortgage.
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Healthy Credit Scores
Two institutions calculate your credit score, with the most popular system used by lenders being FICO. Here’s a brief breakdown of credit score categories that will qualify you for a loan.
Any score below 580 will make it incredibly challenging for you to find finance.
Credit scores between 580 and 669 are considered fair, and some lenders will approve you for a mortgage, but they may offer you unfavorable credit terms. In this case, it may be a prudent strategy to apply for a government-backed loan over a conventional mortgage.
Scores between 670 and 739 are considered good credit, and you should have a variety of mortgage lenders that are willing to work with you. The lender will also be more likely to offer you favorable terms on your mortgage.
If you have a credit score of 740 or more, then you are in the upper echelon of good credit, and you can expect the lowest terms from any lender.
VantageScore is another credit score system created by Experian, Equifax, and TransUnion, who are the three main credit Bureaus in the United States. Some lenders use VantageScore, as it takes consumers less time to build a score on this platform than it does with FICO.
Qualifying Credit Scores
To acquire government-backed mortgages and conventional home loans, the minimum score required to access a mortgage facility is typically 620 on the FICO system.
Applicants looking to take on an FHA loan may qualify with a score of 500, but the lender may require you to place a 10-percent down payment on the total loan amount. Veterans looking to apply for a VA loan do not require any specific credit score. However, the lender may look at the borrower’s financial profile to determine risk.
The Down Payment
The final qualifying criteria for a mortgage is a down payment. Lenders require a down payment to show that you have an equity stake in the home that proves ownership. Before 2008 lenders did not require a down payment, and this policy mistake exacerbated the effects of the crisis.
By making a down payment, you typically cover the costs involved in purchasing a home. Should you be unable to make your mortgage payments, then the down payment will ensure that you do not owe the lender money after foreclosure on the home.
Lenders require proof of funds when making your down payment to meet international anti-money laundering legislation (AML). Acceptable sources of funds for your down payment include your checking or savings account, a 401(k) or IRA, as well as investments like bonds, stocks, or a trust account.
Lenders will not allow you to use a personal loan for the down payment on your home. This piggybacking strategy places you at further financial risk, should you default on their mortgage payments. The size of the down payment varies depending on the size of the mortgage. Most government-backed mortgages have minimal down payment requirements, with some such as the VA loan, not requiring any down payment from the borrower.
Wrapping Up – Additional Requirements for Qualifying for a Mortgage
When applying for a mortgage, there may be extra costs involved. A home appraisal is necessary to determine the value of the home, allowing the lender to assess the down payment requirement.
The evaluation also determines the amount of money the institution is willing to lend you for the mortgage. If the appraisal states that the home is worth $200,000 and you try to apply for a loan of $250,000, then the lender will not approve you for the full amount.
A survey and inspection of the property is also a requirement for most lenders, to ensure that the home is structurally sound. Title insurance protects both the lender and the borrower, in case of outstanding claims, such as a tax lien.
You also need to account for the money for closing costs, which may be anywhere between 2 and 5-percent of the purchase price of the property.