Qualifying for a mortgage can seem intimidating if you've never gone through the process or you hear about lenders tightening loan approval standards. But by knowing what the bank is looking for, you will take some stress out of getting a home loan.
The approval process "breaks down into four basic categories," says Nicole Rueth, producing branch manager of Fairway Independent Mortgage Corp. in Englewood, Colorado. "If you nail these, your approval is straightforward. Of course, each of these has 100 variations, which is where the nuance comes in."
Here's what goes into the mortgage approval process, how to improve your chances of approval and what to do if your application is denied.
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What Do Lenders Check When You Apply for a Mortgage?
Lenders look at four categories – capacity, capital, collateral and credit – to determine your eligibility for a mortgage. These are typically the minimum requirements:
Capacity, or your ability to repay the loan. The lender will check your income and employment stability from the last two years to make sure you can comfortably take on the monthly mortgage payments. Most homebuyers show their income with:
- W-2 forms.
- Recent pay stubs.
- Tax returns.
- Contact information for employers.
The requirements vary if your income is from sources such as dividends, alimony, rental income or self-employment, Rueth says.
Capital, or your assets and cash reserves. You'll need to show you have the funds to cover the down payment and closing costs, plus cash on hand to pay the mortgage in a financial emergency. The cash reserve is usually two months' worth of mortgage payments for conventional loans. For documentation, lenders generally accept statements that show your bank account balances, liquid investments, properties and other assets.
Collateral, or the value of the property you're buying. The bank will order an appraisal to check the home's value and make sure the mortgage doesn't exceed it. The appraisal report might show that flaws in paint, stairs or utilities, for example, need to be fixed before the bank can fund the loan. "Lenders are in the business of loaning out money, not owning property," Rueth says. "If a loan defaults, we need to make sure the property can be quickly resold."
Credit, or your likelihood of repaying the loan. Your credit history and credit score play a big role in whether you will be approved for a mortgage and at what interest rate.
"Underwriters are looking for proof that you can manage large, long-term debt," Rueth says. "If you did have a credit hardship, such as a short sale or bankruptcy, underwriters want to see that you have maintained a positive history since that time."
Borrowers generally need a credit score of at least 620 to qualify for a conventional loan, and the minimum credit score for a Federal Housing Administration loan is 500 or 580, depending on the borrower's down payment.
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How to Improve Your Chances of Approval
When applying for a mortgage, you have to either meet or exceed the lender's basic requirements. Here's what can help you get a home loan:
Check your credit. A few months before applying for a mortgage, pull your credit report from each of the three bureaus at AnnualCreditReport.com. Check your reports for evidence of fraud, such as accounts you don't recognize.
Errors are also common, so check that reports are accurate, complete and contain only items about you. Any mistake about identity, account status or balance, for instance, can be disputed with the credit bureaus.
You can also pull your credit scores from free third-party services. Because many lenders have tightened their underwriting standards in response to the pandemic, you might need to improve your credit before moving forward.
The average FICO credit score among mortgage borrowers in March 2021 was 751, according to the mortgage software company Ellie Mae. This falls in FICO's very good range.
Take a few months, and focus on paying down your debt and staying current on all of your bills. Try not to get other types of new credit, which could increase your debt and create hard inquiries that temporarily lower your credit score.
Calculate your debt-to-income ratio. DTI is the percentage of your monthly income you spend on debt payments. This figure tells the lender how much house you can afford.
Your lender will look at two ratios: Front-end DTI checks how much of your income goes toward housing costs, and back-end DTI accounts for other debts, such as credit cards and car loans.
Let's say your future mortgage payment will be $975 and you have a $200 student loan payment, a $250 car payment and a minimum credit card payment of $150. Your monthly income is $4,000. Here's how you would calculate those ratios:
- Front-end DTI. $975 / $4,000 = 0.24 or 24%
- Back-end DTI. ($975 + $200 + $250 + $150) / $4,000 = 0.39 or 39%
Lenders generally look for a back-end ratio of 43% or less and a front-end ratio of 28% or less. If yours needs work, focus on paying down your debt or increasing your income.
Save your money. You'll need to have cash reserves, plus enough to cover the down payment and closing costs.
Let's say you're looking to buy a $200,000 home with a $975 monthly payment and your bills each month amount to $2,000. Here's how much you might want to save:
- Closing costs. These averaged $6,087 in 2020 for a single-family home. Your lender can provide a more precise estimate once you've chosen a home.
- Down payment. Some mortgage programs allow as little as 3% down, which is $6,000 on a $200,000 mortgage. But you'll avoid private mortgage insurance with a 20% down payment.
- Cash reserves: Your lender might require you to have two months' worth of mortgage payments on hand, which is $1,950. But many financial experts recommend saving three to six months' worth of expenses, which is between $6,000 and $12,000 in this example. Consider what's required, how much you can afford and what would make you a strong applicant.
Borrowers who make larger down payments are less likely to walk away from their homes in the event of financial difficulty, says Mike Tassone, co-founder and chief operating officer at Own Up, a technology company that helps homebuyers find mortgages. Similarly, having more cash reserves shows the lender that the homebuyer can continue making payments even with "short-term shocks to their monthly income," he says.
Get preapproved for a mortgage. A preapproval is a letter from a mortgage lender that shows how much you can borrow. Going through this process before shopping for homes is a good idea because it shows sellers you're serious and guides your budget.
"Once you start looking at $600,000 homes, it's hard to find the perfect $480,000 home if that's all that fits your budget or income," Rueth says.
The typical person can afford to finance a home that costs two to three times his or her gross annual household income, according to some financial experts. If you earn $75,000 a year, then you might be able to afford a mortgage of $150,000 to $225,000.
Make the right offer. The red-hot seller's market means you will have to make a strong offer to beat the competition, but it still needs to align with the home's value. If comparable sales do not support your bid, the bank won't lend you this amount and instead offer the home's appraised value. You can pay the difference between your offer and the appraised value out of pocket, try to appeal the appraisal, or pull out of the deal.
Talk with a few lenders. Every mortgage lender has its own borrowing requirements, and one might be a better fit for you over another. For example, one bank might specialize in lending to people with lower credit scores or borrowers who need a jumbo loan.
Ashley Luethje, a loan officer with Paramount Residential Mortgage Group, suggests setting up a phone call with a few lenders. "This provides the client with an idea of what program is the best fit for them, the amount of their monthly payment, how much they need to save for down payment and closing costs, as well as if there are any other additional credit or program requirements," she says.
Don't make big changes before closing day. Any changes to your financial situation "could affect the customer's ability to qualify," Luethje says. "If someone purchases a new car or takes out a new credit card, ultimately that is an additional monthly payment that would increase debt ratios and potentially disqualify the customer."
If possible, don't apply for new credit or put a lot of charges on your credit card while you apply for a mortgage. And if you're thinking of changing your job, wait until you close.
"A job change, especially for FHA loans, can cause a 30-day delay," Rueth says.
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What to Do if Your Mortgage Application Is Denied
The lender must tell you within 30 days whether your mortgage is approved, and if your application is rejected, the lender must inform you in writing.
"If your mortgage application is denied, don't give up," Rueth says. "Find out why it was denied and what it will take to get you there."
That might involve going to another lender, she adds.
The lender has 60 days to give you the reason your mortgage application was rejected. The reason must be specific. For example, the bank might say your income is too low or you don't have a long enough employment history.
You also have the right to ask the lender for:
- Reasons you received less-favorable terms than you wanted. If the lender offers you a smaller mortgage or higher interest rate than you applied for, the lender must tell you why.
- A copy of the property appraisal. The bank may reject your mortgage if the appraised home value is too low or too high. Make sure the appraisal report includes accurate information about the home, and consider disputing the appraisal if you are not satisfied.
- A copy of the credit reports your lender used. If your application was rejected because of negative information in your credit reports, the lender must tell you. The lender must also provide the name, address and phone number of the credit-reporting company that provided the information.
Kim Porter began her career as a writer and an editor focusing on personal finance in 2010 and has since been published everywhere from U.S. News to Credit Karma. Her work for U.S. News focuses on student loans and credit health.