Financial institutions look at a wide variety of things when a customer applies for mortgage financing on a home. There are 3 main building blocks that create the foundation for a solid mortgage application. If any of these 3 building blocks are compromised, it can result in a less than desired type of financing or having to change your financing to allow you to proceed. The 3 main building blocks of a purchase or refinance request are: Credit score, debt-to-income ratio and down payment percentage.
The most important building block is the credit score. This is your ticket to get into the race. The reason why so much weight is put on the credit score is because it’s a reflection of your past financial choices. Credit scores take time to develop and take root and are usually based on years of data collected from creditors. You need to have a good credit score to qualify for the best financing available. If your credit score is low, it eliminates options for you and makes things more expensive. The lower your credit score, the more it will cost you in fees and in your monthly payment.
Credit scores range from 300 to 850 and most lenders use the FICO (Fair Isaac Corporation) scoring model. Each loan program has their own set of rules that need to be met to qualify. For example, FHA loans require a minimum of a 580-credit score and conventional loans require a minimum of a 620-credit score. These are the bare minimum credit score requirements though. Just because your score is at that point, it doesn’t necessarily mean you will qualify. You need to meet other qualifications as well such as your debt-to-income ratio.
The debt-to-income ratio is the 2nd most important building block of the transaction. If credit score was in a race against debt-to-income ratio, debt-to-income ratio would come in a very close 2nd place finish. Other than the credit score, it plays the largest role in which loan you can qualify for and how much. For example, you may want a conventional loan because you have a great credit score but if your debt-to-income ratio is too high, you may take yourself out of the running for qualifying for a conventional loan and you might even not qualify for a loan at all! You can have a 780-credit score but not qualify for a mortgage because of having too high of a debt-to-income ratio. Financing can be changed to accommodate a higher debt to income ratio, but it may not be in your best interest.
There are two pieces of the debt-to-income ratio that you must consider; The front-end ratio (housing ratio) and the back-end ratio (Overall ratio). Every loan has a different front-end ratio and back-end ratio and that’s another reason why your debt-to-income ratio is so important. If you want to qualify for a specific loan, you need to meet its debt-to-income ratio requirements.
As a general rule of thumb, you want your front-end ratio to be 28% or less, and your back-end ratio to be 45% or less. The front-end ratio, also known as housing ratio, is your new total monthly mortgage payment divided by your gross monthly income (before taxes are taken out of your paycheck). For example, if your new mortgage payment is going to be $1,500 per month with everything included and your gross monthly income is $6,000 per month, you would have a 25% front-end housing ratio. This is acceptable and considered a positive.
The back-end ratio or overall ratio is calculated by adding up all of your monthly payments that show up on your credit report and adding in your new monthly mortgage payment and dividing that by your gross monthly income. For example, if you have student loans, a car payment, and a balance on a few credit cards; you might already have monthly payments around $1,000 and then when you add in the new monthly mortgage payment of $1,500 that puts you at $2,500 for total monthly obligations in relation to income. $2,500 divided by your gross monthly income of $6,000 puts you at a total debt-to-income ratio of 42%. This is getting close to the maximum allowed but is still considered a positive.
The last building block is the down payment percentage. This is an important building block because different loan types have different down payment requirements. If you don’t have the required down payment funds, you will have to choose a different loan type. Also, it helps in a variety of ways with loan requests. The biggest thing it helps with is loan pricing. The more you put down, the less risk and lenders hate risk. You will get a better interest rate for putting more money down.
Also, it helps lower your debt-to-income ratios because you are putting more money down therefore borrowing less. Lastly, it helps eliminate or lower PMI (Private Mortgage Insurance) which is a lender protection that is required when not putting 20% down in most cases. It can also act as a compensating factor because it shows you saved money successfully to put towards a down payment on house vs. borrowing 100% of the money.
Ideally, to create the best outcome for yourself, you will want to make sure that you have as high of a credit score as possible, as low of a debt-to-income ratio as possible and have saved at least 3-5% for a down payment (20% preferable to avoid PMI). When you accomplish all of these things, you put yourself into the lowest category of risk and like I said earlier, financial institutions dislike risk and will reward you with a better loan scenario / product for doing things right on your end. I hope you find this article helpful. I’m a Mortgage Lender with Guaranteed Rate in Rochester, MN. If you have any questions, feel free to reach out to me at the contact below.