February 7, 2024 • 12 mins
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If you are planning to buy a home, getting preapproved for a mortgage can give you an edge over other buyers and help you secure your dream home.
A mortgage preapproval is a statement from a lender that shows how much money you can borrow, what types of loan programs you qualify for, and what your interest rate might be. However, getting preapproved is not a guarantee that you will get a loan. You still need to meet certain conditions and provide additional information before closing.
So, how do lenders decide whether to preapprove you for a mortgage or not? They look at four main factors, commonly known as the four C’s: credit, capacity, capital, and collateral. Read below to understand what each of them means and why they matter.
Your credit score and history are one of the most important factors that lenders consider when pre-approving you for a mortgage. Your credit score is a numerical representation of how well you have managed your debt obligations in the past – or how responsible and trustworthy you are as a borrower. Credit scores range from 300 to 850, with higher scores indicating better creditworthiness. Your credit history is a record of your past and current credit accounts, such as credit cards, loans, and mortgages. It shows how much you owe, how often you pay on time, and if you have any negative items such as late payments, collections, bankruptcies, or foreclosures.
Lenders use your credit score and history to assess your risk level as a borrower. They want to see that you have a good track record of paying your bills on time and that you are not overextended with debt. Generally, the higher your credit score and the cleaner your credit history, the more likely you are to get preapproved for a mortgage and the lower your interest rate will be. Different loan programs have different credit score requirements, but typically, you need a minimum score of 620 to qualify for a conventional loan and 580 to qualify for an FHA loan. But qualifying is just one part of the process. Having a higher score can help you get better terms and save money on interest. For example, if your credit score is less than 580, you will have to make a 10% down payment on an FHA loan.
To improve your credit score and history, you should pay your bills on time, keep your credit card balances low, avoid applying for new credit, and check your credit reports for errors. You can get a free copy of your credit report from each of the three major credit bureaus (Equifax, Experian, and TransUnion) once a week at [AnnualCreditReport.com]. You can also check your credit score for free through various online platforms, such as [Credit Karma] or [NerdWallet].
Your capacity is your ability to repay the mortgage loan. Lenders look at your income, employment, and debt to determine how much you can afford to borrow and whether you can make the monthly payments. They use two ratios to measure capacity: the front-end ratio and the back-end ratio.
The front-end ratio, also known as the housing ratio, is the percentage of your gross monthly income that goes toward your housing expenses, including your mortgage principal, interest, taxes, insurance, and homeowner’s association (HOA) fees. Lenders typically prefer that your front-end ratio does not exceed 28%, meaning that you spend no more than 28% of your income on housing.
The back-end ratio, also known as the debt-to-income ratio (DTI), is the percentage of your gross monthly income that goes toward all of your debt obligations, including your housing expenses and other debts, such as credit cards, student loans, car loans, and personal loans. Lenders typically prefer that your back-end ratio does not exceed 36%, meaning that you spend no more than 36% of your income on debt.
To calculate your front-end and back-end ratios, you need to divide your monthly housing expenses and your monthly debt payments by your gross monthly income. For example, if you earn $5,000 a month and your housing expenses are $1,400 and your total debt payments are $1,800, your front-end ratio is 28% ($1,400 / $5,000) and your back-end ratio is 36% ($1,800 / $5,000).
To improve your capacity, you should increase your income, reduce your debt or both. You can increase your income by getting a raise, a bonus, a second job or a side hustle. You can reduce your debt by paying off your balances, refinancing your loans, consolidating your debt or negotiating lower interest rates. You can also choose to buy a less expensive home that will result in a lower mortgage payment.
Your capital is the amount of money you have available to use for the home purchase. Lenders look at your assets, such as your bank accounts, investment accounts, retirement accounts and other sources of funds, to determine how much you can contribute to the down payment, down payment, closing costs, and reserves. They also look at your liabilities, such as your outstanding debts, to determine how much you owe and how much you can afford to borrow.
Your down payment is the amount of money you pay upfront for the home. It is usually expressed as a percentage of the home price. For example, if you buy a home for $300,000 and you make a 10% down payment, you pay $30,000 upfront and borrow $270,000. The size of your down payment affects your loan-to-value ratio (LTV), which is the percentage of the home value that you finance with a loan. For example, if you borrow $270,000 for a $300,000 home, your LTV is 90% ($270,000 / $300,000).
Different loan programs have different down payment requirements, but typically, you need between 3% and 5% for a conventional loan and 3.5% for an FHA loan. Making a larger down payment can help you get a lower interest rate, avoid paying private mortgage insurance (PMI) and reduce your monthly payments.
Your closing costs are the fees and charges that you pay to finalize the mortgage loan. They include items such as appraisal fees, title fees, origination fees, recording fees, taxes, and prepaid items. Closing costs vary by lender, loan type, and location, but they typically range from 2% to 5% of the loan amount. For example, if you borrow $270,000, your closing costs could be between $5,400 and $13,500.
Your reserves are the amount of money you have left in your accounts after paying the down payment and closing costs. Lenders want to see that you have enough reserves to cover several months of mortgage payments in case of an emergency, like a job loss, an unexpected health event, or a home repair. The amount of reserves you need depends on your loan program, your credit score, your LTV, and your DTI, but typically, you need at least two to six months of reserves for a conventional loan and one to two months of reserves for an FHA loan.
The only way to improve your capital is to save more money, sell some assets, receive a gift or a grant or use a down payment assistance program. You should also avoid making large purchases or withdrawals before applying for a mortgage, as they could affect your asset verification and your loan approval.
So, how do lenders decide whether to preapprove you for a mortgage or not? They look at four main factors, commonly known as the four C’s: credit, capacity, capital, and collateral.
Your collateral is the property that you are buying with the mortgage loan. Lenders look at the value, condition, and type of the property to determine whether it meets their standards and whether it provides adequate security for the loan. They use an appraisal to assess the property’s value and a title search to verify the property’s ownership and legal status.
The appraisal is an independent evaluation of the property’s market value, based on its location, size, features, condition, and comparable sales. The appraiser inspects the property and prepares a report that includes a description, photos, maps, and an opinion of value. The lender uses the appraisal to ensure that you are not paying more for the property than it is worth and that the property meets the minimum requirements for the loan program. For example, if you are applying for a VA or FHA loan, the property must meet certain health and safety standards, such as having adequate heating, plumbing, and electrical systems.
The title search is a review of the public records related to the property, such as deeds, mortgages, liens, judgments, easements, and taxes. The title company or the attorney conducts the title search to confirm that the seller is the legal owner of the property and that there are no outstanding claims or issues that could affect the transfer of ownership. The title company or the attorney also issues a title insurance policy that protects you and the lender from any losses or damages due to title defects or errors.
To improve your collateral, you should choose a property that is in good condition, has a clear title, and has a market value that is equal to or higher than the purchase price. You should also avoid making any changes to the property or the contract after the appraisal and the title search are completed, as they could affect the loan approval and the closing process.
When applying for a mortgage, you will need to provide certain documents to the lender. These will be used to verify your income and assets and demonstrate that you can afford the mortgage.
These required documents may include:
If you are getting the money for the down payment from a family member or friend, you will also need to provide a gift letter. This letter should state that the money is a gift and not a loan.
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