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Denied Credit for Your Home Loan: What’s Next?

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Let’s start with some good news. Across the board, the denial rate for home loans has been declining for a solid decade. According to the Federal Reserve, just over 11% of applicants were turned down in 2016; encouraging news considering the rate hovered around the 15% mark in the years following the housing crisis.

But the picture changes a bit when you look at specific loan types. While conventional mortgage denials are also on a downward trend, nonconventional loans — including government-backed Federal Housing Administration and U.S. Department of Agriculture loans — are a different story. As of 2016, more than 13% of these loan applications were denied, marking a slight uptick from 2006.

If you’ve been turned down, don’t fret — it doesn’t mean your dream of homeownership is out the window. It’s more than possible to course correct, rehab your mortgage application and get approved for a home loan. Let’s dig into how.

Common reasons home loans are denied

Getting on the right track after being denied a home loan is extremely case-specific. The first thing to do is be clear with your loan officer regarding why you were denied, which will dictate the appropriate course of action. Here are some common reasons, along with some expert-backed ways to set things right.

Your debt-to-income ratio is too high

The Federal Reserve research mentioned above lists a high debt-to-income (DTI) ratio as the leading reason home loans get denied. Think of it as a snapshot of how your income relates to your debt. To put it simply: How much of your pay is being funneled toward debt payments? From credit card balances to student loans, to your car note, it all counts.

It’s a critical question because the mortgage loan you’re applying for represents new debt, and the lender needs to feel confident that you have the financial means to make good on your monthly payment if approved. To measure your DTI, add up all your monthly debt payments, then divide that number by whatever your gross monthly income is. What’s left is your DTI ratio. (To make it even easier, check out our handy debt-to-income calculator.)

Fannie Mae’s lending standards, which set the tone for most mortgage loans, cap DTI at 36%. However, those who meet specific credit score and reserve requirements can go as high as 45%.

“Forty-three percent, for most lenders, is the magic number, but certainly there are ways to go above that,” Aaron Galileo, a New Jersey-based senior loan officer, told LendingTree.

How to fix it: Short of picking up a side gig or getting a raise to bump up your income, the other part of this equation is reducing your debt. Begin by taking a hard look at your monthly expenses to identify wasteful spending habits. Simple hacks like meal planning, making coffee at home, trimming your cable package and canceling unused subscriptions can all free up cash that you can redirect toward your debt.

Once you know where your money is going, set yourself up for success by revamping your budget to support your debt payoff goal. This includes getting in the habit of paying yourself first in order to grow a starter emergency fund, which will help break the debt cycle and prevent you from grabbing a credit card the next time you run into an unexpected expense. (Our insiders recommend a $1,000 cushion.)

One other important thing about your DTI. Most lenders run your credit at the beginning of the application process, then do another soft pull right before making a final decision. For this reason, it’s really important not to open any new lines of credit or rack up any new debt while in the mortgage application process. Doing so could push your DTI over the edge, inadvertently disqualifying you from the loan.

“I explain to my clients that they need to be smart with their spending during the mortgage process,” said Galileo. “After getting really excited about getting approved, I’ve seen people go out and purchase new furniture for the new house on credit, which just increased their DTI, and potentially lowered their credit score.”
 

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Your credit score needs work

Your credit score is, hands down, one of the most important factors when it comes to snagging a home loan. According to Chris Bettis, a director and government affairs chairman for the National Association of Mortgage Brokers, those with a score of 740 or above can pretty much “qualify for anything.” FICO, the nation’s leading credit reporting agency, says the national average comes in at 700, which is considered a good score.

“The higher your credit score, the more likely you are to get approved with the best rates and terms,” Bettis told LendingTree. “When you start dipping below 680, approval is certainly still possible, but the interest rates start to get higher.”

A low credit score can create a barrier between a borrower and a mortgage, especially if it’s coupled with a high debt-to-income ratio. Let’s consider the bare-bones minimum score for the most prominent types of home loans:

Minimum Credit Score Needed for Home Loan
Type of mortgage Minimum credit score
Conventional loan 620
FHA loan 500
VA loan No minimum
USDA loan 580

An important thing to keep in mind is that every lender is different. Bettis says that while one may turn you down for a conventional loan with a 620 credit score, another could very well give you the green light. This is precisely why it’s so important to shop around.

“Never accept your first lending [number]; if one is unable to do it, go onto the next,” he said.

If you still don’t qualify for a loan with a reasonable interest rate, you can always step away from the market for a bit, rebuild your score, then jump back into the ring when you’re ready.

How to fix it: Your credit score is intimately related to your DTI — reducing your debt will inevitably boost your score. Your score itself is actually determined by a number of factors. Here’s a closer look at the FICO model’s measuring stick:

  • Payment history: 35%
  • Amounts owed: 30%
  • Length of credit history: 15%
  • Credit mix: 10%
  • New credit: 10%

Improving your credit score isn’t an exact science, but most lenders use credit report simulators that can identify what needs work,” said Galileo. “If your mortgage application was denied because of a credit issue, your loan officer should be able to give you some advice on how to get it up to where it needs to be.”

If, for example, your credit utilization ratio is high (i.e. you’ve maxed out more than 30% of your available credit), your score will take a hit since the “amounts owed” category factors so heavily into your score. You can get this down by either increasing your credit limits or consolidating your debt with a personal loan. Since a personal loan is considered an installment loan, not a revolving credit line, it’s a move that’ll bring down your credit utilization ratio relatively quickly.

On the flip side, if your credit score is low due to a late payment, the only thing that’ll help is time since they typically take seven years to come off your credit report.

Regardless of the reason, one fact remains — you have to know what’s actually on your credit report. My LendingTree and AnnualCreditReport.com are great resources. (Bonus perk: they’re free.) Things like delinquent accounts and derogatory notes can impair your credit score, especially if they’re inaccurate. According to the Federal Trade Commission, roughly 26% of people have at least one potentially material error lurking in their credit profile.

When Bettis was buying his first home, he discovered accounts on his credit report that actually belonged to another person by the same name in another state. “It became a huge issue at the eleventh hour,” he said. “We got it resolved, but we almost didn’t get approved for our home loan.”

A spotty employment history

When applying for a mortgage, the lender is looking for assurance that you’ve got a reliable flow of incoming cash. This is where your employment history comes in. Having a W-2 that reflects a steady income and consistent work history makes this pretty easy, according to Galileo.

“It takes a little more preparation to qualify if you’re self-employed,” he said. “Most lenders want to see at least two years’ worth of business and personal tax returns.”

In other words, lenders want to see in black and white that you have a job and are earning enough to cover the loan you’re applying for. It’s extreme, but Galileo has seen people lose their job during the application process, then no longer qualify.

How to fix it: If you’ve recently started a job with a new employer, Galileo says that if you’ve been there for a few months, that’s usually enough to satisfy most lenders.  An offer letter confirming future employment is helpful, but most lenders will want to see that the borrower has started the job and received a paycheck prior to the closing. (Again, every lender is different.)

Thanks to tight underwriting standards, there’s less wiggle room with self-employment. If you’re about to embark as an entrepreneur or full-time freelancer, Bettis says it’s in your best interest to hold off until after your mortgage loan is sewn up.

Insufficient cash

The days of putting $0 down, for the most part, are long behind us. (The 2008 housing crisis brought that trend to a screeching halt.) If your credit score is below average or your debt-to-income ratio is skewing high, an insufficient down payment could be the nail in the coffin where your home loan is concerned.

Remember, a 20% down payment is the gold standard, but it’s no longer the norm. It’s possible to qualify for a conventional loan with a 5% down payment; 3.5% for FHA loans and even 0% for Veterans Affairs loans. Putting less down does typically translate to paying mortgage insurance and ultimately paying more in interest over the life of the loan since you’re borrowing more, but you can still get approved.

Another word on cash. You need to be able to verify it since Galileo says most lenders are going to look back at least 60 days into your bank statements.

“If there’s a large deposit, you’ll need to be able to substantiate where the deposit came from,” he said. “If it’s a gift from your mother, that’s fine, but we need a paper trail, as well as a signed gift letter.”

Again, everything is connected. Opting for a cash advance on credit or taking out a personal loan may free up cash for a higher down payment, but it’ll also increase your debt-to-income ratio.

“People are always looking for ways to beat the system,” Galileo added. “The bottom line is that if you can’t substantiate large deposits, the underwriter may not let you use it, which may mean not qualifying for a home loan.”

How to fix it: If cash reserves are tight, have an open and honest conversation with your loan officer — if you can’t scrape together enough to qualify for a conventional loan, are you open to switching to an FHA loan, which allows for a smaller down payment?

“Sometimes considering an alternative loan product is what gets you approved,” said Bettis. “In other cases, getting approved may actually mean putting less down and using your cash reserves to pay down revolving debt, which will increase your credit score.”

Remember: Your debt, credit score and cash reserves are connected. One impacts the others, and lenders are taking a big picture view of your overall financial health when processing your application. If you have a 5% down payment, a good credit score and a low debt-to-income ratio, you’re more likely to get approved than someone with a 20% down payment, but bad credit and unreliable income.

Either way, keep all your documents organized so that you’re able to substantiate all cash deposits. As long as you can prove a paper trail and provide a gift letter, Galileo said, there’s no formal cap on how much you can accept in gifts.

“It really depends on the bank; some like to see that the borrower has at least 5% of their own money in the deal, but others allow the whole down payment to be a gift,” he said.

Key takeaways about home loans

If your home loan gets denied, keep your chin up. Our insiders say turning it around comes down to understanding why you were denied, making a plan to fix it, then staying the course until you’ve made enough progress to reapply.

There’s no one-size-fits-all answer when it comes to getting things right, but the most common reasons have to do with a high debt-to-income ratio, less than perfect credit, employment inconsistencies and insufficient cash to close the deal. The bottom line is that all of these things can be fixed if you have a little patience and keep your eye on the prize.

“When it comes to locking down a home loan,” Bettis said, “there’s always hope, and there’s usually a solution.”

 

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