Applying for a mortgage, especially for a first-timer, can be an anxiety-producing experience. A Chicago survey of 1,000 borrowers found that about half experienced major discomfort when applying for a mortgage, and nearly 25 percent said they'd rather gain ten pounds than deal with it again! However, qualifying for a loan isn't a mysterious process -- knowing what to expect can help applicants relax and put themselves among the 75 percent who are approved for their home loans.
1. Credit Scoring
Mortgage underwriters examine credit to determine the applicant's ability to manage debt. There is a difference between low credit scores and bad credit -- The FHA recognizes this and allows loans to be approved with credit scores as low as 500 for 90 percent mortgages and 580 for 96.5 percent home loans.
However, low credit scores are allowed, but bad credit is not. FHA guidelines state that, "Borrowers who have made payments on previous and current obligations in a timely manner represent a reduced risk. Conversely, if a borrower's credit history, despite adequate income to support obligations, reflects continuous slow payments, judgments, and delinquent accounts, significant compensating factors will be necessary to approve the loan."
The lack of credit history should not cause a loan to be declined. Lenders are expected to compile non-traditional credit reports, using information from landlords, utility companies and other accounts to get a complete picture of the applicant's ability and willingness to pay debts.
2. Down Payment
Mortgage borrowers can apply for loans with down payments of zero percent (for USDA and VA home loans), three percent (for community mortgage programs through Fannie Mae and Freddie Mac), 3.5 to 10 percent (FHA), and five to 20 percent (conventional lenders). Mortgage insurance is usually required for conventional mortgages with less than 20 percent down, and insurers have their own underwriting guidelines, which are often more stringent.
Higher down payments alleviate much of the risk for mortgage lenders. Statistics from the Federal Reserve indicate that borrowers putting three percent down or less have default rates 200 percent higher than those putting ten-to-15 percent down, and 500 percent higher than those putting at least 25 percent down. Therefore, applicants with smaller down payments are often required by lenders to show strength in other areas -- credit scores, income and / or assets.
3. Debt-to-Income and Payment Shock
Qualifying for a loan requires sufficient income to comfortably make mortgage payments and cover other monthly obligations. Lenders consider the applicant's debt-to-income ratio, or DTI. This is the total of all monthly obligations -- the new loan's principal, interest, taxes and insurance, or PITA, plus monthly obligations like car payments, credit cards and student loans (but not household expenses like food or utilities), divided by the gross (before tax) income. Typical limits are 38-43 percent. The stronger the rest of the application, the higher an applicant can push the ratios, and the reverse is also true. That's not the only income consideration, however -- there is also payment shock.
Payment shock is the difference between what an applicant currently pays for housing and the proposed housing expense. For example, if a couple pays $1,000 per month for an apartment, and the house they want would cost $2,250 a month for PITA, their payment shock is the new payment divided by the current payment, minus 100 percent. In this case, $2,250 / $1,000 is equal to 2.00, or 200 percent. Subtract 100 percent results in payment shock of 125 percent.
Payment shock is a factor when consumers have few assets or make small down payments. This makes sense -- if an applicant has been paying $1,000 per month while spending everything he or she earns, where is that extra $1,250 a month going to come from? Many guidelines, such as the USDA's for its Rural Housing program, consider payment shock exceeding 100 percent to be an added risk.
4. Property Use
Property use matters. Here are Fannie Mae's minimum down payments and other requirements for primary, second and investment properties -- single family residences financed with fixed-rate loans.
Reserves are amounts of cash or other liquid assets that could be used to pay the mortgage if the borrower's income stops. Reserves are calculated by dividing the liquid assets that the borrower will have after closing by the total PITA. Funds that will be used for the down payment and other costs are not considered. An applicant who will have $6,000 in the bank after closing on a home purchase with a $1,700 PITA has 3.53 months of reserves (6000 / 1700 = 3.53). Greater amounts of reserves can offset weaknesses like a short job history, high DTI or smaller down payment.
Qualifying for a Loan: The Bottom Line
Consumers who wish to know in advance if they'll qualify for a mortgage can check out a few useful tools. First, LendingTree's Home Affordability Calculator shows them how their income and expenses affect their ability to buy a home -- providing conservative, average and aggressive scenarios. Next, applicants can get their free credit scores from LendingTree and calculate their payment shock and reserves. Those with lower scores, smaller down payments and greater payment shock should probably go with the conservative scenario, which is more likely to result in approval. Finally, applicants can get an idea of their approvability by checking out LendingTree's LoanExplorer. By putting in their credit score, loan amount and purchase price, they can judge their likelihood of approval by the number of mortgage offers that come up.