Mortgage Qualification: Key Factors That Determine Your Eligibility

There are many factors that determine whether someone qualifies for a mortgage. These include income, debt, credit score, assets, and property type. Lenders will also look at job stability and pull a credit report from three different institutions: Experian, TransUnion, and Equifax. They will also consider the applicant's debt-to-income (DTI) ratio, which measures how much of their income is going towards debt payments. A lower DTI ratio is generally more attractive to lenders. Additionally, the type of loan applied for, such as a conventional loan or a government-backed loan, will have specific qualification requirements.

Credit score

A good credit score is crucial when it comes to mortgage approval. It reflects your creditworthiness and predicts how reliable you are in paying back a loan. Lenders use your credit score to assess the risk you pose as a borrower. The higher your score, the lower the risk for lenders, and the more likely you are to be offered a mortgage with an attractive interest rate.

Lenders typically pull a credit report from three different reporting institutions: Experian, TransUnion, and Equifax. They consider all three scores and use the median score in the decision-making process. These scores can range from 300-850 points. The scores indicate to the lender how responsible a consumer has been with their previous or current creditors.

The minimum credit score required for a mortgage varies depending on the type of loan. Conforming loans, backed by Fannie Mae or Freddie Mac, typically require a minimum credit score of 620 or higher. However, some lenders may require a higher score of 740 or additional documentation, such as proof of income or assets. For government-backed loans, the requirements are more flexible. FHA loans, insured by the Federal Housing Administration, may allow borrowers with credit scores as low as 500 to qualify with a 10% down payment. Most FHA lenders prefer scores of at least 580, which reduces the down payment requirement to as little as 3.5%. Similarly, VA loans offer more relaxed requirements for qualifying veterans and active-duty military members, with most lenders preferring scores of at least 620.

A higher credit score increases your chances of getting approved for a mortgage and leads to lower interest rates. A difference of 0.5% in the interest rate can result in thousands of dollars over the term of your mortgage. Borrowers with excellent credit scores may qualify for significantly lower interest rates than those with poor or fair credit scores. Lenders want to ensure they are lending to individuals who have demonstrated responsible financial behaviour and are likely to repay their debt on time.

It is essential to regularly review your credit score and take steps to improve it. This includes paying bills on time, maintaining low credit card balances, and disputing errors on your credit report. Additionally, when shopping for a home, avoid applying for other loans or credit cards as hard inquiries and new credit accounts can lower your credit score.

Debt-to-income ratio

Lenders use the DTI ratio to assess a borrower's creditworthiness and evaluate the risk of extending credit to them. The lower the DTI ratio, the more attractive the borrower is to lenders. A low DTI ratio reflects a good balance between income and debt. Most lenders prefer a DTI ratio of below 35-36%. However, this can vary, and some lenders may allow a DTI of up to 43-45%.

DTI is one of the two subcomponents of the qualifying ratio, the other being the housing expense ratio. The qualifying ratio is used by lenders to decide if a borrower qualifies for the loans they offer. The housing expense ratio is made up of monthly principal, interest, property taxes, and insurance payments (PITI). Lenders prefer borrowers to spend no more than 28% of their gross monthly income on PITI payments and no more than 36% of their gross monthly income paying their total debt (DTI). This is known as the 28/36 rule.

When calculating DTI, only the minimum monthly payment of each debt needs to be included. For example, if a borrower has a $15,000 student loan but only needs to pay back $150 a month, only $150 should be included in the calculation. Expenses such as utilities, entertainment, and health insurance premiums are not included.

DTI is an important factor in determining a borrower's creditworthiness, and understanding it can help borrowers make informed decisions about managing debt and applying for new credit.

Income

To calculate the required income, lenders use a debt-to-income (DTI) ratio, which compares an applicant's current debts and the proposed new house payment to their income. The DTI ratio is calculated by dividing total monthly expenses by pre-tax household income. A lower DTI ratio indicates a stronger financial position and is generally viewed more favourably by lenders. Most lenders prefer a DTI ratio of 45% or lower, including any new home payments.

When assessing income, lenders typically require verification of income over a two-year period. This can include employment income, such as base pay, wages, bonuses, commissions, and overtime payments, as well as income from self-employment or investments. For salaried or hourly employees, lenders may calculate monthly gross income by multiplying the hourly wage by 2080 hours (based on a 40-hour workweek) and then dividing by 12. Lenders may request additional documentation, such as pay stubs, bank statements, and tax documents, to support the income claims.

It is important to note that income requirements can vary depending on the type of loan and the lender. Some loans, such as conventional loans, may have specific income limits or thresholds that must be met. Additionally, self-employed individuals may face additional scrutiny and are advised to plan well in advance to improve their qualification prospects.

Assets

Lenders will subtract all the debts you owe from your total assets to calculate your net worth, giving them a better picture of your financial situation and how you will make your mortgage payments, down payment, and closing costs. They will also consider your assets to determine how you would continue making payments if you lost your job. Lenders will look at your checking and savings accounts, as well as the amount of equity you have tied up in assets.

Physical assets are also important because they can be quickly converted into cash if needed to make mortgage payments. These include items such as cars, jewelry, stocks, homes, boats, RVs, and artwork. To determine the value of these physical assets, you can hire a professional appraiser or use online appraisal calculators.

Before applying for a mortgage, it is advisable to avoid large purchases or withdrawals, as these can affect your asset verification and loan approval. Lenders want to see that you have enough reserves to cover several months of mortgage payments in case of emergencies, such as job loss or unexpected expenses. The amount of reserve you need depends on your loan program, credit score, LTV, and DTI, but typically, a conventional loan requires at least two to six months of reserves, while an FHA loan requires one to two months.

Property type

Lenders will consider the property type to assess the risk of lending to the borrower. For example, a property with a higher risk of damage or loss may be more difficult to qualify for a mortgage. This could include properties in areas prone to natural disasters or those with a high crime rate.

The property's location is also important. Lenders may consider the local economy, job market, and population trends to assess the potential for future property value growth or stability. They may also consider the supply and demand for similar properties in the area, as this can impact the property's potential for capital growth and the ease of resale in the event of loan default.

The type of property can also influence the down payment requirements. For example, some lenders may require a higher down payment for investment properties or vacation homes compared to primary residences. Additionally, certain property types may have specific loan requirements. For instance, condominiums may need to meet certain standards set by the condominium association, and older homes may require a larger down payment if they don't meet traditional lending guidelines.

Furthermore, the property's intended use can impact the mortgage qualification. Lenders may offer different terms for primary residences, second homes, or investment properties. Owner-occupied properties often come with more favourable terms, as lenders view these as less risky.

Lastly, the property's condition can also be a factor. Some lenders may require that the property meets specific health and safety standards, especially for older properties. They may also consider the potential for future repairs or renovations, which could impact the borrower's ability to repay the loan.

Frequently asked questions