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What do mortgage lenders look for on credit reports? This is one of the most common questions asked by first-time home buyers. Naturally, your credit score is important, but it’s not the only factor that determines whether you qualify for a home loan.
Lenders also look for information on your debt-to-income ratio, your payment history and your assets. Keep reading to learn more about how mortgage lenders assess your credit profile.
Your credit history
In addition to requesting your FICO® credit scores, your lender will pull at least one copy of your credit report. Many lenders request reports from the three major bureaus—Equifax, Experian and TransUnion—to get a clearer picture of your credit situation.
FICO scores are based on five categories: payment history, amounts owed, length of credit history, credit mix and new credit. This information can be found in your credit reports, allowing mortgage lenders to see if you’ve missed payments, made late payments or opened many new accounts in a short amount of time.
Lenders can also use your credit report to determine if you’ve ever had a foreclosure or judgment filed against you. The most recent items, along with any negative items, are the most important.
What you can do
Before applying for a mortgage, get copies of your reports and read them carefully to determine if there are any errors. If you find inaccurate information, you have the right to dispute each item with the credit bureaus and ask to have it removed from your reports.
You should also obtain your FICO credit scores to determine what range they’re in. If your scores are lower than expected, you can take steps to improve them before you submit your mortgage application.
Your debt-to-income ratio
Your credit reports can also help lenders calculate your debt-to-income ratio (DTI), which compares your monthly debt payments to your gross monthly income. Lenders use this ratio to determine if you have the means to make monthly mortgage payments. Lenders use two kinds of DTI ratios: front-end DTI and back-end DTI.
Front-end DTI is the total of all your housing expenses—principal, interest, insurance and taxes—divided by your gross monthly income. Lenders like to see a front-end DTI of no more than 25 to 28 percent.
If your monthly gross income is $5,000 and your lender allows a front-end DTI of 25 percent, then your mortgage payment should be no more than $1,250 per month ($5,000 x 0.25).
Back-end DTI adds your housing expenses to your long-term debt payments and divides the total by your gross monthly income. Depending on the lender, you may be allowed to have a back-end DTI of 33 to 36 percent.
If you’re aiming for a back-end DTI of 36 percent, have gross monthly income of $3,000 and have a $750 mortgage payment, then your long-term debt payments can’t total more than $330 per month or you’ll exceed your target ratio.
What you can do
If your debt-to-income ratio is a little too high, you have two options. The first is to pay off some of your debt to reduce your monthly payment obligations. The other is to save a larger down payment to reduce the amount of money you have to borrow.
With a lower mortgage amount, your monthly payment will be lower, giving you a little more wiggle room when it comes to calculating your front-end and back-end DTIs.
Your down payment and other assets
Your lender also needs information about your down payment and other assets. The minimum down payment required varies by lender and mortgage type.
For a conventional mortgage, you should plan to have a down payment of at least 20 percent of the purchase price of the home. If you plan to apply for an FHA loan, you may be able to put down as little as 3.5 percent of the home’s purchase price.
A large down payment can help you secure a lower interest rate and reduce the amount of your monthly mortgage payment, but don’t wipe out your savings just to put more down on your dream house.
Lenders want to see that you’ll still have cash and other assets left over after your loan closes. Keeping some money in the bank shows lenders that you have the means to make your monthly mortgage payments.
What you can do
Start saving for a down payment as early as possible. The more time you have to save, the less money you need to put aside each month. You should also be realistic about your budget.
Just because you qualify for a $100,000 mortgage doesn’t mean you have to buy a $100,000 house. If you choose a less expensive home, you won’t need as much money for your down payment.
Your employment history
Mortgage lenders are also interested in your employment history, as they need to know that you have a steady source of income that can be used to make your monthly mortgage payments. With a stable job history, you may even qualify for lower interest rates, saving you money over the life of the loan.
What you can do
Avoid applying for a mortgage right after you start a new job. If possible, stick with the same job for several years to show lenders you have a consistent source of income.
The real estate market
You can’t control the real estate market, but it’s important to understand how market forces affect your ability to qualify for a home loan. In a buyer’s market, the number of homes available exceeds the total number of potential buyers.
When there are more sellers than buyers, home prices tend to be lower. Another characteristic of a buyer’s market is that homes don’t sell as fast as they usually do. If a home has been on the market for months, you have more power when negotiating the sale price.
A seller’s market is just the opposite—the number of buyers exceeds the supply of homes for sale. In this type of market, the seller has much more bargaining power.
When you find a home you like, you may find yourself in a bidding war with multiple buyers, pushing up the price and increasing the amount of money you have to borrow to submit a winning bid. Homes also sell much faster than usual, with homes in desirable neighborhoods selling a few days or even a few hours after they’re listed for sale.
It’s important to understand the market conditions in your desired neighborhood. Even when general economic conditions are favorable, you can find a seller’s market in one area and a buyer’s market in another.
Try to give yourself as much lead time as possible so you can find just the right home without having to pay more than you can afford or agree to terms that aren’t in your best interest.
What you can do
Knowledge is power. When you understand the market conditions in your area, you can work with your lender to make sure you have everything in order before you find the perfect home. For a hassle-free experience, shop around for the best rates and then get preapproved by your preferred lender.
The preapproval process involves filling out a mortgage application and undergoing a thorough credit check. If you’re preapproved, the lender will issue you a letter indicating the amount of money you qualify to borrow.
Start preparing for homeownership now
Before you apply for a mortgage, you’ll want to get a copy of your credit report from Equifax, Experian and TransUnion. Review these reports carefully to make sure they don’t contain any inaccuracies that could make it difficult to get a mortgage.
You’ll also want to check your credit score and determine your current debt-to-income ratio. If your score is lower than you want it to be, take steps to increase it before trying to get preapproved for a home loan. You can also pay off some of your debts to reduce your back-end DTI.
Once you complete these steps, start researching the real estate market in your desired neighborhood. Your research can help you determine if you need to save up a larger down payment or prepare to pay higher interest rates in your area.
