Preparing Your Finances For Home Loan Application
I’m in the process of applying for a home loan and I have learned more about finances—and particularly my finances—in the last two weeks than I have learned my entire life. In some ways, it’s been a blessing. Wanting to finally buy a place with my partner forced me to research and understand money matters that I knew nothing about before. In another way, it’s been frightening and frustrating. When you finally see the light, you realize how much in the dark you were before. How did I go so long without knowing these basic and important facts about money—both money at large and my money? I work hard. I pay my bills on time. I have a bit saved. I figured we could walk into a bank and apply for a loan yesterday. It turns out we are months out from being able to apply for a home loan, if we want the result to be in our favor. Here’s what you should know about preparing your finances for home loan application.
What is your debt to income ratio?
You may believe that if you make a lot of money, you should get a loan—no problem. But the bank wants to see not just how much you make, but also how much of that you spend. This is called your debt to income ratio. Someone who makes $7,000 a month but spends $5,000 isn’t a very desirable applicant. The bank doesn’t believe that person will be able to pay his mortgage of $2,300 a month reliably. So look at your debts: credit cards, auto loans, student loans, individual insurance plan if you don’t get one through work. There could be a lot. When that adds up, what percentage of your actual income is left? That’s what the bank is looking at.
Improve it by paying off debts
If your debt to income ratio is looking pretty bad, there are things you can do to improve it like paying off your debts. If you’re leasing a car, and can afford to make all of the remaining payments now, do so. Don’t re-lease a new one until after getting your home loan. You want that debt off your report for now. Can you refinance a student loan for a lower rate? Bringing down that monthly payment?
How your credit card usage is assessed
If you have a couple grand on a credit card right now, don’t fret: the bank isn’t looking at your balance. They are looking at the minimum payment on the card. That is the certain recurring debt that you have. So, if the minimum required monthly payment is $100, that’s the debt—in the eyes of the lender.
Are you an authorized user on other cards?
Perhaps your parents or even an old boyfriend added you as an authorized user to one of their credit cards. If you don’t use those cards, it could be time to get off of them. The minimum payment on those cards is affecting your debt to income ratio.
If you remove yourself, how’s your FICO?
Now before you go removing yourself from every account you’re an authorized user on, consider how that will leave your credit score. It can be tricky. Remember that the oldest account on your report has the biggest impact on your score. Make sure you have several of your own accounts in your name that have been around for several years and are in good standing. If you don’t have such accounts, those authorized-user accounts may be the only reason you have much credit at all. Now you’re in a bind.
If you don’t have credit, will you even get approved?
Many young prospective buyers find themselves in this predicament: most of their credit report consists of their parents’ accounts, of which they are authorized users. But the minimum payment on those is messing up their debt to income ratio. But without them, they’d have no credit (or bad credit). If this is you, you may need to hit pause on the home loan application process, and do some things to boost your credit first (that don’t include being added as an authorized user on someone else’s account).
Where is your down payment?
This happened to both my partner and myself. We are fortunate enough to have parents that started a modest fund for each of us when we were born, that they’ve been building over the years, for this very purpose: to help us with a down payment on a house. But when we called them to ask for that money, it wasn’t available. “What do you mean?” we asked. Well, my parents have been growing that fund by investing it in various personal loans throughout my life, and right now, it’s in one such loan that won’t pay off for another couple of months. So now, I just have to wait.
Are you prepared for closing costs?
Don’t forget about closing costs. Those are some of the surprise expenses of buying a home. Closing costs typically make up between one and 1.5 percent of the value of the property. They include appraisal fees, county clerk office fees, notary fees, and more. So if you’re buying a $500,000 home, have around $5,000 to $5,500 set aside for closing costs after your down payment.
What’s your employment history like?
Even if you have been, in your opinion, killing it as a freelancer, having landed a few great clients this past year that resulted in big pay days, the bank likes to see a consistent employment history of at least two years. So if you jumped from odd dog walking and personal assistant work for five years until finally, 14 months ago, starting your own business that hasn’t yet turned a profit, you may not be a good applicant. Even if you have an income.
How about your partner’s?
If you’re applying with a partner on this loan, everything we’ve discussed—debt to income ratio, credit score, and employment history—will be looked into on his end, too.
If one’s history is spotty…
If one individual has terrible credit or a very spotty employment history, they may just be a disadvantage in this home application process. They could bring the whole thing down. You may go in there and find that one person should be left off this application entirely. He or she can be on the deed of the house, and agree to help with those mortgage payments, but the bank should not be looking at that person as an applicant.
You may need a cosigner
If the last-mentioned scenario occurs, you may need a cosigner. So, perhaps one of your parents—if they really think it’s a good idea for you to buy a home and know you’re good for those payments—would be willing to put their finances on the line and cosign on this thing.
Do you have a cosigner—really?
A lot of individuals believe their parents would make great cosigners because they have lots of money. But, stop right there. Know that the person with the highest wages impacts the loan the most. Yes, I said wages. If your parents are retired, even though they have a nice home and a good life, they may be collecting no wages. Or, maybe they’re collecting retirement, but it isn’t much. They may not be the superstar cosigners you thought they were.
What percent of your income goes to housing?
No matter how much you improve your debt to income ratio, the bank will always be looking at what percentage of your income will go to housing aka this mortgage. They don’t like to see it rise above 43 percent. Maybe they’ll accept 45 percent. But keep that in mind because it will impact what value of house they’re going to approve you to make offers on. They don’t want you to have a mortgage of $2,500 a month if you make $5,000 a month. That puts your housing cost at 50 percent of your income, and that’s too high.
Will you have reserves left over?
The bank will want to see that you have what they call “reserves.” That’s just a fancy word for liquid cash, after making your down payment, and after handling those closing costs. The amount of reserves required will vary from lender to lender, but typically they’ll want you to have cash that would cover at least two months worth of mortgage payments, home insurance, and property taxes.