Whether you’re a first time home buyer needing your first mortgage or if you’re an experienced home buyer ready for your next home, knowing how the mortgage process works and how to qualify for a new mortgage is an important first step in the process of buying a home.
You’re obviously not expected to know the various acronyms and details involved in how to qualify for a mortgage, but having some general understanding of the process and expectations will put you in the best financial position for buying a new home. It’ll also simplify the process for you.
Credit scores required for a mortgage
Your credit score is really the starting point that most mortgage lenders look at in determining your mortgage qualification. While credit scores are certainly not an indicator of wealth, they do provide a baseline for lenders to determine your creditworthiness. It’s also the tool that determines all of the other ratios we’ll look at below and the interest rates which you will qualify under.
The higher your credit score, the lower the costs of getting a mortgage and the lower the interest rates will be. For the most part a minimum credit score of 640 is needed, however there are several programs available for home borrowers with credit scores as low as 580.
Income requirements for a mortgage
Your income shows the ability to repay the mortgage. Income combined with credit score make up a large portion of what a mortgage lender look at when qualifying you for a mortgage. Mortgage lenders are looking at your Gross Monthly Income. They prove this income through your W-2’s from your employer, your paycheck stubs from your employer, and your 1040 tax return from the IRS. They’ll also consider other regular income that isn’t salary based like dividends from stocks or company ownership, child support, or other income that is consistent.
Your income is the starting point in mortgage calculations for how much mortgage you can qualify for.
Qualifying limits for a mortgage
Obviously credit scores and income are important pieces in qualifying for a new mortgage. But they are only the starting pieces of the puzzle mortgage lenders look at when issuing a mortgage.
One of the most important pieces is actually your Debt-to-Income ratio (DTI).
This ratio is calculated by adding up all of your current debts like car payments, student loan payments, minimum monthly credit car payments, and other debt payment plus adding in the future estimated mortgage payment. Then you divide that monthly amount by your provable gross monthly income. This will give you a percentage of debt-to-income.
Depending on your credit score, there are different limits for this DTI ratio. The higher your credit score, then the higher your DTI ratio can be and still qualify for a mortgage. But it is fairly typical for the limit to be around 42% maximum as a good rule of thumb. There are circumstances and loan programs that will allow for this ratio to be as high as 50%.
This is process is how mortgage lenders determine how much house you qualify to purchase as a maximum. They start with your provable income, verify the maximum DTI you are allowed to have based on your credit score, and calculate the maximum amount of monthly payments you can have. Then they subtract out your existing debts, which leave them with the maximum monthly mortgage payment.
House Qualifying Limits
Loan-to-Value (LTV) is another important piece of the puzzle that determines several aspects of your qualifying limits. The LTV is the percentage of mortgage you’re borrowing against the value of the property. Your downpayment helps to determine the Loan-to-value.
An FHA mortgage will allow you to have a minimum down payment of 3.5% of the purchase price. While there are conventional programs that have various down payment options starting as low as 0%, the most common minimum down payment percentage allowed on a conventional loan is 5% down.
The LTV is a risk measure for the mortgage lender. The smaller the down payment you have, then the higher the LTV ratio is which means the higher the risk the mortgage lender is taking by issuing you a mortgage. Therefore they price their loan accordingly to the risk they’re taking.
A 20% down loan will have fewer closing costs, lower interest rates, and no Private Mortgage Insurance, whereas a 3.5% down payment will have higher overall costs associated with the mortgage.
These mortgage costs all factor into the estimated monthly mortgage payment, which ultimately carry into your DTI ratio for qualifying. Remember, your DTI ratio has to be under the maximum allowed limit as determined by your credit score and loan program.
How to Estimate a Mortgage Payment
There are 4 pieces to a monthly mortgage payment: Principal, Interest, Taxes, and Insurance. There’s a 5th piece called Private Mortgage Insurance (PMI) if your LTV is higher than 80%.
You can calculate the Principal & Interest (P&I) portion of your payment using any payment calculator. A 30 year loan (360 months) or 15 year loan (180 months) with the total amount of money you plan on borrowing for the mortgage with an average market mortgage rate. This will give you your fixed monthly payment.
Taxes are fairly simple to calculate, although they can be different for each house on the market. The easiest way is to look up the local tax rates and multiply that percentage by the sales price. Divide by 12 and that’ll give you your monthly tax bill. The more specific way is to go to your county website and find the actual tax bill for each property you want to buy and divide the amount by 12.
Homeowners insurance varies by geographic location, company, type of house, age of roof, square footage of house, and price point. It’s difficult to estimate this annual premium without knowing a specific house and receiving a quote. However mortgage lenders in your market can make an educated guess based on their knowledge of recent loans and housing types in the area. You can always ask your mortgage lender or a Realtor in your area how much you should estimate for homeowners insurance. A good rule of thumb is $200/month, knowing that it could be more or less depending on the house and time.
You take these 4 elements, P&I, taxes, and insurance and add them together for your estimated mortgage payment. If you have less than 20% down payment, then you’ll need to also add in an estimated PMI payment (Private Mortgage Insurance). There are calculators online for this and the actual amount will vary depending on LTV, credit score, and overall amount financed. A general guideline would be $130/month knowing that it could be more or less.
How to qualify for a mortgage
These are all of the primary elements that go into mortgage qualifications. A mortgage lender takes your credit score and provable income to start the process and figure out what loan program may work best for you.
They look at your down payment percentage on a specific house to determine the LTV. Based on your credit score and loan-to-value ratio they then are able to calculate mortgage pricing for origination and interest rate costs as well as PMI.
They use all of that information to determine the estimated monthly mortgage payment including taxes, insurance, and PMI.
They then add that new estimated monthly mortgage payment to your existing debts. If the total of those debts divided by your gross monthly income is under the DTI ratio requirement, then you likely qualify for the mortgage.
What options are available if you don’t qualify for the mortgage?
After all of those elements are reviewed, if you come back not qualifying then the mortgage lender reviews each of those individual elements to see where adjustments could be made.
Maybe, your credit score is 714 which gives you a 45% DTI maximum but at a 720 credit score your qualifying DTI maximum would increase to 48% under some circumstances. If you have revolving debt like credit cards that have a high utilization rate, then paying down those credit cards would increase your credit score enough to get into the better pricing bracket.
Maybe you have enough cash available for down payment to get to 20% down instead, which eliminates PMI from your calculations and would get you under the maximum DTI limits.
Maybe there’s other income you forgot to include in your application that would increase your Gross Monthly Income enough to get under the maximum DTI limits.
Maybe you have a retirement account or savings reserves that give you 6+months of reserves the lender can use to increase your qualifying ratios.
There are dozens of different things mortgage lenders can do to adjust and help you in mortgage qualifying.
Should you get a new mortgage?
Just because you may technically qualify for a mortgage doesn’t mean you should rush out to buy a home. There are guidelines out there that would allow you to buy a house where the monthly mortgage payment is 50% of your gross monthly income. There’s not a financial advisor in the world that would say that is a wise decision, even though you could technically qualify for that loan.
Your first step is to make sure your financial house is in order, that you have your consumer debts eliminated or super limited, and that you have enough cash in the bank for a down payment. Then determine how much you personally feel comfortable budgeting each month for your housing costs (20%-33% is a realistic and understandable amount for most families in the US.)
From there, you should meet with a professional Realtor to help you start narrowing in on all of the details in purchasing a home and helping you navigate the process. Your professional agent will have several mortgage lenders that will help you qualify for a mortgage and get the process started. If you’re in the DFW area, our team would love to help you get qualified for a mortgage and buy your new home. Learn more about our team and how we help home buyers here!