Homeownership is still the primary way people in the US prosper, with just over half our wealth coming from the equity in our homes. Let’s demystify the mortgage loan process and help you navigate through it -- whether you’re looking to buy your first home, refinance your existing home, move into a larger home, purchase a second home, or purchase investment property.
Let’s get a clear understanding of what mortgage lenders are looking for.
From a mortgage lending perspective, there are three legs to the stool: credit, assets, and income.
CREDIT: Generally, you need a minimum score of 620. As your credit score incrementally improves to 640, 660, 680 and beyond, and depending on your loan-to-value, you get a more preferential interest rate. Click here for an article from the Consumer Finance Protection Bureau on how to get and keep a good credit score.
ASSETS: The monies you will need for down payment or reserves you need, depending on the program you are looking for. The type of accounts you keep your assets in does matter – is it liquid in checking, savings, money market, etc.? Maybe it’s in stocks, an IRA, or your 401(k), which might be a little harder to access. Maybe you have Bitcoin or some other digital currency. Wherever it is, if you are going to use it for your Earnest Money Deposit (EMD) or cash to close, you will have to show proof of liquidation. In other words, the lender wants to know where the cash came from. Let’s say you saw the recession coming and you bought one ounce of gold coins which you then sold; you have to document this. If you sold a car or a motorcycle, you must get bill of sale and paperwork/proof to show the lender that you held and then transferred title. Some portfolio and agency loans require reserves when you have over 45% dept-to-income ratio. Reserves show you have something to turn to if there is some disruption in your income. However, a lot of times on refinances you don’t need any assets. Reserves can be a 401(k) or IRA and you will be required to show terms of withdrawal and show how you can gain access to the funds if needed.
INCOME: After the Great Recession, which ended in 2009, mortgage lending became much more heavily regulated. From this came Appendix Q, which required lenders to confirm a borrower’s Ability to Repay (ATR). Essentially, lenders must document your income and show that you can “afford” the loan payment. These rules are applicable to all lenders; however, lenders may vary somewhat in their interpretation of rules and guidelines.
Lenders will calculate your DTI (debt-to-income ratio) which is your total monthly debt (taken from your credit report) divided by your gross monthly income. The standard guideline is 45%. Your monthly payments cannot exceed 45% of your gross monthly income. There are government-guaranteed loans (Freddie Mac and Fannie Mae) that have the same 45% DTI; however, lenders will go up to 50% in some instances with reserves (additional assets), or other compensating factors like lower loan-to-value (LTV), higher credit scores, or a combination.
- Debt-to-Income-Ratio example: The new home you want to purchase has a $2,378 monthly payment and the monthly credit payments that appear on your credit report (car, credit card, other loans) total $567, so your total monthly payments = $2,945. Your gross monthly income is $6,800. You take your total $2,945 debt / $6,950 income = 42.4% DTI and is within the 45% max DTI guideline.
Time on the job is crucial, as is the type of work you do and whether it is W-2 or self-employed income. The guideline is that you should have done the same or similar job for two years or more with no significant gaps, meaning no gaps of more than 30 days for that income source. If you have income from tips, it can be used if it’s included in wages and you have a 24-month history of earning tips. The same applies to other sources of income such as overtime and bonuses.
The mortgage process does not have to be difficult. The more knowledge you have, the better equipped you will be to make your dream of home ownership a reality. Reach out to your bank and have them help you assess where you are with regard to the three primary drivers of mortgage lending: income, credit, and assets. If you need to shore up any of these areas, create a plan and stick to it.
When you reach your goal of qualifying to buy a home, ask the bank for a pre-approval so you will know how much home you can afford. This may also give you more leverage with sellers. By increasing your knowledge and doing your research in advance, you can be prepared to get a mortgage that works best for you and your family.