BUYER’S ARTICLES – FOR THE SMART CONSUMER


Congratulations on making the first step toward fulfilling the American Dream.  Even deciding that you are ready to buy a home can be quite exciting, especially for first-time buyers.  One of the most important steps in preparing for the purchase of a home is to get pre-approved by your lender of choice.  But do you know what the pre-approval process is and how it works?

Your lender will look at five specific criteria in order to determine whether you are a credit-worthy borrower and decide how much money should be offered to you toward the purchase of your home.  The five criteria are incomefinancial stabilitydebt-to-income ratiocredit history and the value of the home that you are planning to purchase. The combination of these five factors gives the lender the ability to make a decision rather quickly.  In the mortgage-lending industry, each of these individual combinations are known as ratios.

In contrast, some lenders will look at only your credit score and your total income when making a pre-qualification decision.  Each lender has a different method of pre-qualifying potential borrowers, but most lenders take a very similar approach to the actual approval process. 

There are two ratio calculations that lenders use to assess a potential borrower’s creditworthiness: the front-end ratioand the back-end ratio.  Both take into consideration the borrower’s gross monthly income.  The difference is that the front-end ratio considers the borrower’s estimated housing expenses, while the back-end ratio considers the borrower’s total debt, including the estimated housing costs.

After performing these calculations, the lender will determine what percentage of the home’s value you will be permitted to borrow.  Generally, this is 80% and is called the loan-to-value ratio.  Basically, it means that a lender is willing to risk a certain percentage of the home’s value by giving you a loan with which to buy the home.  Where does the other 20% of the home’s price come from? Generally, the borrower will be required to make a down payment that is equal to 20% of the home’s sale price.

 

What Are The Benefits of Making a Down Payment?

When making a down payment, obviously the borrower reduces the amount that he or she is borrowing.  Moreover, the down payment allows the new owner to generate immediate equity in the property that is being purchased.  Simply put, equity is capital.  Determining how much equity you have in your home is a fairly simple process. Simply subtract the amount remaining on your mortgage from the market value of your home.  For example, if your home is valued at $400,000 and you have $150,000 remaining on your mortgage, your equity is equal to $250,000.

The other benefit of the immediate equity earned through a sizable down payment is that the owner will most likely not be required to carry private mortgage insurance (PMI) in order to secure the lender’s investment in the home.  PMI is one of those additional costs of home buying that most people would simply prefer to avoid.  The purpose of PMI is to insure the lender’s investment should the borrower default on the mortgage.  However, when the borrower is able to make a down payment of 20% or more, the lender will view the loan much more favorably.

Now that you understand how lenders calculate some of the common ratios, let’s take a look at where the ideal ratio scores land.

The general rule of thumb for all types of housing costs, including rentals, is 30%.  In general, mortgage lenders prefer that their borrowers have housing costs that do not exceed 28% of their gross monthly income. 

Similarly, the debt-to-income ratio discussed above is ideally around 36% or less. 

The purpose of these ratios, and the percentages that lenders prefer, is to help the lenders and underwriters identify which applicants would make the best possible borrowers and which would be most likely to default on their monthly payments.  Different lenders have different ratio requirements, some looser and many more restrictive. 

Depending on your individual credit score, the ratios may be adjusted upward or downward by the lender.  Keep in mind that just because you cannot meet the 28% or 36% ratios does not necessarily mean that you will not be able to buy a home.  It simply means that you might need to make a larger down payment or cover the difference with PMI. 

 

Ideas to Consider if You Feel Your Ratios are too High

Lenders and underwriters have the latitude to offer you a mortgage loan, regardless of your ratios, if they believe that you would be a good borrower.  In most cases, they will be able to issue financing even if your payments will exceed one-third of your income.  Under these circumstances, the possibility of a lender issuing a mortgage is much higher if you can present documentation that you have been exceeding this percentage to cover your housing costs under a previous mortgage loan in good standing, or with rent payments.  Also, if you are willing and able to make a larger-than-required down payment, the lender’s ratio requirements will almost certainly be less restrictive.

Lenders often have a variety of mortgage products, each with differing ratio requirements and flexibility.  For example. Although you might not qualify for the market-rate, 30-year, fixed-rate loan, you might be able to meet the requirements for an adjustable-rate mortgage with an initial rate that is competitive with the 30-year loan.  Be aware, however, that the initial rate will generally span only the first two to five years of the loan and that the payments will increase significantly should the rate increase at the end of the introductory period. 

Now that you have a good understanding of lenders’ expectations and ratio calculations, you probably have a better idea of whether you will be able to afford a particular home.  This is all part of the pre-shopping process.  You might want to use an online pre-qualification calculator, entering your specific debt load and income, in order to determine the price range in which you should be looking for a home.

The only way to know for certain how lenders will view you financial situation is to complete the pre-qualification process.  This process is fast and you can expect to have an answer about your loan eligibility within a day or two of completing the required application form.