Chapter 5: How To Prepare For Your Mortgage
Initial Preparation for a Mortgage
Before beginning shopping for a home or a mortgage, you need to assess your financial situation by reviewing items like the amount of money that you make, spend and owe each month. This is a good first step before you go to get a mortgage prequalification.
To do a complete evaluation:
1. Review your individual financial situation.
2. Establish the size of mortgage that you can afford.
3. Assess your credit score and credit report.
4. Collect the information required by lenders.
Review Your Individual Financial Situation
Lenders determine creditworthiness based on overall financial situation, instead of only one factor (like credit score). They look at four main factors:
- Income: The money collected each month from all sources, including earned income (work), passive income (investments), and alimony. Lenders are looking to see that there is enough income to cover mortgage payments and all other expenditures.
- Debts: Existing debts, including auto loans, credit card debt, personal loans (from family, friends, or other persons), and mortgages. Lenders are particularly cautious of borrowers with a debt-to-income ratio of 0.40 or higher (this is explained below).
- Assets: Owned item of value, including cars, land, homes, stocks, bonds, precious metals, and other investments. If lenders are concerned about your debt-to-income ratio, they will consider if your existing assets could ease their concerns about lending you money. For example, if you have considerable liquid assets- assets that can be converted to cash, such as stocks and bonds-lenders may be willing to loan money to you despite a less than ideal debt-to income ratio.
- Expenses: Bills paid monthly in addition to debts, like alimony, homeowner’s association dues, utilities, transportation, medical, and entertainment expenses. It is likely that if lenders see that the monthly income does not cover the monthly expense, they will refuse to offer a loan to you unless you have very substantial assets.
How to Create a Monthly Budget Worksheet
A worksheet for monthly budgeting should contain an inventory of your monthly income and expenditures. Creating a monthly spreadsheet can help you to:
- Collect all of the documentation and data needed to fully evaluate you financial state.
- Assess the amount of money you have remaining each month to pay a mortgage and other bills that may occur consequentially from purchasing a home.
In order to create your budget worksheet, it is helpful to download, print and fill in Freddie Mac’s budget worksheet template at http://www.freddiemac.com/corporate/buyown/english/pdf/monthly_budget_worksheet.pdf
Once your budget is laid out, it’s easy to predict where lenders may find problems with your financial condition and work to fix those issues prior to applying for a mortgage loan. For example, if your expenditures slightly surpass your income, you could potentially increase your appeal to lenders by cutting back on some of your non-essential expenditures. Although you can likely make some changes right away, you will need to keep this up to date, as most lenders will want a 2-3 year financial history before they feel comfortable providing you with a loan.
How to Determine Your Debt-to-Income Ratio
A debt -to-income ratio shows lenders the way a person’s monthly debts balance with monthly income. In order to determine this, divide your total monthly debt by you total monthly income. Your debt-to income ration needs to be less than 0.40, and ideally less than 0.35, before applying for a mortgage. For example, if you have a monthly debt of $1,000 and a monthly income of $5,000, your debt-to-income ratio would be 1,000 ÷ 5,000, or 0.20.
Determine the Amount You Can Afford
If you don’t have a history of bad credit or bankruptcy, you will likely be approved for a mortgage with a monthly payment equal to one-third of your monthly pretax income. Therefore, if your monthly income is $6,000 before taxes, you would probably be approved for a mortgage with a monthly payment of about $2,000.
Should You Get the Biggest Mortgage Possible?
The short answer is no. Simply because you can get approved for a mortgage of a certain amount does not mean that you really can afford it. To determine if you have the funds for a certain mortgage, you need to consider not only your current financial status, but also plans for children, future job prospects, home maintenance and repair costs, aging parents, etcetera. Issues like these establish the amount of risk that you would be able to take and should help in deciding , for instance, if you should consider a riskier mortgage, such as an ARM, or go with the safer and more predictable choice, like a 30-year fixed-rate mortgage.
How to Determine How Much You Can Afford
Never leave it to a lender to tell you the amount that you can afford on a mortgage. Alternatively, you should evaluate your own financial state and arrive at an amount that you feel comfortable borrowing. A way to determine the size mortgage that you can afford is to subtract your total monthly expenditures (including debts) from your total monthly income. The difference should equal an amount that is greater than the monthly mortgage expense that you are planning to undertake by at least several hundred dollars. For example, if you have $1,000 left after paying all monthly expenses, you should feel at ease to get a mortgage with a monthly payment of no more than $500-700.
The 200-Times-Your-Rent Rule
If you currently rent your home, this common rule may assist you in estimating the size mortgage that you can manage to pay for:
1. The average person purchasing a home is able to pay for a mortgage worth approximately 200 times the amount of their current monthly rent. For instance, if your current is rent is $1,000 per month, you could probably afford a mortgage of 200 x 1,000, or $200,000.
Review Your Credit Score and Report
Credit history is a record of how credit has been used and managed in the past. Almost every one of your financial transactions involving credit for the last 7-15 years is recorded in your credit history. Lenders examine credit reports and credit scores along with your income, debts, assets, expenses, and your history of paying off accounts to determine if they want to approve you for a mortgage loan- and if they do approve you, at what interest rate.
- Credit Score: A credit score is a number, based on credit history, that indicates the creditworthiness of the borrower. Credit scores range from 300-850, with 850 representing flawless credit. Lenders offer the lowest interest rates to borrowers with good credit, those having a credit score of 700 or more.
- Credit Report: A credit report is a written account that lists current and past credit accounts. This includes credit “events,” like tax liens or bankruptcies, as well as any other data that may impact your credit. Lenders read credit reports to better understand the types of credit accounts that you have, as well as your credit limits and history of completing payments on those accounts.
Are Credit Scores Really that Important?
It is true that a credit score is not the only consideration lenders use to make their decisions, but credit scores are a major aspect when a lender is deciding on the interest rate to give you in a mortgage. For example, if your credit score is 750, you may qualify for a loan at an interest rate of 6%, where as if you have a credit score of 550, you may qualify for a loan at 9%. 3% may not seem like a lot, but on a $100,000 mortgage, the difference would equal $2,400 per year- $74,000 over the lifetime of 30-year fixed-rate mortgage. If you have a particularly low credit score (600 or lower), it is probably most wise to work on repairing your credit prior to applying for a loan.
How to Order Your Credit Report and Credit Score
Prior to applying for a mortgage, it is imperative to review a copy of your credit report and get your credit score. Your credit score is typically not included in your credit report. A free copy of your credit report can be obtained at https://www.annualcreditreport.com/ Your credit score can also be viewed on that website after paying a small fee.
How to Review Your Credit Report
The main reason for reviewing your credit report is to make sure that all of the information is completely correct. If there are inaccuracies in your report, like past due accounts that you paid off in full, or accounts that you did not open, you need to get these inaccuracies corrected prior to applying for a loan. To correct an error in your credit report, you should contact one of the three major credit bureaus- they are required by law to respond to requests within 30 days,
- TransUnion: 800-888-4213, or at www.transunion.com
- Experian: 800-397-3742, or at www.experian.com
- Equifax: 800-685-1111, or at www.equifax.com
Collect Information for Lenders
In order to accelerate the process of applying for a mortgage loan, you should have the following data and documents readily available.
1. Your current home address and the two addresses before this one.
2. If you are a renter, have the names and addresses of your current and previous landlords.
3. Names and addresses for your current employer and previous employers.
4. Your W-2 or 1099 forms as well as federal tax returns for the two prior years.
5. Your two most recent pay stubs and contact information for your employer’s human resource department (unless you are self-employed).
6. Savings and checking account numbers, as well as contact information for the bank where these accounts are held.
7. Investment and banking account statements for the last 2-3 months.
8. Account details and statements for all of your major assets, like the title for your car(s).
9. In the case that a family member or friend will be supplying a portion of your down payment, you will want to have a signed gift letter where the gifter acknowledges the objective of the gift.
10. A written description of any late payments or other credit issues, like liens, foreclosures, legal judgments against you, or bankruptcies.
11. Your calculated monthly budget worksheet.
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