How to Get Started?
Mortgage prequalification is the essential first step buyers should take before even starting to look for a new home with their real estate agent. Here is a scenario we see all time: A REALTOR® meets with a home buyer to discuss buying a house. The buyers are very excited and they’ve already started the home search online and have a bunch they really want to see. The REALTOR® asks if they have talked to a lender, they reply, no. The REALTOR® does a quick prequalification and finds out that the buyer actually can’t qualify for a home loan on the houses they’ve already fallen in love with. This is really disheartening for the buyers as well as the REALTOR®.
Mortgage prequalification is an important first step to help you make sure that there’s nothing standing in the way of getting the homebuying process started, and ensure that your REALTOR® is showing you houses within your price range. Prequalification is different than pre-approval; the prequalification process will let you know how much you can afford, what type of loan you’ll be using, and how your credit looks. Pre-approval is the next piece of the puzzle – that process includes a full-blown loan application complete with all of the supporting documentation. The preapproval letter that you receive will be proof of your mortgage preapproval and that you are a serious buyer.
So if you’re just getting started on the home buying process, your very first step is to get prequalified with a lender. If you don’t know how to find a lender, just ask your REALTOR® – they’re here to help and they know the best mortgage lenders! Here we’ll outline the process of prequalification, and what that means for you.
When you contact a lender, they will be looking at your credit, debts, and income and may include financial documents such as recent pay stubs, bank statements, tax returns, etc. Based on those numbers, they figure out what purchase range you can afford.
First, a lender will run a credit check. When looking into a potential borrower’s credit history, they’re not only looking at debts but income as well. If you’re sitting at home trying to figure out exactly how much house you can afford before moving forward, unfortunately, there’s not going to be a quick, straight answer, but we’ll do our best to explain what each piece of the puzzle looks like to a lender when you’re applying for a loan.
What about your Credit Report?
As mentioned earlier, the first thing a mortgage lender will do when someone starts the prequalification process is run a credit report. The minimum credit score to qualify for an FHA or conventional loan is 620. If a borrower doesn’t qualify through their credit score, the lender can often point them in the right direction to improve their credit enough to qualify. Other loan programs such as government loans, on the other hand, occasionally accept credit scores under 600, and the credit score won’t drastically change the rate. These loans look at credit history, debt, and income for the rate, not just your credit score, unlike non-government loans. With non-government loans, your credit score will play a large factor in the interest rate of your loan. The higher the credit score, the better the rate.
If more than one person is on the loan – a married couple, for example – then the lender will be looking at the mid score between them. When there is a single client, the lender will be looking at only their credit score.
As long as the borrower(s) meet the minimum credit score guidelines, they’ll qualify for the current rate.
If you have bad credit there are some things you can do to improve your score. Your lender should be able to give you some advice on how to improve your chances of qualifying for a loan.
How much can you qualify for?
When going through the mortgage process of prequalification, your mortgage loan officer will be using your credit, income, and long-term debt in order to figure out what you can afford. Ideally, the sum of your monthly mortgage payments combined with your long-term debt should be no more than 45% of your gross monthly income.
As we mentioned earlier, this is a general idea of how much you’ll qualify for until you talk to a lender. But, if you’re sitting at home trying to get an idea of what price range of homes to target, Bobby White, a lender in Colorado Springs gives us a general equation for how to look at the numbers and how much home you can afford.
To break it down, the best way to look at how much you qualify for starts with your gross monthly income, based on your pay stubs. Your gross monthly income is how much you make each month before taxes. At this point in the prequalification process, your lender will want two years of employment history, and a paystub or W2 so that they can accurately calculate your income. If you don’t know your gross monthly income off the top of your head, you can take your gross yearly income (before taxes) and divide it by 12.
Your monthly mortgage payment should ideally be no more than 28% of your gross monthly income, so multiply your gross monthly income by 0.28, and the result will be the maximum monthly mortgage amount you can afford.
Next, look at your long-term debt. Your long-term debt is going to be the sum of all of your minimum monthly payments; for example, car payments, student loans if you have them, etc.
Once you have those two numbers, add your long-term debt (sum of monthly payments) to the maximum monthly house payment that you calculated earlier. Now take this sum, and divide it by your gross monthly income. Multiply the resulting decimal by 100. Now you have a percentage, and this is your Debt to Income Ratio. According to our lender, your debt to income ratio should not exceed 45%. This is a good first step at figuring out how much money you can afford and the specific loan amount that you are qualified for. Keep in mind that this is a formula based on some basic information and cannot take everyone’s detailed financial situation into account.
A real-life example
Here’s an example with a $50,000 yearly income and $400 per month in long-term debt:
Gross Yearly Income = $50,000 (this should come from your most recent tax return).
Gross Monthly Income = Gross Yearly Income divided by 12
- $50,000 / 12 = $4,166
- Gross Monthly Income = $4,166
To calculate your Maximum Monthly Payment, multiply Gross Monthly income by 0.28
- $4,166 x 0.28 = $1,166
- Your Max Payment = $1,166
Now, add your Monthly Debt to the Max Payment
- Monthly Debt = $400
- $1,166 + $400 = $1,566
Divide this number by your Gross Monthly Income to determine your Debt to Income Ratio
- $1,566 / $4,166 = 0.38
- Multiply by 100 to get a percentage 0.38 x 100 = 38%
- Debt to Income Ratio = 38%
Remember, the Debt to Income Ratio should not exceed 45%
To take this formula one step further, we can figure out the maximum amount of debt the buyer could have in addition to their house payment.
Gross Monthly Income x Max Debt Allowed=Total Debt including House Payment
- $4,166 x 45%=$1,874
45%-Maximum amount of allowable debt beyond house payment
- $1,874 – $1,166 =$708
The maximum purchase price you can afford is based on the monthly house payment and the percentage calculated above. If a borrower is well qualified (good credit, etc.), and hasn’t come close to meeting the 45% debt to income ratio, then they have the option to qualify for a larger loan if they choose to.
In other words, if your credit is good and the percentage you calculated with your ideal monthly home payment is significantly under 45%, you’ll have the option to qualify for a much larger loan.
Keep in mind that down payments for conventional loans or FHA loans have the borrower putting down 3.5% of the purchase price of the home, so you will need to have some money available to use for the down payment. On a $200,000 home, 3.5% is around $7,000. If you need help with the down payment, there are some great down payment assistance programs that may be available to you. Your mortgage broker or your REALTOR® can give you some additional information on down payment assistance programs, especially for first-time potential buyers.