When someone is ready to buy a house, they often hop in their car and start browsing the local home listings for their new home. It can be an exciting venture, especially when they’ve found a few in their price range.
But what is their “price range,” really? Do they know what that corner dream house with the covered patio and finished basement will cost them each month?
The truth is, the sticker price in the home buyers guide is just part of the total housing cost and doesn’t take into account all the other costs and criteria that a lender will be considering when your client applies for a mortgage loan.
There are distinct questions a lender must answer before they can determine the mortgage payment amount. Let’s start at the beginning.
Loan application process
The first step in the process is to apply for a mortgage loan. Unfortunately, not everybody qualifies for mortgage loans, and a lender has to deny applications. There are three criteria lenders consider for every loan application:
- Credit Score/Profile
- Debt to Income Ratio
- Funds to Close
Funds to close include down payment, hard costs (closing costs), and soft costs (prepaids). We will discuss these later.
For now, let’s focus on credit and income. An applicant’s credit score, or your FICO score, is based on information contained in their credit report. According to Experian.com, scores range from 300 to 850, with 710 being the average score in the U.S. in 2020.
The higher the score, the better the mortgage interest rate/terms. Applicants can usually expect the best terms if their score falls within 720 to 760.
Determining credit scores
Five things determine a credit score:
- Payment history– Are bills paid on time?
- Amount owed– What is the overall debt and how does it compare to their total credit available?
- Length of credit history– How long has the applicant been borrowing money? The longer they’ve been borrowing, the better.
- New credit– Have they applied for new credit?
- Types of credit used– Having a variety of credit is best, such as bankcards, car loans, student loans, etc.
Most lenders use the FICO score as a means to determine interest rate and what type of loan they qualify for. Most homebuyers qualify for an FHA loan with a score of 620 or higher. Fair credit ranges from 620 to 659, Good is 660 to 719, and Excellent is 720 and up.
Free Credit Reports are available
Anyone gets one free credit report annually from each of the three reporting bureaus: Equifax, Experian, and TransUnion. Your clients should take advantage of this and get their report BEFORE they start house hunting.
This will give them time to go over the report and check it for inaccuracies or improve their score if it’s too low.
If their report is out-of-date or inaccurate, they contact the reporting bureau via email, telephone, or letter. Your client’s information will be tagged as “disputed” until the issue is resolved. Disputes are required to happen within 28 days (1 month).
If their credit information is accurate, there’s no way to change it. However, they can take steps to make it a little bit better:
- Voters’ Roll– Ensure that they are recorded on the electoral roll at their current address to affirm that they live where they say they do.
- Credit Accounts – Ensure payments are up-do-date on their accounts, and that any late payments are settled.
- Credit Applications – Avoid making multiple applications for credit. Searches are on record for up to two years and having many searches out there can be a red flag for either desperation or potential fraud.
- Provide Full Address History – Always provide the full address. Omission can be a red flag for potential fraud.
- Court Judgments – Ensure any past judgments are paid off and marked as “Satisfied.”
- Notice of Correction – This can be added to entries on the report to explain late payments or gaps in credit history.
- Address Links –Ensure links to other addresses are accurate and true. Query any that they’ve never been connected to.
- Financial Associations –Ensure any connections with other people are correct. If they no longer exist, ask for them to be removed.
- Aliases –Ensure the list of aliases is accurate and true.
Remember, the easiest way to build credit is to use credit cards responsibly. Using them for affordable purchases to pay off quickly is a great way to build credit, but your clients should be cautious not to live on them. Credit card debt can go from benefit to burden quickly.
How Much House Can Your Client Afford?
Along with credit history, lenders are interested in monthly gross income and how much cash they can put down on the house. They determine this by figuring out debt-to-income ratios. They do this in two ways.
First, they consider housing expense ratio, or your client’s front-end ratio. This shows how much of their gross (pretax) monthly income would be put toward the mortgage payment. Typically, the monthly mortgage payment, which includes principal, interest, real estate taxes, and homeowners insurance, shouldn’t exceed 30% of your client’s gross monthly income. Your clients can figure out their maximum housing expense ratio with the following equation:
Annual salary x 0.30 / 12 (months) = Maximum Housing Expense Ratio
The back-end ratio, or total debit to income ratio, shows how much of their gross income goes toward other debt obligations, such as mortgage, car loans, child support, credit card bills, and student loans. This shouldn’t exceed 43% of gross income, and they can calculate their maximum with a similar equation:
Annual salary x 0.43 / 12 (months) = Maximum Allowable Debt-to-income Ratio
Example: Your client’s household earns about $80,000 per year. Their maximum monthly mortgage payment based on those guidelines would be $2,000. Additionally, their maximum allowable debt load would be $2,867.
Figuring out these numbers is the first step to take when determining what your client can afford for a house payment. There is more to the process, but this is a good start to helping your client understand the home lending process.
Resources.display. (2021, May 18). What is a good credit score? Experian. https://www.experian.com/blogs/ask-experian/credit-education/score-basics/what-is-a-good-credit-score/.
*Not intended as credit counseling, accounting or investment advice. Contact your financial representative for more information.