Don't let bad finances stop you from getting a mortgage
Before you apply for a home loan, make sure your finances are in order - or your application may fall into the rejection pile.
When you find the perfect house and you're ready to get a mortgage, your financial history may be more important than you think.
"There are so many components of your financial life that impact your ability to secure loans," says Elle Kaplan, CEO and founding partner of Lexion Capital Management located in New York, New York. "Whenever you apply for loans, be sure to educate yourself on all your options, and know what's required."
Brian Koss, executive vice president of Mortgage Network in Danvers, Massachusetts, agrees. "It's important for borrowers to know what type of activities can lead lenders to view borrowers as high-risk applicants," since this designation can lead to higher interest rates and fees, and may even result in the application being rejected.
Worried your finances will slow down your home buying process? Keep reading to find out which nagging financial issues can come back to haunt you.
#1 - Low (or No) Down Payment
You can pay now or pay later: If you fail to save up a sufficient down payment, it's going to raise the amount of your monthly payments.
"Mortgage loans are generally based on an 80 percent loan-to-value (LTV) ratio, which means that financial institutions will lend 80 percent of the property value/price," according to Bennie D. Waller, PhD, department chair and professor of finance and real estate at Longwood University's College of Business and Economics in Farmville, Virginia.
Waller says that lenders prefer for the home buyer to have at least 20 percent equity, or a 20 percent down payment. He refers to this as having "some skin in the game." In other words, a homeowner who has put at least 20 percent into the cost of the home is less likely to walk away or default on the property.
On the other hand, "the lower the down payment, the higher the risk of default and the higher the interest rate charged to the homeowner," explains Waller.
In addition to a higher interest rate, borrowers will also be charged private mortgage insurance (PMI). "On a conventional loan, anything less than a 20 percent down payment will require the homeowner to pay private mortgage insurance (PMI)." If the homeowner defaults, PMI helps lenders to offset the cost of default mortgages.
So how much is your PMI and how long will you be required to have it?
"You are typically required to carry private mortgage insurance until you reach 20 percent equity in your home," says David Bakke, personal finance expert at the consumer-savings website, moneycrashers.com."Private mortgage insurance usually costs around 1 percent of your outstanding balance. So if your current balance is $200,000, you'll pay about $2000 per year."
As a result, Bakke concludes that it definitely behooves you to save for a substantial down payment.
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#2 - Low Credit Score
"Your credit score is the single most important snapshot of your credit health, and represents all the information on your credit report - including your credit accounts and payment history," says Ken Lin, chief consumer advocate at Credit Karma, Inc.
A low credit score sends the wrong signal to potential lenders, one that may even prevent you for being approved for a loan.
"A low credit score says that you're not a reliable borrower and it may be difficult to get approved at all," warns Lin. "If you are approved, your lender will use your score as one of the primary factors in determining your interest rate."
So what's considered a good or a bad score? "Anything above 760 is normally the top tier of credit, so an 800 score and a 761 will get the same interest rate pricing, says, Michael Metz, mortgage broker at V.I.P Mortgage in Scottsdale, Arizona. "Below 760, every 20 point increment (740, 720, etc.) will cause an additional "hit" to the pricing, resulting in a higher interest rate available to the buyer."
#3 - Bankruptcies or Foreclosures
"Bankruptcies and foreclosures are serious business," says Koss. "If your credit profile and finances have ever dropped so low that you were not able to bail yourself out, it is hard for lenders to think you won't do the same to them."
After declaring bankruptcy or being foreclosed on, the requirements vary for different loan types. For example, "the Federal Housing Authority (FHA) requires you to wait three years after a foreclosure before you can get a home loan - unless there are "extenuating circumstances," like illness or relocation that led to the event," says Joe Parsons, senior loan officer with the mortgage lender, PFS Funding, in Dublin, California.
Also, if a borrower filed a chapter 13 bankruptcy - which means they paid their creditors through the court - the Trustee of the Bankruptcy Court must approve the purchase and the borrower must have made timely payments on the Chapter 13 repayment plan for at least one year, says Parsons.
For Chapter 7 - which means that all debts are discharged, and the borrower is no longer legally liable for them - Parsons says there is a two-year waiting period after the discharge date before a borrower can get another loan.
"For a conventional loan, the waiting period after foreclosure is two years if the buyer makes a down payment of at least 20 percent," Parsons explains. "If they can prove extenuating circumstances, the down payment requirement could be lowered to 10 percent."
Waller adds that getting a home loan after foreclosure is difficult, but not impossible. "Many times, individuals can get another mortgage soon after a foreclosure if they have a significant down payment, like 30 percent to 40 percent of the total cost of the mortgage."
[Click to compare loan products and interest rates from multiple lenders now.]
#4 - Late Payments
"When lenders check a borrower's credit, late payments will show up on the report, and it may sound harsh, but one or more late payments show an inability to handle current or past debts," warns Koss.
He explains that a borrower who has a number of late payments on his or her credit report raises a red flag for lenders. "And to offset the risk of loaning money to these borrowers, the lender will charge a higher rate, or turn down the loan request altogether."
Michael Garden, a realtor with the Garden Collaborative in Philadelphia, Pennsylvania, says home loans, car loans, credit cards and many other types of loans will show on your report - as will any late payments.
What's more, if the borrower currently has a mortgage or has had one in the past, the payment history on the mortgage will also be considered. "If a borrower has made more than two mortgage payments more than 30 days late in the past year to two years, it is unlikely that borrower will be approved for another mortgage," warns Garden.
However, all is not lost - especially if you've made strides to maintain on time payments. "As you get further from the late payment, the credit score will improve," says Metz. To speed up the credit score recovery process, he advises consumers not to close late accounts, so there's a visible payment history.
#5 - Debt
"High levels of debt are an indication of risk. Too much debt is a signal to lenders that the borrower may be in trouble or heading toward trouble financially," says Waller.
As a result, "if all of your debts totaled up are more than 36 percent of your gross income, you likely won't qualify for a mortgage, or at least it'll be a lot more difficult," according to Bakke, who says that this percentage will vary depending upon the lending institution.
That may seem like a low number, but Bakke says that according to the Ability-To-Repay rule recently passed by the federal government, your debts can't exceed 43 percent of your income. And some banks don't want to come close to that ceiling, so Bakke says their limit may be as low as 36 percent.
And if an applicant's debt-to-income ratio exceeds the government's 43 percent limit, Garden says it is unlikely that the applicant will be approved for a mortgage loan.
So how is your debt load determined? According to Parsons, "[The lender will] calculate this by adding to the total house payment (principal, interest, taxes and insurance) any debt that will last for more than 10 months. This would include student loans, car payments, credit card payments, alimony or child support, etc."
Parsons explains that the sum, "total debt," is then expressed as a percentage of the gross monthly income.
However, if your DTI exceeds the maximum amount, you may be able to enlist the aid of a family member to be a "non-occupant co-borrower." According to Parsons, "The income and debts (including housing expense) for the co-borrower are blended with those of the occupant borrower. This will often bring the DTI to an acceptable level."