Step One: Pre Approval - How Much House Can I Afford?
What is important to realize is that your financial fingerprint is unique just like the one on your finger. That is why the mortgage process is often cursed by those that jump into it. The 10-day loan closing that your friend is boasting about can just as easily be the 2-month nightmare that costs you thousands of dollars and countless sleepless nights. That is because no two fingerprints are the same. Every person has a unique combination of credit, income, and savings. All of these factors will affect your mortgage experience. The goal of this book is not make you a mortgage expert but rather help you understand the parts of your financial fingerprint that will affect your mortgage experience. Understanding how your financial fingerprint impacts your mortgage will put you in a better position to avoid the nightmare home buying experience and help you turn the knob to your new home with ease.
Breaking Down your Fingerprint - The Three 'C’s
Borrowing money is easy to understand as long as you keep this concept in mind. Loan unto others as they would loan unto you! If a total stranger approached you on the street and asked to borrow $500,000 from you to buy a house what would you request from that person before you would lend him or her the money? Think about this hard…imagine you are a bank and you have to lend your money to strangers you know nothing about – where would you start? This is the key to understanding the mortgage lending process. Many people get angry with all the questions, letters, and paperwork that is required to get a mortgage but if you think about it from the perspective of “what if it was my money” you may come to appreciate all those questions being asked.
How banks decide if they will lend you money to buy your home is as simple or difficult as the 3 C’s. Capital (savings), Character (credit history) and Capacity (income).
Character - Your Credit ScoreYour credit score is an important part of the home buying process. A credit score is made up of a 3-digit number that represents your credit worthiness and probability that you will pay back your debts. Pretty simple concept here – the better you manage and pay your credit the higher your score. Credit scores are used by mortgage lenders, credit card companies and banks to assess the risk involved in lending money to consumers.
There are three trade bureaus that all report your credit score. Your credit score for lending purposes is the middle score of the three. For example, if you have 700, 750, and 800 – 750 will be score the bank uses to underwrite your mortgage. Important Note: Online free credit score trackers are extremely inaccurate. I have yet to receive a copy of a free credit report that is within 20 points of a borrower’s actual credit score. Don’t trust credit monitoring services – they may be good to detect unusual activity on your accounts but the scores they spit out cannot be trusted.
In order to qualify for a home loan, most lenders require a minimum FICO credit score of 620. While this number may vary from lender to lender, it’s a good idea to do everything you can to increase your credit score before you buy your home. Pay on your current debts on time, get those old collections for unpaid parking tickets paid, and try to keep the balances on your credit cards at 35% or less. Most lenders have the ability to give advice on how to raise your credit score so don’t throw in the towel if you have a low score.
Derogatory CreditA derogatory trade line is a negative credit event such as a collection, charge off, or late payment on a mortgage. A major derogatory is a bankruptcy, short sale, foreclosure, etc. If you have any of the items above, it doesn’t mean you can’t buy a home it just may narrow down your loan options. There are several loan programs designed for borrowers that are bouncing back from negative credit events. Don’t give up…make the call to your lender to find out if there is a fit for you.
Credit Buckets - Am I Good?
- 780+ You are the best – HIGH FIVE!
- 760+ You are close to the best and will still get the best rates
- 740+ Still great buy may lose a little on certain loan programs
- 720+ Above average but your interest rate/closing cost are getting impacted
- 700+ Average
- 680+ Average
- 660+ Below Average
- 620-660 – Below Average
- Below 620 – Poor, limited loan options
Once you drop below 740 your loan starts being negatively impacted by your credit score. This doesn’t mean you don’t get a loan it just means that from this point on the lower your score goes the more expensive your loan gets. Lower score = higher risk. Higher risk = higher rates/costs.
Capacity - How Much Can You Afford?The last thing you want is to buy a home and be constantly stressed whether or not you can afford to pay the mortgage each month. It is also the last thing the bank wants because if you are stressing out about your mortgage you will be more likely to miss a payment/s. To prevent this they have affordability rules you need to follow. At the core of these rules are ratios. Ratios are fractions. The ratios that banks are concerned with are debt to income ratios and your housing ratio. Let’s look at the numbers that get baked into your ratios.
Factors that are important to consider when it comes to how much you can afford include:
Calculate your gross monthly income before taxes. Include bonus and commission only if you have received it for 2 years.
Add up all of your monthly debt payments including: Car loans, credit cards, personal loans, alimony, child support and other monthly debt payments.
Debt to Income Ratio (DTI)
This is your total monthly debt divided by your gross monthly income. If your DTI is 43% or lower, you are considered in great standing, but in most cases you are still ok with a DTI up to 45% of your monthly income. It is important to note that, for an FHA loan, your DTI can be as high as 55%.
The calculation for DTI = RIMD+HE/GMI = DTI
Capital – How much is all this going to cost me?Capital is often referred to as savings. In the mortgage world you will often hear savings used in the following terms – down payment, reserves, and assets.
Down PaymentThere are many loan programs that offer the ability to put very little down, and in some cases 0. But like my dad used to tell me: nothing is free. A key concept to remember is that the less you put down the more it is going to cost you. The 2 factors that compensate the bank for your choice to borrow more than they want you to are higher rates and mortgage insurance.
Your down payment funds must come from your own money. Your own money is considered money that has been in your bank account for 60 days. This is often referred to as seasoned funds. Any money that has not been in your account for 60 days will need to be explained and sourced to the bank to determine if it is acceptable. Be prepared to explain any deposits that are listed on your most recent 2 months bank statements as that is the money the bank needs to verify is your own.
You do not need a 20% down payment to own a home!
- Conforming loan programs allow for as little as 5% down up to loan amounts of $625,500
- Government loan programs allow for as little as 3.5% down up to loan amounts of $625,500.
- If you need to borrower more than $625,500 then you will be in a jumbo loan and your minimum down payment is currently 10% for these programs up to 1.1 million.
- Almost all loans allow for a portion of your down payment to be a gift. Gifts must be made from immediate family members. Strangers cannot gift you money.
- You cannot borrower against credit cards for a down payment.
Earnest Money DepositThis is a cash deposit you can offer a seller along with your offer on a home in order to show the seller you are serious about purchasing the home. Talk to your Realtor to estimate the amount needed for your earnest money deposit. This money stays in escrow during the home purchase process and is applied to your down payment at closing. This money is refunded to you if you decide to cancel the transaction during the contingency period.
Closing CostsEstimate your closing costs to be between 1-2% of your loan amount total and be sure to set this amount aside for closing. Sometimes the closing costs are added into your total mortgage and are able to be paid off with your mortgage, so be sure to get clear on what you owe at closing and how the costs will be paid.
ReservesMost conforming and government loan programs do not have reserve requirements unless you are buying investment properties. Jumbo loans do have reserve requirements. Reserves basically equal one month of your housing expense (HE). For example, if your housing payment was $5,000 per month and the bank required 2 months reserves you would need to have $10,000 in the bank left over after you closed on your new home. The bank wants you to have reserves because it makes them nervous if you are spending every penny have to buy a home. This increases the risk that will not have the financial staying power to ride out an unforeseen calamity – job loss, health issue, etc.
Putting it All TogetherIn most cases you don’t choose your own loan, the loan chooses you. Your financial fingerprint is the most important factor in determining which type of loan you can qualify for. This is the most important concept in this chapter. Most consumers go out and get educated on a whole bunch of loan types that don’t apply to them because the combination of their C’s doesn’t work for that loan. This is where the importance of a pre-approval comes in. Rather than trying to become a mortgage expert by spending hours sifting through the google wormhole the pre-approval is designed to review your 3 C’s and approve you for the best possible loan you can afford. That is why after organizing your C’s the pre-approval comes next. That said, before we jump into the pre-approval process we need to look a bit closer at loan types and programs so that after your pre-approval is done you have an idea about the options in front of you.
Loan Types - Which is Right For Me?
There are 3 main loan types that you may qualify for during your search – conventional, government, and jumbo. It is possible that you may qualify for more than one loan type. They differ in the amount of money they allow you to borrow, the credit score requirements, the required down payment, and the interest rates on offer. Rates for each program are determined by LLPAs (or Loan Level Price Adjustments.)
LLPAs - What Determines the Interest Rate You Qualify ForSimply put the more risk a loan has the more it is going to cost you. Below you will find an LLPA grid for conforming loans. This LLPA table is similar for all loans types. As you can see one axis is loan to value (how much you borrow) and the other is credit score. The numbers in each box are percentages that are multiplied by your loan amount and are broken down in .125 increments. Any number in parentheticals is a credit to you. As you can see, the lower your credit score and the higher your LTV the bigger the number in the box. So let’s to the math on one. You want to put 20% down payment on a $500,000 home and your credit score is 719. Your loan amount will be $400,000. The LLPA is .5%. That means you are paying a $2000 risk penalty because of your credit score and down payment amount. In the same scenario if you put 25% down and a 750 FICO score you would have no penalty. The LLPA is the answer to most of the questions I get about price. Everyone has a friend that got a better deal than you. What most people don’t realize is that friend had a higher credit score and put more money down. The LLPA is important to keep in mind as you are surfing the web looking and mortgage rate quotes. If you read the fine print you will find out that the lender is quoting out the scenario with no LLPAs or even credit LLPAs that make the rate look even better.
Special Loan Programs
This month we have special programs with low interest rates for both Owner Occupied & Second Homes. Contact us now to determine your eligibility!