How to Get Approved for a Home Loan
Getting approved for a mortgage takes more than filling out an application. To succeed, you want to start the process long before you plan to apply for a loan. There are several ways to increase your chances of approval. We discuss these methods below.
Would You Give Yourself a Loan?
You're about to go out and ask someone to trust that you will pay them back hundreds of thousands of dollars over time. It's a big ask. Banks aren't as lenient on how they say "yes" as they were before the 2008 financial crisis. They don't give out mortgages as freely as they give out credit cards.
Before you go knocking on lenders' doors, do some self-assessing to see if you are worthy of such a big loan. Can you truly afford the pricey commitment? Missing a mortgage payment is a bigger risk than missing a rent payment one month. You may find as you go through this list that you have some work to do, and your dream of owning a house may have to wait a couple of years.
If you think you're ready, then go through these steps to show lenders you are prepared and organized (i.e., a reliable borrower).
What You Need to Know Before You Get a Mortgage
Calculate Your Income
Along with a stable employment history, you need to be able to show lenders you have a stable income. They want to see proof. They'll ask to see your recent pay stubs to prove you're currently employed, and they'll also want to know your income history - usually two years' worth. This means you need to provide:
- The W-2s from the last 2 years
- Tax returns from the last 2 years (if you are self-employed or work on commission)
- Verification of employment
When you calculate your income, you may come up with a different number than the lender. This is because many lenders take an average of your income over the last 12-24 months. This allows them to account for any peaks and valleys your income may experience. The average covers the highs and the lows. This prevents lenders from approving you for a loan amount that you may not be able to afford year-round.
Keep in mind, though, that lenders also need adequate proof of your assets. You cannot just say you have $10,000 in your account and expect them to accept it. Instead, they need "seasoned funds." This means funds that sit in your account for at least six months. They will verify this by evaluating your bank statements over the last 6 to 12 months. If they notice any unusual deposits, they will inquire where the money came from. They may also require a paper trail. This is to prevent you from "stuffing" your account with someone else's money.
Secure a Pre-approval
Once you have everything in line to make a great loan application, you should secure a pre-approval. This is the first step the bank takes to approve you for a loan. They need your credit report (in general, they're looking for a score of at least 680), income documents, and bank statements to determine how much loan you qualify to receive. Many sellers and realtors prefer to work with buyers that have a pre-approval. It helps to give you the edge on the competition.
The pre-approval also helps you realize how much home you can purchase. You can use the mortgage calculators online, but until you talk to an underwriter, you won't know what lenders think. The pre-approval process takes less than an hour. In many cases, you can walk away with a pre-approval letter from the lender the same day.
We recommend that you don't settle for just one lender. There are different types of lenders, and they each have very different terms. At the very least, consider applying for each of the following:
- FHA loan
- Conventional loan
- Private bank loan
Veterans and low-income families in a rural area can also apply for the VA or USDA loan. The idea is to see the different options available to you. This is important if you do not put 20% down on the home. This way, you can compare the mortgage insurance payments and interest rates of an FHA and conventional loan.
Not every bank offers the same programs. One may turn you down completely, while another may have other options for you. The risk levels each bank can accept vary. In addition, each bank has different requirements for profit levels on various loans.
Not Yet Ready? Here's How to Work Toward Pre-approval
You may find, after looking at all the figures, that you're not in a position to own a home just yet. It's better to realize that now than to be in over your head with debt and risk the heartache and embarrassment of losing your home. Here are long-term ways to build yourself up to the point where you can get that desired OK from a bank.
Stabilize Your Job History
Lenders need to see stability in your life in order to approve you for a loan. This includes a stable job history. The magic number is 2 years. Many lenders prefer that you work at the same job for at least that long for stability. This ensures the lender that you have consistent income to cover the pending mortgage payment.
There is some leeway with this requirement, though. You are not stuck at a dead-end job for two years just to secure a future loan approval. If you need to switch jobs, try to keep it within the same industry. Many lenders look at this as consistent employment. This is only true, of course, if your income is along the same lines. If you took a drastic pay cut to change jobs, the lender may be leery of the change.
If you are new to the working world, you may have to wait a while to apply for a loan. The time you have to wait depends on the lender and your chosen profession. College graduates who secure a job in the industry they studied are an exception. If you took a job in a different area, though, you may have to wait 2 years.
Manage Your Debts
Another factor lenders use to determine your ability to secure a mortgage is your debt-to-income (DTI) ratio. This means how much of your income covers your monthly debt. The lower the ratio, the easier it is to secure a mortgage.
The good news is not every debt you have figures into the debt ratio. Only those debts that are reported to the credit bureaus count. These include:
- Credit card minimum payments
- Car loan payments
- Student loan payments
- Any collections or judgments filed against you
Lenders take each of these payments and total them. They then divide the debts by your qualifying income, as we talked about above. Here's a simple example:
You have 3 credit cards with minimum payments totaling $150 and a car payment of $300. Your pending mortgage payment, including principal, interest, taxes, and insurance, equals $1,200. Your total debts equal $1,650. If your monthly income equals $4,000, your debt-to-income ratio equals 41%.
Every lender has a different threshold for debt ratios. Many go by the Qualified Mortgage Rule, which states your total debt ratio cannot exceed 43%. Others have other guidelines, higher or lower than this number. It depends on the lender.
In order to minimize your debt ratio, start paying your debts down as early as possible. If you can eliminate your credit card debt, it would help your DTI greatly. If not, at least get the accounts paid down as low as you can so the minimum required payment decreases. Any loans you can pay off completely also help your DTI.
Save for a Down Payment
Lenders look at how much "skin in the game" you have. This means how much you invested in the home yourself. There are many different down payment requirements depending on the program you choose. Unless you are a veteran or purchase a home in a rural area, though, you will need a down payment. VA and USDA loans are the only programs that offer loans with no down payment. Any other program requires at least 3.5% down, if not more.
The earlier you start saving for a home, the better your position for loan approval. As a standard rule, 20% down gives you the most leverage. With this investment, you don't need to pay Private Mortgage Insurance. This could amount to a monthly savings of $100 or more on your mortgage payment. There are loans for those who don't have 20% to put down, but they usually have higher interest rates and the dreaded PMI.
Decide early on how much money you intend to put down on a home and start saving. Then create a plan to make it happen. The easiest way is to set up an automatic savings plan according to your pay schedule. Automatically including savings as a part of your budget takes minimal effort. Other ways include:
- Automatically saving any bonuses or commission checks you receive
- Create a savings account strictly for your down payment so you don't use it for other things
- Make lifestyle changes that help you save more money
- Take on a second job or work overtime to sock away more money
Work on Your Credit Reputation
Does your credit score need some care and attention? If you feel your score won't win over a lender just yet, you can focus your efforts on bringing it up by doing the following:
- Pay your outstanding bills on time. Credit bureaus report late payments once they are 30 days late.
- Don't over extend your available credit. Use no more than 20% of your available credit. Anything higher negatively affects your credit score.
- Don't open any new credit accounts. Any new credit can bring your credit score down. Try to avoid new accounts for at least six months before applying for a loan.
- Watch how many creditors pull your credit. New inquiries can pull your credit score down. Inquiries also serve as a red flag to lenders as it might mean new debts.
It is also important to ensure the validity of everything reported on your credit report. Before you apply for a mortgage, order your free credit report from each of the bureaus. You are able to secure one free report from Trans Union, Experian, and Equifax per year. Go over the reports to make sure there are no errors. Human mistakes happen, but if you don't catch them, it could hurt your chances of loan approval. If you do find an error, provide the proof of its inaccuracy to the reporting bureau to correct it.
As you can see, you may find that you need some more time to ready yourself for a loan approval. The sooner you start, the greater your chances of approval. Always keep an eye on your credit, save as much as you can, and you'll get your foot in the door.