Preparing for Homeownership: Three Factors in Mortgage Approval

Owning a home is a huge piece of the American Dream, and reaching this key milestone is one of the most important accomplishments in a person’s life. But many people lack understanding of the mortgage approval process when they set out to purchase their first home. Obtaining a mortgage loan can be daunting and quite stressful, especially if you’re ill-prepared. This article covers the three primary factors in the mortgage approval process to get you started.

Before those three factors come into play, you’ll be required to complete a mortgage application – a highly-detailed document with specific questions about income, employment, outstanding debts, assets, and credit history. Be accurate and honest on this application. Discrepancies will get you declined; fraud has serious consequences, even imprisonment. It’s never worthwhile to lie on a loan application.

When you apply for a mortgage loan, the underwriter will consider three factors to evaluate whether you qualify: 1) capacity; 2) character; and 3) collateral. Let’s take a brief dive into those three factors.

Capacity refers to your ability to make mortgage payments on time. The underwriter will explore aspects like your job type, job history, and income stability to evaluate capacity. A mortgage is an extremely long-term commitment – typically no less than 15 and as long as 30 years. The underwriter wants to be very sure you have capacity to pay before disbursing hundreds of thousands of dollars. They’ll calculate two ratios: debt-to-income and overall debt-to-income.

Debt-to-income ratio divides the amount of debt payments paid out monthly by your monthly income before taxes. The lower the ratio, the better. The standard qualifying debt-to-income ratio for a conventional mortgage is 28%. Overall debt-to-income ratio includes your house payment plus ALL your existing monthly payments, and cannot be more than 36% of gross monthly income. So the more debt you have, the less house you can buy.

Character refers to your credit history. This is the biggest obstacle most borrowers face. The lender will heavily scrutinize your entire credit and payment history, gathering data from the three main credit bureaus – Equifax, Experian, and TransUnion. The credit bureaus monitor your entire credit history and assign you a score known as a FICO® score. The higher your FICO® score, the better your chances of loan approval.

Collateral refers to the value of the property you’re purchasing. You’ll use the property value as security toward repayment of your mortgage loan. The lender will hire a licensed appraiser in your area to verify the home’s market value.

Now that you have an overview of the three factors in mortgage loan qualification, here are a few actions you can take to start preparing for this important process:

• Get copies of your credit reports from the three credit bureaus. You can get all reports and credit scores once per year at www.annualcreditreport.com.
• Check your credit reports carefully to make sure everything is accurate.
• If you have credit issues, it’s best to resolve them before you apply for the mortgage. Here are a few tips:
  • Resolve any errors on your credit reports by communicating with the credit bureaus.
  • Pay down, but do not pay off, your existing credit accounts.
  • Make all your credit payments on time.
  • Get balances down to under 30% of the available credit limit.
• Review the mortgage loan applications from a few lenders to get a feel for the questions they ask.
• Gather all the records you’ll need including 2 most recent paystubs, 2 most recently filed tax returns, 2 most recent months of bank statements, and valid state-issued photo ID.
• Calculate your gross monthly income and your total monthly debts (all existing debts + other obligations, e.g. child support/alimony).
• Calculate your debt-to-income ratio and overall debt-to-income ratio.

If you enter into the mortgage application process with open eyes and a clear understanding of what loan qualification takes, your chances of approval increase. Being well-prepared helps save you from the stress and embarrassment of being declined. The more information you gather in advance, the higher your capacity to repay, and the cleaner your credit history, the better opportunity you will have to realize the American Dream of homeownership.