If you’ve decided to buy a home, congratulations, you’ve taken a big step. Now it’s time to get your finances in order.
In fact, your financial profile is so important that — if you’re one of the many Americans who have to borrow money to buy a house — you’ll want to start working on it well before you’re ready to apply for a mortgage. That way, if you need to repair your finances or your credit, you’ll have some time.
Here’s what you need to know about getting your finances ready to buy a home.
What lenders look at when assessing your finances
When you apply for a home loan, lenders want to assess whether you’ll be able to pay them back. They’ll check to see that you have a steady income and look at how much cash you have available to cover a down payment, closing costs, taxes and other expenses. Recent banking activity, investments and other aspects of your finances will come under the microscope too.
If you’re a candidate for a no down payment loan, such as through the Department of Veterans Affairs, you’ll need documentation to prove it.
Lenders will also check your credit to assess your history of paying your debts and look at how much outstanding debt you have.
Different lenders may look at different things when checking your finances, but the goal is the same — to help decide whether to risk lending you money, and how much interest to charge. Here’s a list of what lenders are likely to consider in their assessment.
FICO® credit scores and credit history
Down payment amount
List of assets (stocks, real estate, etc.)
Income and employment history
Tax returns
Banks statements for two to three months
Desired loan amount compared to value of home
Total debt compared to income — your debt-to-income ratio
Rental history (if you’re currently renting or have rented in the past)
To improve your chances of getting a home loan with the best possible terms, you should save as much as you can for your down payment, get your debt-to-income ratio under 43%, and do what you can to improve your credit scores. Specifically, we’re talking about the scores compiled by Fair Isaac Corp., known as FICO, which are the mortgage-industry benchmark.
A higher credit score can help you get a better mortgage
It’s not possible to say exactly how to raise your FICO® scores — everyone’s personal situation is different — but there are a few practices that can usually help, especially if you adopt them a year or more before you apply for a mortgage.
Pay your bills on time: Your credit scores will fall if you’ve missed payments on a credit card or another debt.
Use less of your available credit: Your credit utilization ratio, which measures how much debt you’ve taken on compared to what’s available to you, is an important factor in your scores. Using less than 30% of your available credit may lift your scores. Paying down your debts may also lower your debt-to-income ratio, another measure that doesn’t impact your credit scores but is used by banks to assess your creditworthiness. (We’ll explain later.)
Don’t open new credit accounts: When you apply for credit, a lender will initiate a hard credit inquiry, which will have a temporary negative effect on your scores.
Maintain a mix of credit accounts: Your credit scores are affected by what kinds of credit accounts you have, how old they are, and how many of them you have. If you’re managing a mix of different types of credit without trouble, you’ll look less risky to lenders. Note that you shouldn’t open new accounts just for the sake of creating this mix (see point above).
If you have poor credit and stick with these approaches, your credit scores are likely to rise over a period of months, and that’s a good thing, because lenders may see you as a better risk and charge you a lower interest rate on your mortgage.
Why should you worry about your credit scores? Imagine getting a $250,000 mortgage that lasts 30 years and has a fixed interest rate. Take a look at the table below to see how credit scores affect how much you could pay just in interest (not counting the actual money you borrowed) over the life of the loan. You can plug in your own information to get a better idea of what your interest payments could be.
The down payment: Bigger is better
As we said earlier, you should save as much as you can for a down payment. A bigger down payment means you’ll own more of your new home from the start. This makes you a lower-risk borrower in the eyes of lenders and usually translates into a lower interest rate on your home loan.
Another reason to put down more cash is to avoid private mortgage insurance, or PMI. Most lenders will require you to buy PMI — which protects the lender in case you default on your loan — if your down payment is less than 20% of the purchase price of your home.
The cost of PMI depends on the type of mortgage you get, how much you put down and some other factors, but usually costs between 0.5% and 1.5% of the loan amount each year and can add up to thousands of dollars.
Debt-to-income ratio: Getting to 43%
Your debt-to-income, or DTI, ratio — which measures your outstanding debt as a percentage of your income before taxes — is used by lenders as another way to gauge your ability to repay your mortgage.
Your DTI ratio is calculated by adding up all your current monthly debt payments (think student loans, personal loans, credit cards) and your proposed mortgage principal, interest, taxes and insurance payments, and then dividing that number by your gross monthly income (your income before taxes and other deductions).
For a qualified mortgage — a home loan that meets certain regulatory requirements put in place in 2014 to protect lenders and borrowers — you’ll need to have a DTI ratio of 43% or less.
Lenders can extend loans to borrowers who have a DTI ratio higher than 43%, but you generally need a compensating factor like high cash reserves, and even then it’s rare. Lenders consider a higher DTI risky for both you and the lender, as it suggests to them that you may struggle to pay your mortgage and keep up with all your other debts.
If your DTI ratio is too high for lenders’ comfort, you’ll need to lower your debt or increase your income, or both. Since changing jobs or demanding a raise mid-mortgage application may not be practical, you may want to focus on paying down debt.
There are differing opinions about the best way to tackle the job. Some experts recommend paying off your smallest debt first — which research has shown can be effective. Some say it’s better to start with the highest interest loans — that way you pay less interest over the long term. Still others say that paying down your debt with the biggest monthly bill is the best way to lower your DTI quickly.
Whichever way you decide to go, keep in mind that the goal is to lower the amount of debt you have as a percentage of your income, so choose a method that you can commit to and that effectively moves you in that direction.
Bottom line
It may take months — or longer — for you to save for a down payment, lower your DTI ratio or improve your credit scores, but if you work hard and stick with it over time, you may begin to see your efforts rewarded with easier loan approval and more advantageous loan terms.