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- By improving your finances before applying for a mortgage, you give yourself the best shot at getting good terms.
- In evaluating your creditworthiness, lenders consider your credit score, income and other assets, debts, the amount of your debts in relation to your income, and your employment history.
- You can boost your financial profile by improving your credit score, reducing your debt load and ramping up your savings.
As a first-time homebuyer, you might not have much income or savings to work with. That doesn’t mean you won’t qualify for a mortgage, however. Here are three ways to prepare your finances before you apply for a home loan.
What financial elements are considered in the mortgage process?
How do you know you’re really ready for a mortgage? There are some signs that might point to yes, according to a recent study by Freddie Mac. These include:
- Your credit score: One of the bigger determining factors for mortgage approval, a credit score of 661 or higher places you in the creditworthy category, according to the study. If your score is between 600 and 660, you could be close to being ready for a mortgage, but not there yet. If your score is 599 or lower, you’re likely not ready to take on the additional debt.
- Your debt-to-income (DTI) ratio: DTI is also significant, and there are two measures. The front-end ratio, which compares your projected monthly mortgage obligation to your monthly income, should be, ideally, 25 percent or less. The back-end ratio — your overall debt, including auto loans and student loans, can be higher, but most lenders like it to be no more than 36 percent, with 43 percent as the max.
- No bankruptcies/foreclosures: It’s best if your credit profile is free of these blemishes, and has been for the last seven years.
- Timely debt payments: Your credit report should also be free of debt payments that are 90 days or more overdue.
Bankrate’s take: This isn't to say you won't get approved for a mortgage if you have a lower credit score or don't meet all of the other criteria — you just might be stretching yourself too thin or unable to achieve other financial goals.
How to improve your finances before getting a mortgage
When you apply for a home loan, the mortgage lender reviews all aspects of your credit and financial profile to assess your risk as a borrower. This includes your credit history and score, employment history, income, debt and savings or other assets.
Taken together, the strength of these factors helps the lender decide whether to approve or deny you for a loan, and for how much. Below are three tips to boost your chances of getting approved for the amount you want.
1. Check your credit
Well before you get a mortgage, take a look at your credit reports and scores. You can obtain your credit reports (which don’t include your scores) for free on a weekly basis from each of the three credit bureaus (Equifax, Experian and TransUnion) through AnnualCreditReport.com. You can get your credit scores directly from the credit bureaus; sometimes your bank also offers a way to get the info.
On your reports, keep an eye out for errors, such as incorrect contact information. If you spot a mistake, reach out to the reporting bureau to begin a dispute claim. Take note of any late payments listed, as well — this’ll help you identify areas that need improvement.
When you apply for a mortgage, the lender may look at your scores associated with each of the three credit bureaus and base its decision on the middle number. For most mortgages, you’ll need a minimum 620 score, although some loans allow for as low as 500 or 580 if you have other “compensating factors,” such as substantial savings. For a bigger loan, outside of the conforming loan limits, you’ll likely need a credit score of at least 700.
That said, the best interest rates and terms go to borrowers with scores of 740 or higher. If your score isn’t there yet, read on.
2. Work on your debt
To improve your credit score, begin by making on-time payments (as you should be doing already. Nothing dings your score like late payments). In the months leading up to your home purchase, strive to pay all of your bills on time. If you’re having trouble making payments, now’s the time to contact creditors or service providers to arrange a payment plan or other form of relief.
Along with maintaining a history of on-time payments, start chipping away at any outstanding balances. There are many ways to tackle them, including:
Aside from the positive impact on your credit score, less debt lowers your DTI ratio, the proportion of your monthly debt payments (including estimated mortgage payment) relative to your gross monthly income. Lenders take this into account when determining how much to approve you for.
It depends on the loan program, but most lenders look for a DTI ratio of no more than 45 percent, although some are stricter and cap it at 36 percent. Others are more flexible, and will allow up to 50 percent. You can use this DTI ratio calculator to get a sense of where you stand.
Lastly, avoid taking on any new loans. This’ll add to your debt load, which increases your DTI ratio and can potentially dent your score. This is especially so if your credit utilization is already high or you find you can’t handle the additional payments.
3. Get serious about savings
Unless you qualify for a no-down payment mortgage — an increasingly rare creature, outside of certain government-guaranteed loans — you’ll need to be ready with considerable upfront cash: savings for a down payment and closing costs, along with general reserves for costs like furniture or home repairs. All of this in addition to an emergency fund, which usually equals three to six months’ worth of expenses.
For the third quarter of 2023, the median down payment on a home was $35,050, according to ATTOM Data Solutions, an analyst of property and real estate data. The good news: You can get away with putting down as little as 3 percent for a conventional mortgage. The amount of closing costs depends on where you’re buying, but they generally range from two to five percent of the purchase price. Nationally, the average closing costs were $6,905 in 2021, the latest year for which figures were available.
Source: National Association of Realtors
- Put funds earmarked towards the home purchase in a high-yield savings account.
- Avoid or cut back on eating out and other discretionary expenses.
- Cancel unnecessary memberships, services or subscriptions.
- Sell items you no longer need or want, such as clothing or furniture.
What if I can’t improve my finances?
Due to income, you might be limited in how much you can put toward debt or savings. That’s OK — this could simply mean you need to wait to become a homeowner or need more time to get established in a career and build your earnings.
In the meantime, do everything possible to maintain your credit score. If you can’t afford or don’t qualify for a mortgage now, with good financial habits, you’ll be able to in the future.
The amount of money you should have before buying a home depends on your budget (your income, your other obligations), how much home you’d like to buy and the amount of cash you can afford to pay up front. When buying a home, you need to have enough money for both a down payment and closing costs. It’s also important to have money for moving costs and enough savings as a cushion for emergencies.
Closing costs are typically between two percent and five percent of the mortgage loan principal amount.
Moving costs vary based on the amount of belongings you need to move and the distance of the move. On average, you can expect to spend between $883 and $2,552, according to Angi.
Not outright, certainly, but it’s about enough to cover a down payment. The median sale price of a home in November 2023 was $387,600, according to the National Association of Realtors, and the average down payment is around 13 percent. A 13 percent down payment on the median-priced home would amount to $50,388. That figure does not include closing costs or moving expenses.
The sooner you can start saving for a house, the better. But if you have a lot of debt, it may make more sense to pay down some of it first before saving for a house to have a better DTI ratio, and qualify for better mortgage rates.
Additional reporting by Allison Martin