How to improve your finances before your first mortgage
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As a first-time homebuyer, you might not have as 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.
Are you ready for a mortgage?
How do you know you’re really ready for a mortgage? There are some signs that might point to yes, according to a study by Freddie Mac. These include:
- A credit score of 661 or higher
- A debt-to-income (DTI) ratio of 25 percent or less, at least for the front-end ratio, which looks at just mortgage debt to income. Overall debt, including auto loans and student loans, can be higher than 25 percent of income.
- No bankruptcies or foreclosures in the last seven years
- No debt payments 90 days or more overdue
One of the bigger determining factors: your credit score. A 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.
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 these for free from each of the three credit bureaus (Equifax, Experian and TransUnion) through AnnualCreditReport.com. Currently, you can get your reports on a weekly basis.
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, 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, if you aren’t already. 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 debt. There are many ways to tackle debt, 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, and others more flexible, 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, especially 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, you’ll need to have savings for a down payment and closing costs, along with general reserves for costs like furniture or home repairs. All this in addition to an emergency fund, which usually equals three months’ to six months’ worth of expenses.
In 2021, the average down payment was more than $70,000, mortgage data firm Optimal Blue reports. First-time buyers typically put down between 6 percent and 7 percent of the home’s purchase price, according to the National Association of Realtors.
The good news: You can get away with putting down as little as 3 percent for a conventional mortgage. (Here are the minimum down payment requirements for other types of loans.) The amount of closing costs depends on where you’re buying. Nationally, the average was $6,905 in 2021, according to ClosingCorp.
Even if you don’t know your homebuying budget or how much house you can afford yet, start saving now. Here are some strategies:
- Automate your savings to 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.