List 4 factors a lending institution might use when determining your eligibility for a home loan.

Financial institutions look at a wide variety of things when a customer applies for mortgage financing on a home. There are 3 main building blocks that create the foundation for a solid mortgage application. If any of these 3 building blocks are compromised, it can result in a less than desired type of financing or having to change your financing to allow you to proceed. The 3 main building blocks of a purchase or refinance request are: Credit score, debt-to-income ratio and down payment percentage.

The most important building block is the credit score. This is your ticket to get into the race. The reason why so much weight is put on the credit score is because it’s a reflection of your past financial choices. Credit scores take time to develop and take root and are usually based on years of data collected from creditors.

You need to have a good credit score to qualify for the best financing available. If your credit score is low, it eliminates options for you and makes things more expensive. The lower your credit score, the more it will cost you in fees and in your monthly payment.

Credit scores range from 300 to 850 and most lenders use the FICO (Fair Isaac Corporation) scoring model. Each loan program has their own set of rules that need to be met to qualify. For example, FHA loans require a minimum of a 580-credit score and conventional loans require a minimum of a 620-credit score.

These are the bare minimum credit score requirements though. Just because your score is at that point, it doesn’t necessarily mean you will qualify. You need to meet other qualifications as well such as your debt-to-income ratio.

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2. Debt-to-income ratio

The debt-to-income ratio is the 2nd most important building block of the transaction. If credit score was in a race against debt-to-income ratio, debt-to-income ratio would come in a very close 2nd place finish. Other than the credit score, it plays the largest role in which loan you can qualify for and how much.

For example, you may want a conventional loan because you have a great credit score but if your debt-to-income ratio is too high, you may take yourself out of the running for qualifying for a conventional loan and you might even not qualify for a loan at all! You can have a 780-credit score but not qualify for a mortgage because of having too high of a debt-to-income ratio. Financing can be changed to accommodate a higher debt to income ratio, but it may not be in your best interest.

There are two pieces of the debt-to-income ratio that you must consider; The front-end ratio (housing ratio) and the back-end ratio (Overall ratio). Every loan has a different front-end ratio and back-end ratio and that’s another reason why your debt-to-income ratio is so important. If you want to qualify for a specific loan, you need to meet its debt-to-income ratio requirements.

As a general rule of thumb, you want your front-end ratio to be 28% or less, and your back-end ratio to be 45% or less. The front-end ratio, also known as housing ratio, is your new total monthly mortgage payment divided by your gross monthly income (before taxes are taken out of your paycheck).

For example, if your new mortgage payment is going to be $1,500 per month with everything included and your gross monthly income is $6,000 per month, you would have a 25% front-end housing ratio. This is acceptable and considered a positive.

The back-end ratio or overall ratio is calculated by adding up all of your monthly payments that show up on your credit report and adding in your new monthly mortgage payment and dividing that by your gross monthly income.

For example, if you have student loans, a car payment, and a balance on a few credit cards; you might already have monthly payments around $1,000 and then when you add in the new monthly mortgage payment of $1,500 that puts you at $2,500 for total monthly obligations in relation to income. That $2,500 divided by your gross monthly income of $6,000 puts you at a total debt-to-income ratio of 42%. This is getting close to the maximum allowed but is still considered a positive.

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3. Down payment percentage

The last building block is the down payment percentage. This is an important building block because different loan types have different down payment requirements. If you don’t have the required down payment funds, you will have to choose a different loan type.

Also, it helps in a variety of ways with loan requests. The biggest thing it helps with is loan pricing. The more you put down, the less risk and lenders hate risk. You will get a better interest rate for putting more money down. It helps lower your debt-to-income ratios because you are putting more money down therefore borrowing less.

Lastly, it helps eliminate or lower PMI (Private Mortgage Insurance) which is a lender protection that is required when not putting 20% down in most cases. It can also act as a compensating factor because it shows you saved money successfully to put towards a down payment on house vs. borrowing 100% of the money.

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Ideally, to create the best outcome for yourself, you will want to make sure that you have as high of a credit score as possible, as low of a debt-to-income ratio as possible and have saved at least 3-5% for a down payment (20% preferable to avoid PMI).

When you accomplish all of these things, you put yourself into the lowest category of risk and like I said earlier, financial institutions dislike risk and will reward you with a better loan scenario/product for doing things right on your end. I hope you find this article helpful. I’m a Mortgage Lender with Guaranteed Rate in Rochester, MN. If you have any questions, feel free to reach out to me at the contact below.

Whether you are a first-time home buyer or are re-entering the housing market, qualifying for a mortgage can be intimidating. By learning what lenders look at when deciding whether to make a loan, you'll be more confident in navigating the mortgage application process.

Standards may differ from lender to lender, but there are four core components — the four C's — that lender will evaluate in determining whether they will make a loan: capacity, capital, collateral and credit.

Capacity to Pay Back the Loan

Lenders look at your income, employment history, savings and monthly debt payments, and other financial obligations to make sure you have the means to comfortably take on a mortgage.

One of the ways that lenders verify your income is by reviewing several years of your federal income tax returns and W2s, along with current pay stubs. They evaluate your income based on:

• The source and type of income (e.g., salaried, commission or self-employed)
• How long you've been receiving the income and whether it's been stable
• How long that income is expected to continue into the future

Lenders will also look at your recurring monthly debts or liabilities, such as:

• Car payments
• Student loans
• Credit card payments
• Personal loans
• Child support
• Alimony
• Other debts that you 're obligated to pay

Capital

Lenders consider your readily available money and savings plus investments, properties and other assets that you could access fairly quickly for cash.

Having money saved or in investments that you can easily convert to cash, known as cash reserves, proves that you can manage your finances and have funds, in addition to your income, to pay the mortgage. Cash reserves might include:

• Savings
• Money market funds
• Other investments that can be converted to cash, such as Individual Retirement Accounts (IRAs), Certificates of Deposit (CDs), stocks, bonds or 401(k) accounts

Along with cash reserves, other acceptable sources of capital might include:

When you apply for a mortgage, the lender may need to verify the source of any large deposits in your bank account to ensure they're coming from an allowable source. That is, that you obtained the money legally and that it was not loaned to you.

Lenders may also look at the last two months of statements for your checking and savings accounts, money market accounts, or investment accounts to evaluate how much capital you have.

Collateral

Lenders consider the value of the property and other possessions that you're pledging as security against the loan.

In the case of a mortgage, the collateral is the home you 're buying. If you don't pay your mortgage, the mortgage company could take possession of your home, known as foreclosure.

To determine the fair market value of the home you'd like to buy, during the homebuying process your lender will order an appraisal of the property that compares it to similar homes in the neighborhood.

Credit

Lenders check your credit score and history to assess your record of paying bills and other debts on time.

Many mortgages also have minimum credit score requirements. In addition, your credit score could dictate the interest rate that you get and how much of a down payment will be required. 

Even if you are a renter, or don't have plans to buy right now, it's a good idea to get smart about credit and know ways you can build and maintain strong credit health.

For information, resources and tools to help you gauge your options and understand what's involved in looking for, buying and maintaining your own home, visit My Home by Freddie Mac®.