How to Qualify for a Mortgage

Qualifying for a mortgage is not always a straightforward process. Even for the lucky few who’ve avoided major credit mishaps, kept their debts in check, and saved a healthy amount, qualifying for a mortgage is still not a guarantee. When it comes to home loans, perfecting one factor is not enough. Borrowers must qualify across an array of different criteria.

Each of these criteria is aimed at determining your overall ability to repay or ATR. Where you land will determine, not only whether you qualify but often determine the cost of your mortgage as well. The good news is, no matter where you are, it usually takes just a little bit of good information to get moving in the right direction. Mortgage qualifications can be broken down into four major parts.

Part 1: Is Your Credit Score Worthy?

When you call a lender seeking to get a mortgage preapproval, generally, the first thing they will do is want to go over a copy of your credit report. Your credit history is important for determining your ability to repay. Here's what the lenders will consider. 

The Credit Score Itself

Usually, when a lender completes a credit inquiry, the report will show credit scores from three reporting agencies, Equifax, Experian, and TransUnion. The median credit score is what lenders usually use to qualify clients. This score will largely determine whether you qualify, what loan type suits you best (conventional, government, etc.), and may partially determine the cost of your loan.

A credit score of 620 is the general benchmark between qualifying or not qualifying for a mortgage, although technically you can be as low as 580. The Federal Housing Administration's (FHA) 580-619 mortgage program has such a laundry list of other qualifying criteria. It is often not worth attempting as most clients will be denied at some point during the mortgage process. When denied, it's smart to begin the process of credit repair.

For conventional loans, borrowers should have at least a 660; however, since conventional loans are priced based on risk, loans will be unnecessarily expensive unless a borrower exceeds 700 or so. To avoid any pricing adjustments on a conventional loan the optimal credit score is a 740+.

Blemishes on Your Credit

Certain blemishes on your credit report can eliminate or severely hamper your ability to obtain a home loan. Things like foreclosures, recent bankruptcies, and short sales can knock you out of the running. The good news is these major mishaps have a time limit after which they can no longer exclude you from getting a mortgage, while some have no exclusion period at all.

Monthly Debt Obligations

Since most debt obligations show on the credit report, lenders use the information to determine your expendable income, which leads us to the next part.

Pro Tip: Check and Improve Your Credit Before You Apply

Knowing that these price adjustments can cost thousands of dollars at closing, or even tens of thousands over the life of the loan, it is best to take action and improve your credit score at least two months before applying. You can check your credit for free, review your entire report, and tackle debts as soon as possible. This will also give you better leverage when shopping for a mortgage.

Part 2: Calculating Debt-to-Income Ratio

Your debt-to-income (DTI) ratio tells lenders a lot about your ability to repay your mortgage. Before you apply, try and calculate yours and see if you can lower the ratio in your favor by paying down debts or increasing your qualifiable income.

Figure Out Your Qualifiable Income

The key word here is the word “qualifiable.” For hourly and salary workers, qualifiable income is usually the average gross paycheck earnings per month. For others, like those self-employed or paid commissions, determining qualifiable income can be much more complicated.

The days of no-doc loans and stated income are over. After the mortgage crisis of 2008, Uncle Sam tightened the reins. Lenders now must determine self-employed income from line items in the last two years' tax returns.

This presents a dilemma for a lot of self-employed mortgage hopefuls since very few claim their full earnings on their tax returns.

Determine Your Debt-to-Income Ratio

Lenders calculate your debt-to-income (DTI) ratio by adding the total of the monthly payment obligations shown on your credit report and dividing it by your qualifiable income. Payment obligations include debts like car notes, student loans, and credit card payments, not cancelable debts like cellphone bills and gym memberships.  For a qualified mortgage, an optimal debt-to-income ratio (DTI) sits at or below 43%, according to the Consumer Financial Protection Bureau. This figure will give you your ideal housing expense ratio.

Want to calculate yours? Follow this example: 

• First, let's calculate your qualified income. Let's say your salary is $36,000 per year. Your qualified monthly income would be $36,000 divided by 12 months = $3,000.
• Now, let's figure out your debt obligations. You pay $200 toward your credit card debt, $120 toward student loans, and $175 toward a car loan. That's $495 in monthly debt obligations. 
• Your debt-to-income ratio is just your monthly debt obligation divided by your qualified monthly income. In this example, that's $495 divided by $3,000, which equals 0.165. So, your debt-to-income ratio equals 16.5% - not bad.

Pro Tip: Account for Your Realistic Budget

One thing many borrowers shamefully do not account for is their budget. To be clear, the monthly payment a lender qualifies you for is almost never the same as what you can actually afford. Lenders use a rudimentary calculation based on legal guidelines.

They do not account for people's specific lifestyles, non-essential expenses, or even most forms of side income. As such, every borrower should take stock of their true budget long before calling a lender.

Part 3: Determining Your Assets

By almost every statistic, it is abundantly clear that Americans are terrible savers. Although many clients qualify for mortgages based on all other factors, their assets, or lack thereof, are often the equalizer. The main reason assets are necessary for a mortgage transaction is for a down payment.

Depending on the type of loan for the home, your down payment requirements will vary. For Federal Housing Administration (FHA) loans, as little as a 3.5% down payment is required to close, while on a conventional loan, I have seen as low as 1%. Veterans Affairs (VA) loans, on the other hand, require no down payment at all! This may sound fantastic, but you must remember two things. 

Low Down Payments Cost More in the Long Run

The smaller your down payment, the less skin you have in the game as a borrower, and therefore the greater risk lenders assume in writing your loan. To offset that heightened risk lenders are required to charge mortgage insurance for mortgages with low down payments, adding a considerable amount to your monthly payment.

Although FHA loans always carry a Mortgage Insurance Premium (MIP), conventional loans only require Private Mortgage Insurance (PMI) if you put less than 20% down. Since veterans are truly awesome human beings, VA loans do not require any mortgage insurance. Using a down payment calculator is a great way to look at your options.

There Will Be Closing Costs

That's right. Even if you manage to save enough for your down payment, that is not the end of it. Loans carry a litany of closing costs from origination charges, to title fees, to county recording fees, to initial escrow deposits.

There are other ways to cover some, or all, of these costs without coming out of pocket. 

Part 4: Assessing Collateral

Determining property value is one of the trickiest mortgage qualifying guidelines and it is known as the property value assessment. This is partly because the guidelines vary so greatly from program to program and lender to lender. When you are seeking a mortgage, whether you are seeking to purchase a new home or hope to refinance an existing one, there is always a property evaluation conducted by a home value estimator.

The subject property is the lender’s collateral, which means, in case you default on your payments, ownership reverts back to the lender in order to recoup their losses. This lien is what allows mortgages to carry a much lower interest rate than other non-secured loans. However, this means that lenders must verify a list of items before deeming a property mortgage-worthy. As you can see the valuation on a house is an important part of the mortgage process.

1. Property Type

There are several different property types, each with its own qualifying mortgage criteria. Many property types are either difficult to finance or are ineligible for financing by a residential mortgage loan. The following are some examples ranked from least to most risky in the eyes of a lender.

2. Property Value

Lenders must also verify the value of a property to ensure that the collateral is valuable enough to cover their risk exposure. A significant portion of a lender's risk exposure is determined by the size of the loan compared to the size of the borrower’s downpayment. In other words, the loan-to-value ratio (LTV).

Lender’s figure property value and the subsequent loan-to-value ratio (LTV) by getting the property appraised during the loan process. Now, obviously, in a purchase transaction, this step comes after negotiating a purchase agreement with a home seller, making a tenuous situation where parties may have to renegotiate or back out of a deal if the findings do not align with the negotiated price.

3. Property Condition

Although the primary purpose of the appraisal is to determine the value of the property, the appraiser must also determine whether its condition meets the requirements set by Fannie Mae, Freddie Mac, FHA, etc. Generally speaking, government-backed mortgages are strict on property conditions, deeming properties ineligible for things as small as a missing handrail or cracks in the sidewalk.

However, conventional loans are much more lenient in this respect, concerned mostly with the structural integrity of the property, and whether the property is under construction or unfinished in any way.

Homeownership is on the Horizon

Despite a general commonality, qualifications can vary from lender to lender so the best way to see if you qualify is often to speak directly with a loan officer to determine your specific qualifications and see how they stack up. Remember that you do not want to unnecessarily run up the number of inquiries on your credit report, though, so try to garner a good idea of where you stand beforehand.

Frequently Asked Questions