How does a lender determine my pre-approval amount?
Lenders look at several factors when reviewing a loan application:
- Credit score: Your credit score is a number between 300 and 850 that provides a snapshot of creditworthiness. Credit bureaus generate your credit score based on credit history, total debt, debt payment history, and the number of credit accounts. The higher the score, the more appealing your application is to lenders.
- Debt-to-income ratio: Your debt-to-income ratio ("DTI ratio") shows how much gross monthly income you use for monthly debt payments. Mortgage lenders typically look for DTI ratios of 36% or less.
- Annual income: The more money you bring in, the better you look to lenders, at least as a general rule. If you and a spouse apply together, lenders consider your total household income.
If a lender pre-approves you for a mortgage, they may tell you the maximum amount they can lend you to purchase a new home. Remember, though, that a pre-approval only tells you how much your lender is willing to loan you, not how much you can afford in your monthly budget.
A lender's pre-approval letter may show a seller that you are serious about buying their home. If you compete with other prospective buyers for a home, presenting a pre-approval letter to a seller with an Intent to Purchase Real Estate, Earnest Money Agreement, and Home Sale Worksheet may improve your chances.
Tools, such as home affordability calculators and mortgage calculators, are available to help you determine what your price range may be for a new home.
What expenses can I plan for other than the purchase price?
When you buy real estate, you take on more costs than just the purchase price. Other common expenses include:
- Property taxes: States, cities or counties may levy annual property taxes.
- Homeowners insurance: A homeowners insurance policy covers various forms of damage to the home and property. Insurance premiums are typically paid annually. Most mortgage lenders require a certain amount of coverage to be maintained as well.
- HOA fees: If a home is part of a homeowners association (HOA), there may be HOA fees. Many HOAs charge monthly fees as well as larger assessments for big repair projects.
- Cost to maintain the home: When you own your home, you are responsible for all repairs and maintenance, not to mention additional expenses that are often covered in a rental unit, such as water, garbage collection, and more.
- Down payment: You may have to pay part of the purchase price at closing. Some mortgage loan programs do not require a down payment, but for conventional loans 20% of the home price is standard.
- Interest rate: Part of each monthly mortgage payment covers interest and the rest goes toward the loan's principal amount.
- Private mortgage insurance: Your lender may require you to purchase private mortgage insurance (PMI) if you receive a conventional loan and make a down payment of less than 20%. PMI protects the lender in case you stop making loan payments.
- Closing costs: There are various costs when a home sale closes. You may be responsible for some costs, and the seller may pay the others. If any closing costs do not get paid at time of sale, you may be responsible for paying them later.
- Unforeseen and emergency repairs: Much like with routine maintenance and repairs, major problems with your new home are your responsibility. It is prudent to set aside money each month for surprise repairs. Even when these are covered by a homeowners policy, you may want to get the problem repaired first on your own, then file your insurance claim later.
How does my loan affect what I can afford to buy?
The type of mortgage that you choose may determine what you can afford. Some mortgages have different costs because of factors like interest rates and mortgage terms.
- Fixed-rate mortgages tend to be the most predictable of all mortgage loan programs. They are available with loan terms of 15 and 30 years. While they have slightly higher interest rates than other mortgages, the rates stay the same for the life of the loan.
- Shorter-term loans have lower interest rates. A 15-year mortgage, for example, has a lower rate than a 30-year mortgage at the same amount. The trade-off is that you will have higher monthly payments.
- Adjustable-rate mortgages (ARMs) have lower initial interest rates than fixed-rate loans, but the rate can rise over time.
- FHA loans, VA loans, and other special loan programs allow you to buy a home with little money down, but they may have added closing costs and other fees.
Your mortgage's interest rate and payment arrangement may also affect your taxes and your monthly budget.
How does a mortgage payment fit into my monthly budget?
Mortgage payments usually replace rent in a monthly budget. The additional expenses, however, can affect your budget in other ways. When looking for a mortgage that works best, you may want to consider your other monthly payments and expenses, and how those might change. For example:
- Monthly utility costs may increase.
- Additional monthly expenses for home maintenance are common.
- Insurance premiums may increase.
- Your tax liability is likely to increase.
Keep in mind that you are likely to pay more for utilities and home maintenance when you own versus renting. Fortunately, unlike renting, you will be building equity in your home, which can be similar to saving. Budgeting and saving for emergencies can be critical as well. Financial advisors often recommend spending no more than 28% of your income on your housing expenses, and no more than 36% on your total debt payments, including your mortgage.
How can I improve my financial situation before buying a home?
If you are concerned that your current financial situation may affect your ability to afford a home, you may be able to improve your finances. The following examples are common ways to improve your financial outlook:
- Improve your credit score: Identify and address issues that negatively affect your credit score, such as a large number of open accounts or a pattern of late payments.
- Repair your credit report: Federal law requires credit bureaus to investigate and correct inaccurate or outdated information. You can submit a Credit Report Challenge if you find errors.
- Pay down debt: The more outstanding debt you pay off, the better your credit score and DTI ratio may look to mortgage lenders.
- Limit unnecessary spending: Lowering monthly expenses can help your creditworthiness.
- Save for a down payment: Lenders like borrowers who pay more upfront. It shows that lending to you will be a good risk.
- Shop for less than the maximum: Just because you can afford a certain amount does not mean you have to borrow that much.
- Look at your employment: Consider what lenders like when it comes to annual income, either from employment or self-employment. Some changes may improve your position.
If you have questions about the homebuying process or related issues, reach out to a Rocket Lawyer network attorney for affordable legal advice.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.