Before you even begin shopping for a home or a mortgage, first you need to review your financial situation by assessing factors such as the amount of money that you make, spend, and owe each month. To do a complete assessment:
- Review your personal financial situation.
- Determine how large of a mortgage you can afford.
- Review your credit report and credit score.
- Assemble the information that lenders require.
Table of Contents
1. Review Your Personal Financial Situation
Lenders evaluate your creditworthiness based on your overall financial situation, rather than on just one factor (such as your credit score). They look at four main factors:
- Income: The money you receive each month from all sources, including earned income (from work), passive income (from investments), and alimony. Lenders want to see that you have enough income to cover your mortgage payments and all of your other expenses.
- Debts: Your existing debts, including credit card bills, auto loans, personal loans (from friends, family, or other individuals), and mortgages. Lenders are especially wary of borrowers who have a debt-to-income ratio over 0.40 (explained below).
- Assets: Items of value that you own, including cars, homes, land, precious metals, stocks, bonds, and other investments. If lenders are wary of your debt-to-income ratio, they’ll consider whether your existing assets might make them feel more comfortable about lending you money. For instance, if you have significant liquid assets—assets that can easily be converted to cash, such as stocks and bonds—lenders might be willing to loan you money even if your debt-to-income ratio is less than stellar.
- Expenses: The bills you pay monthly in addition to your debts, such as utilities, homeowner’s association dues, alimony, and medical, transportation, and entertainment expenses. If lenders see that your monthly income doesn’t cover your expenses, they’ll likely refuse to offer you a loan unless you have very significant liquid assets.
How to Create a Monthly Budget Worksheet
A monthly budget worksheet is an inventory of all of your monthly income and expenses. Creating one will help you:
- Assess how much money you have left over each month to pay your mortgage and other bills that might result from buying a home
- Assemble all the documents and information you need in order to evaluate your financial situation
Once you have your budget laid out, you can anticipate where lenders might find problems with your financial situation and then try to fix those problems before applying for a mortgage. For instance, if your expenses exceed your income slightly, you might be able to increase your appeal to a lender by cutting back on all but your most essential expenses. Though you might be able to make these changes right away, you’ll need to keep them up—most lenders will want to see at least 2–3 years’ worth of your financial history in order to feel comfortable approving you for a loan.
How to Calculate Your Debt-to-Income Ratio
Your debt-to-income ratio shows lenders how your monthly debts compare to your monthly income. To calculate it, divide your total monthly debt by your total monthly income. Your debt-to-income ratio should be below 0.40 or so, and ideally 0.35 or less, before you apply for a mortgage. For instance, if you have $1,000 in monthly debt and $5,000 in monthly income, your debt-to-income ratio would be 1,000 ÷ 5,000, or 0.20.
2. Determine How Much You Can Afford
Unless you have a history of bankruptcy or bad credit, lenders likely will approve you for a mortgage with a monthly payment of up to one-third of your monthly pretax income. So if your pretax income is $6,000, you’d likely get approved for a mortgage with a monthly payment of up to $2,000.
Should You Get the Biggest Mortgage You Can?
In short, no. Just because you can get approved for a mortgage of a certain size doesn’t guarantee that you can afford it. To decide whether you can afford a particular mortgage, you need to consider not just your current financial situation, but also your future job prospects, plans for children and aging parents, home maintenance and repair costs, and so on. Factors such as these determine the amount of risk that you can tolerate and should help you decide, for example, whether you should consider a riskier mortgage, such as an ARM, or stick with a safer, more predictable option, such as a 30-year fixed-rate mortgage.
How to Determine How Much You Can Afford
Never rely on a lender to tell you how much of a mortgage you can afford. Instead, assess your financial situation on your own and come to a number that you feel comfortable borrowing. One way to determine what size mortgage you can afford is to subtract your total monthly expenses (including debts) from your total monthly income. The difference should equal an amount that exceeds the monthly mortgage payment you expect to take on by at least a few hundred dollars. For instance, if you have $1,000 left over after paying all your monthly expenses, you should feel comfortable getting a mortgage with a monthly payment of at most $500–700.
The 200-Times-Your-Rent Rule
If you currently rent your home, this general guideline might also help you estimate what size mortgage you can afford:
Most home buyers can afford a mortgage worth 200 times their current rent. For example, if your current rent is $800 a month, you can likely afford a mortgage of 200 × $800, or $160,000.
3. Review Your Credit Report and Score
Your credit history is a record of how you have used and managed credit in the past. Nearly every financial transaction in your life involving credit over the past 7–15 years is recorded in your credit history. In addition to your income, debt, assets, and expenses, lenders also examine your credit report and credit score to determine whether to approve you for a mortgage—and if so, at what interest rate.
- Credit report: A credit report is a written report that lists your current and past credit accounts, including credit “events,” such as bankruptcies or tax liens, and any other information that may affect your credit. Lenders read your credit report to get a better sense of the kinds of credit accounts you have, your credit limits, and your history of paying off those accounts.
- Credit score: A credit score is a number, based on your credit history, that reflects your creditworthiness. A score can range from 300–850, with 850 signifying absolutely perfect credit. Lenders offer the lowest interest rates to borrowers with scores over 700 or so.
Do Credit Scores Really Matter?
Though lenders look beyond just your credit score when deciding whether to approve you for a mortgage, credit scores are a major factor in determining the interest rate that you receive on a mortgage. For instance, if you have a credit score of 750, you might qualify for a loan at an interest rate of 6%; if you have a credit score of 550, you might qualify for a loan at 9%. Though 3% might not seem like much, on a $100,000 mortgage that difference would cost $2,400 per year—$74,000 over the term of a 30-year fixed-rate loan. If your credit score is particularly low (below 600), your best move is probably to work on repairing your credit before you apply for a mortgage loan. For more on how to repair your credit, see the Quamut guide to Improving Your Credit, available at Barnes & Noble bookstores and online at www.quamut.com.
How to Order Your Credit Report and Credit Score
Before you apply for a mortgage, it’s crucial to review a copy of your credit report and to get your credit score, which is usually not included in your credit report. You can obtain a free copy of your credit report at www.annualcreditreport.com. You can also view your credit score through that website by paying a small fee.
How to Review Your Credit Report
The main purpose of reviewing your credit report is to make sure the report is 100% accurate. If you find inaccuracies in the report, such as accounts that you didn’t open or past due accounts that you know you’ve paid off in full, you need to correct those problems before applying for a loan. To correct an error on your credit report, contact one of the three credit reporting agencies below—they’re required by law to respond within 30 days to your request.
- Equifax: 800.685.1111; www.equifax.com
- Experian: 888.397.3742; www.experian.com
- TransUnion: 800.888.4213; www.transunion.com
4. Assemble Information for Lenders
To expedite the process of applying for a mortgage, have the following documentation and information on hand.
- Current home address and two prior addresses
- If you’re renting, names and addresses of your current and previous landlords
- Names and addresses of your current and previous employers
- W–2 or 1099 forms and federal tax returns for the previous two years
- Unless you’re self-employed, two most recent pay stubs and contact information for your employer’s personnel or human resources department
- Checking and savings account numbers, as well as contact information for the banks at which they’re held
- Bank and investment account statements from the past 2–3 months
- Account information and statements for all major assets you own, such as the title to your car(s)
- If a friend or family member will be paying for a portion of your down payment, a signed gift letter in which the gifter acknowledges the purpose of the gift
- Written explanations for late payments or other credit-related problems, such as previous legal judgments against you, liens, foreclosures, or bankruptcies
- Your monthly budget worksheet