April 30, 2024
Crunch the most important numbers to prepare for the financing process and get the house of your dreams
As a potential first time home buyer, you’re probably spending most of your time considering square footage, fixtures and finishes. In reality, however, you’ll probably spend the majority of your home buying process working your way through the lending requirements for your mortgage provider. By starting early and ensuring that you keep your eye on your credit score, you can simplify and streamline your approval process. But what constitutes a good credit score, and what should your credit score be to buy a house?
Fortunately, there’s not one specific FICO score that you need in order to buy a house. Credit scores come in different ranges and categories so that you can retain a good score even if it goes up or down by a few points. FICO (Fair Isaac Corporation) is probably the best known and one of the most widely used credit scoring systems. Their ranges are defined as follows:
Fortunately, you don’t have to be at the top of the range in order to buy a home. According to Experian, 67% of Americans fall into the Good or better categories, but there are many types of home loans for people at almost all of these ranges.
Your mortgage lender will gather information about your current and past income, including bank statements, paycheck stubs, and past tax returns. Your income will help them determine how much house you can afford when taken into consideration with other factors, like the amount of debt you have.
The debt-to-income ratio is a simple calculation designed to help you figure out how much debt you have in relation to the amount of money you have coming in each month. The lower the score, the more attractive your loan application will be to a lender. To calculate your debt-to-income or DTI, you’ll divide your monthly bills by your monthly gross income – that is, your income before taxes and other deductions.
Your mortgage lender will look at both your housing-related DTI and your overall DTI in order to determine how much house you can afford. If, for example, your current housing costs are unusually low and your debt is primarily made up of other types of debt – like a car loan or student loans – the lender may determine that it would be difficult for you to afford a new, higher house payment.
The loan-to-value ratio or LTV is an expression of the amount of money you’re borrowing for the home compared to the value of the home itself. LTV is calculated by dividing the loan amount by the appraised value of the home, so for example, a $200,000 home with a $180,000 mortgage would have an LTV of .9 or 90%.
For most mortgage lenders, an LTV of 80% is the minimum desirable number where there is enough equity in the home to reduce their risk to an acceptable level. If you’re financing more than 80% of the home’s cost – or in other words, if you have a down payment of less than 20% – you will usually be required to maintain private mortgage insurance (PMI) to offset the bank’s risk in the property.
There are many mortgage products that require less than 20% down, so it’s up to you as the borrower to decide whether you’d rather put down more and save on the monthly PMI payment or put down less and wait longer to reach an acceptable LTV ratio.
In most cases, once you reach 20% equity, you’ll need to refinance to remove the PMI requirement. Refinancing will generally cause you to incur additional closing costs, and if interest rates are higher at the time that you refinance, you could end up with less favorable mortgage terms.
Once you’ve got a general idea of your ability to apply for a home loan, it’s time to connect with a great lender. You may have someone in mind from your local bank or credit union. If you have friends who have purchased a home recently, they may have the name of a reliable lender with whom they worked. When you find a buyer’s agent, you can ask them for a referral to a well-qualified colleague with whom they’ve worked on previous purchases.
Once you have a shortlist of two or three lenders, you’ll want to get a sense of what it’s like to work with them and what types of loan products they offer. To do so, you as the borrower may want to get a pre-qualification or pre-approval to narrow down your home-buying budget and learn more about the terms they have available.
Pre-qualification is based on the information you provide. It can take place in just a couple of minutes and gives you a very general, informal picture of your potential ability to obtain a home mortgage loan.
Pre-approval is based on paperwork you’ve provided along with a hard pull of your credit, which allows the lender to make more informed decisions about your potential eligibility for a loan. If you’re talking to a few mortgage lenders for comparison purposes, make sure that they all pull your credit within the same few days so that it doesn’t cause a big dip in your credit score.
While you may want to start with a pre-qualification, by the time you get serious about looking at homes you’ll want to complete your pre-approval. In most cases, sellers will not take you seriously unless you have been pre-approved for a loan, so this is a step you’ll want to complete before your real estate agent submits an offer. To learn more, read our post answering the question, “how long does mortgage pre approval last?”
There are a wide variety of loan types and their down payment and credit score requirements can vary widely. These include the following:
Conventional mortgage loans are generally backed by Fannie Mae and Freddie Mac but are not affiliated with a government agency. They can require different down payments, from a minimum of 3% to upwards of 20%. In the case of a conventional loan for a real estate investment, the down payment could be as much as 40%. The minimum credit score range for conventional loans is 620.
FHA loans are backed by the Federal Housing Administration and are designed for buyers with lower incomes and less desirable credit scores. For buyers putting 3.5% down, the minimum credit score is 580. For those with a 10% down payment, you can have a lower credit score range between 500-579.
VA loans are available to active-duty service members and their families as well as to military veterans and to some surviving spouses of military veterans and service personnel. The VA loan is backed by the Veterans Administration and requires no money down. The standard minimum credit score requirement is 620.
Similarly, USDA loans are backed by the US Department of Agriculture and are designed to encourage real estate investment in rural areas. There is no down payment requirement but the lender-standard credit score required is 640.
Whatever loan type you ultimately choose, it’s a good idea to have your lender run a few different scenarios to help you compare terms both monthly and over the life of the loan.
Your credit score is meant to give an overall picture of your financial history and your current financial situation. If you need to make significant improvements to your credit score, it can take several months or even years, especially if you have serious adverse credit items like foreclosures, repossessions, or bankruptcies.
Overall, however, you can make some improvements to your credit score by being mindful of it and practicing good financial management in the months before you apply for your mortgage loan. Here are some of the most important factors that can improve your credit score and simplify the approval and application process.
Each American is eligible to receive a free credit report from each of the major credit bureaus every year. Start early by pulling your credit report and checking for errors. If you find a discrepancy, report it to the appropriate credit bureau and ask for it to be corrected or removed so that your mortgage application will be based on an accurate view of your credit history.
If you have a car payment, loan payments, or credit card payments, make sure that you’re making them on time each month. If possible, pay a little early so that you can be sure that the payment will show up on time consistently.
If you want to improve your debt to income ratio, you will need to pay down or pay off your credit accounts. However, once you do so, do not close out those accounts. Part of your credit score is based on the age of your oldest account and part is based on your ability to maintain open credit without using it. Closing out an account will undermine your score in both of these regards.
When you’re shopping, you may be tempted by an offer to sign up for store credit in exchange for a significant discount on your purchase. When you check the mail, you may receive a pre-approved offer for a new credit card. In either of these situations, it’s important for you to resist the urge to sign on the dotted line since doing so can change your debt-to-income ratio and cause a dip in your credit score.
When you’re looking at that new house, you may be thinking about the furniture and decorative items you’d love to fill it with. You may be thinking about how good a new car would look in that attached garage. You may be thinking about all of the appliances you’ll need to purchase in order to get the home up and running on moving day. While it may be frustrating and even inconvenient, you’ll need to hold off on these purchases until after you’ve closed on your mortgage.
Newzip connects you with the best-qualified and most helpful real estate agents in your market. If you’re looking for a starter home, Newzip’s agent finder can provide you with an introduction to a first time home buyer real estate agent. If you’ve bought before, find a buyer’s agent or even an agent who can help with both your sale and purchase. Best of all, you may even receive a cash back rebate after your transaction.
