If you are thinking about securing or getting pre-approved for a mortgage, it is helpful to understand what lenders will look at as they evaluate your financial profile to assess your creditworthiness. Some of the most common metrics include your debt-to-income ratio (DTI), loan-to-value ratio (LTV), credit history and FICO score, income and employment history.
What is my Debt-to-Income Ratio? Your debt-to-income ratio, or DTI, is a measure of your ability to manage the monthly payments your obligated to make on all of your current debt. DTI is calculated by taking the total sum of all your monthly debt payments and dividing that number by your gross monthly income.
DTI ratio = total monthly debt payments /gross monthly income
Debt payments will include auto loans, student loans, revolving charge accounts and other lines of credit, plus the new mortgage payment. Your gross monthly income is the total household income earned per month before taxes and other deductions.
Depending on the type of loan, borrowers should seek to maintain a DTI ratio at or below 43% to qualify for a mortgage. The higher your DTI ratio, studies show the more likely you will struggle repaying your loan on top of debt payments, therefore the higher risk you pose to lenders. On the other hand, having a lower DTI ratio can potentially qualify you for a more competitive interest rate.
Before you go looking for a mortgage, pay down as much debt as possible. Not only will you lower your DTI ratio, but you’ll also show lenders that you can manage debt responsibly and pay bills on time.
What is my Loan-to-Value Ratio? Your loan-to-value ratio, or LTV, is a comparison between the size of your loan and the value of the property to which the loan is secured to. Put simply, your LTV ratio compares how much you own versus how much you owe. LTV is calculated by dividing the total amount of your loan by the total value of the property you are purchasing.
LTV Ratio = total loan amount / total home value
The total home value is typically based on the most recent property appraisal, which may be lower or higher than the seller’s asking price. The higher the LTV ratio, the more you will have to borrow, resulting in a higher risk for the lender.
As a result, lenders prefer a lower LTV ratio which typically requires you to contribute a down payment of at least 20% percent. If 20% is not achievable, you may be required to pay for private mortgage insurance, or PMI, which protects lenders in the event you fail to repay your mortgage.
Credit history and FICO Score Lenders will look through your credit history and evaluate your credit report in order assess your credit-worthiness as a borrower. In the U.S., your FICO® score is the most commonly used system by lenders and it is typically obtained from the three main reporting bureaus – Equifax, Experian and Transunion. The five factors used to calculate your score include types of credit in use, payment history, length of credit history, new credit and credit utilization. Your credit utilization rate is how much of your available credit you actively use. Canada’s scoring system is very similar to the U.S., with scores ranging from 300 to 900 versus the U.S. system which ranges between 300 to 850. The higher your FICO® score is, the less you can expect to pay for your mortgage.
If you have not opened credit cards or any traditional lines of credit such as an auto or student loan, you might have trouble getting a mortgage pre-approval. You can build your credit by opening a starter credit card with a low credit line limit and paying off your bill each month. It could take up to six months for your payment activity to be reflected in your credit score so be patient as you build your credit profile. It is worth the effort as in some circumstances a 100 point score difference could mean tens of thousands of dollars in lower interest over the life of your mortgage.
Employment and Income History In order to understand how stable your income stream is, lenders will typically request two years’ worth of W-2s and contact information for your employer. They need to be sure that you have the capacity to handle the mortgage payment associated with the loan you seek, as well as the additional costs of home ownership. Lenders might even ask for recent pay stubs and bank statements.
Conclusion: Get ready Be sure to understand your own finances and factors that lenders seek to understand before you go looking for a mortgage. Once you understand where you are at, make any changes that you need to get to where you want to be with these factors before you apply for pre-approval or mortgage approval. It will make the experience a whole lot more satisfying and successful.