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By Tema Flanagan, Mediafeed
Buying a home can be as nerve-wracking as it is thrilling. Indeed, applying for a mortgage is the most stressful part of the process for many prospective buyers. After all, your financial and employment history become open to scrutiny when you apply for a mortgage, and you may be (reasonably) concerned that past mistakes will come back to haunt you.
Learning about the major factors that impact your mortgage application is an important first step toward homeownership. As you’ll see, most of these factors are ultimately within your control, which means that you can improve your odds of getting a mortgage either by bettering your overall financial profile or by seeking a lender that’s the right fit for you now (take heart: Chances are good that the right lender is out there!).
Mortgage 101: The basics
Before we dig into the individual reasons why mortgage applications are often denied, it’s important to clarify that lenders are all unique when it comes to the applications that they accept and deny. Different lenders have different thresholds for factors like credit scores and debt-to-income ratios, which play a role in mortgage application decisions. What this means for you is that while one lender may deny your application, it’s possible that another lender may give you the green light. It might even approve you for the exact same mortgage product that another lender denied you.
This dissonance has to do with what are called lender overlays.
“An overlay is just an additional hurdle to approval that a lender decides to enforce,” said Dan Green, founder of the mortgage education website Growella.
Let’s back up a minute. Banks and mortgage lenders originate loans to individual home buyers — this means that they provide the cash that allows borrowers to purchase a home in the first place. Additionally, these banks and lenders are able to issue mortgages at a much higher volume because they typically don’t keep the loans that they originate on their books for long. Instead, they sell the mortgages to government-sponsored enterprises like Fannie Mae and Freddie Mac (in the case of FHA loans, the government actually insures the loan itself, which allows lenders to work with borrowers with lower credit scores and/or incomes). While Fannie Mae, Freddie Mac, and the FHA don’t actually issue loans, they do set lending guidelines that become industry-wide standards. This ensures that the loans they purchase or insure aren’t too risky.
Most banks and lenders don’t just apply the minimum guidelines as laid out by Fannie, Freddie, and the FHA, though. Instead, they apply their own in-house overlays, which may vary depending on the type of loan offered. For example, the FHA’s minimum credit score requirement is 500 (assuming a 10 percent down payment), but many individual lenders that work with the FHA raise that minimum requirement. Overlays are used by lenders to further reduce the risk associated with the mortgages that they issue. This is partially because the overall quality of each lender’s mortgage portfolio is assessed by the partners that purchase from them: Fannie, Freddie and the FHA. At the same time, of course, these overlays “make it tougher for buyers to get mortgage-approved and lead to a lot of turn-downs,” Green explained.
Overlays can make the mortgage application process feel opaque and confusing, but there’s a silver lining: Because different lenders use different overlays, a denial from Lender A doesn’t necessarily mean a denial from Lender B. “There are so many available mortgage programs for homebuyers that, if there is a turn-down, many times it’s because there’s a mismatch between consumer and lender; it’s not low credit or being brand-new to a job,” Green said.
With all of that in mind, let’s take a look at the top four factors that can lead to mortgage application denials.
Four factors that can lead to your mortgage being denied
1. Debt-to-income ratio
Whether you go through a traditional bank or a mortgage lender, your debt-to-income ratio is one of the most important parts of your mortgage application. This ratio is a simple measure of how much debt you carry expressed as a percentage of the amount of money you earn before taxes and deductions each month.
To calculate your debt-to-income ratio, add up all of your fixed monthly debts (including student loans, car payments, credit card bills and other loans with fixed amounts) and divide that by your gross — or pre-tax — monthly earnings. Most mortgage lenders are looking for a debt-to-income ratio that doesn’t exceed 43 percent. That figure includes the mortgage payment that you are applying for.
Let’s suppose that you earn $50,000 annually—or $4,167 monthly before taxes and deductions. Your debts include a $400 monthly car payment, a $350 monthly student loan payment and $125 per month in credit card bills. That’s $875 per month in debts, which gives you a debt-to-income ratio of 21 percent while not including a mortgage. Since 43 percent of your gross monthly salary is $1,791, you can likely apply for and be awarded a mortgage of around $900 per month. By paying off any one (or more) of your debts, you’d free up more money to go toward a potential mortgage.
There are some exceptions to the 43 percent rule, but this is generally the number that you want to keep in mind when you calculate initial debt-to-income ratio. Not only does this tell you whether you are carrying more debt than most lenders are willing to work with, it also tells you how large a mortgage you can realistically hope to borrow.
If your debt-to-income ratio is too high to consider taking out a mortgage at the moment, that’s a good sign that it’s time to focus on paying down debt before doing any serious house-hunting.
One last thing: When it comes to your debt-to-income ratio, debt is debt no matter its form. That said, it’s worth mentioning that rising student loan debts are now making it especially difficult for millennials to become homeowners.
Jim Quist, president and founder of Chicago-based NewCastle Home Loans, has seen the trend play out firsthand.
“Recently, we’ve seen an increasing number of mortgage applications we must deny because applicants have too much student loan debt,” he said.
Income-based student loan repayment plans, which can help reduce monthly payments, are a good first step to consider. However, Quist cautioned that it may still be harder to get a mortgage even after getting on a reduced payment plan.
“Some mortgage programs don’t allow lenders to use reduced payments to approve loans,” Quist said. “FHA, for example, requires lenders to use 1 percent of the current student loan amount. Someone with $50,000 in student loans must qualify with a $500 monthly payment even if their income-driven payment is only $100 per month. Unfortunately, we’ve had to turn down many home buyers because they just don’t meet FHA debt-to-income requirements.”
2. Credit score
This is another biggie. As you probably know, credit scores are used by lending institutions to assess each individual’s creditworthiness based on their financial history. This assessment takes payment history (on-time versus late or missed payments), total amount of debt, length of credit history and other factors into account. Credit scores, which are measured slightly differently across the three major reporting agencies, range from 300 to 850 and are considered at-a-glance measures of individual borrowers' trustworthiness.
Credit scores below 640-670 are typically considered subprime and may make it more challenging to get a mortgage, especially when coupled with the most competitive interest rates. (If your credit score is in the subprime category, you aren’t alone. As of 2015, a little over half of American consumers — 56 percent — were found to have subprime scores.)
Consumers who have lower credit scores may still be able to get a mortgage — they just might need to shop around more (having more cash on hand for a down payment is helpful, too). While Fannie Mae and Freddie Mac each require a minimum credit score of 620, the FHA has more forgiving parameters, making those loans a better bet if you are in credit repair mode.
FHA loans were created in the 1930s to make homeownership more accessible, and their guidelines stipulate that credit scores as low as 500 may be accepted with a 10 percent down payment. Credit scores of 580 or above, meanwhile, may be eligible with as little as 3.5 percent down. Remember, though, that you will need to identify lenders that don’t apply additional credit score overlays on top of these minimum requirements in order to actually score a mortgage with the lowest required scores.
Additionally, keep in mind that when you apply for a new loan, you’ll typically accrue a “hard inquiry” on your credit report as your potential lender checks your credit history. Too many hard inquiries can negatively impact your credit score, so if you know you will be applying for a mortgage soon — or if you’ve already been pre-approved for a mortgage — you’ll want to avoid applying for any other loans (like credit cards or car loans) until after you’ve secured your mortgage.
3. Employment history
Your employment history is another major piece of your mortgage application. In general, most lenders want to see at least two years of consistent employment preceding your application.
Requirements may differ depending on whether you are paid a salary versus an hourly wage, work part time or full time, and whether you are employed or self employed. Note, too, that different lenders may handle income from, say, a second job or overtime differently. These sources of income may not always be counted toward your overall income on your mortgage application. Given these variables, you should be sure to tell potential lenders the details of your employment situation right away to make sure that you don’t hit any unforeseen speed bumps.
If, after approaching a handful of lenders, you find that your employment history is a little too spotty, now may be the time to focus on remaining consistently employed for a year or two before applying for a mortgage.
4. Appraisal issues
Occasionally, a mortgage application may be denied because of issues with the property itself and how it is valued rather than your own personal information.
Remember that the sale price of a home may not always correspond with its appraised value. The appraised value is based on local comps (other comparable houses that have recently sold in the same area), and other factors. Because the house that you are buying will be used as collateral against your home loan, lenders use appraisals to confirm that the mortgage amount you are requesting is in line with the actual value of the house. If the appraised value is significantly lower than the agreed-upon sale price, you’ll either need the seller to lower their price or pay the difference out of your own pocket.
Note that especially unique properties — think geodesic domes, for example — may come up against appraisal issues because of a lack of relevant comps.
How to improve your chances of getting a mortgage
Ready to apply for a mortgage? Here are a few strategic tips to help improve the odds that you'll get it.
Check your credit
The first step in preparing to apply for a mortgage is to check your credit and make sure you have a good idea of where things stand. You’ll want to get a copy of your actual credit report (which is typically available annually at no charge) and check your credit scores, too. Keep in mind that free credit score services don’t typically provide the same version of your scores as lenders use, so you may want to pay for your official FICO scores from all three reporting bureaus (Experian, TransUnion and Equifax) to ensure that you’re seeing the same numbers as your potential lenders.
Shop around
Even if you’re pretty sure you’re not every lender’s ideal candidate, chances are you’ll get a better deal if you talk with at least two potential lenders before deciding where to apply. Shopping around is smart but, as previously mentioned, multiple hard inquiries from loan applications can reflect negatively on your credit score. The good news is that FICO considers all hard inquiries made within a 45-day period on a mortgage, car loan, rental or student loan to be a single inquiry, so you can avoid credit score penalties by doing all your comparison shopping within a 45-day window.
Ask about minimum requirements
Ask potential lenders about their minimum requirements on factors like credit scores, debt-to-income ratios, employment history and down payment for the mortgage products that you are interested in.
Lead with your weaknesses
This may seem counter-intuitive, but be sure to mention any potential weak spots on your application to potential lenders. Doing so may help you avoid an unnecessary denial by learning which lenders are more likely to accept your application, warts and all.
Get a pre-approval
Mortgage pre-approvals aren’t ironclad, but they are a solid indicator of an eventual approval so long as nothing major changes between pre-approval and the final appliaction.
“I have seen people that have wanted to switch jobs or make major financial decisions in the middle of their application process,” said CORE New York real estate broker John Harrison. “Don’t do it. Every type of approval down to the final loan commitment is still usually contingent on something. If you change the scenario, you may pull the plug on the whole deal.”
What to do if your mortgage application is denied
If your mortgage application is denied, don’t fret — and definitely don’t assume that one denial means that you won’t get approved elsewhere. Start by figuring out why your application was denied.
“Hear the fact of why your loan was not approved, and then you can talk to an industry person to say, ‘here’s why I was turned down, what do you recommend?’” Said Growella founder Dan Green. “Every mortgage lender evaluates loans differently, even through the same programs and loans. It’s helpful to know upfront what the issues are, because they will all come out anyway.”
Keep talking to different lenders; chances are, you’ll end up with an approved mortgage application when all is said and done.
Finally, it may help to put the mortgage application process in a different perspective.
“Oftentimes you only hear terrible stories, so there is a feeling from the general public that it doesn’t make sense to apply because they think they won’t get approved,” said Green. He points to Fannie Mae’s monthly housing survey, which finds that around half of Americans think it would be difficult to get a mortgage, as evidence of this feeling. In reality, though, the the vast majority (75 percent) of all mortgage applications are approved — a number that is actually growing.
“The way consumers think about home loans is different from how lenders think of them,” Green explained. “Lenders lend. If they don’t make loans, they go out of business, so mortgage lenders are always trying to find ways to continue to lend. There is a connotation that lenders are doing consumers a favor, but it’s the other way around: You are doing the lender a favor.”
In the end, Green’s motto may be the best advice: “If at first you don’t succeed with your approval, apply, apply again.”
This article originally appeared on HouseMethod.com and was syndicated by MediaFeed.org.
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