Lesson 3: Getting Pre-qualified or Credit Approved
Jewell: My name is Jewel DeDuca and welcome to American Consumer Credit Counseling's presentation on home buying. Our home buying workshop is a nine lesson series focused on the essentials of owning your own home. Today we are discussing Lesson 3; Pre-qualified or Credit Approved loans. Let's begin.
Now that you've examined your monthly spending plan and credit file, you need to generate an unbiased assessment of your ability to qualify for a home loan. If you're comfortable with your financial stability and believe that you can obtain a competitive loan, as well as support its repayment, you're now ready to contact a lender to get a pre-qualified or credit approved loan.
People often ask what's the difference between a pre-qualified and credit approved loan. Well, if you've received a pre-qualified loan, then you have only received an estimate of the amount that you can borrow. This estimate is not guaranteed. Also the lender has not looked into your credit file. The odds of the condition of this loan changing are very high.
When you receive a credit approved loan, you have to fill out the actual application for the lender. The lender will verify the information on your credit file and most importantly, your file has been sent to an underwriter in order to reach your loan decision. Also, if anything should change like your income, employment, or marital status or credit situation, then your approval would not be guaranteed and the underwriter would need to review your loan application again based on these changes.
As you can see, a credit approved loan is a more accurate measure of your loan potential. A credit approved loan will more than likely give you a better indication of your home loan capacity. Before individuals apply for a credit approved loan they often ask themselves how much money do I need to have to buy a house? The answer to this question varies; however, it's important to remember it takes money to borrow money.
In order to obtain a home loan, the borrower must put at least a minimum amount of his or her own money into the transaction. This minimum amount will depend on the type of loan, but it's usually zero to five percent of your purchase price. If you don't meet normal underwriting guidelines, this amount could be higher. However, there is assistance. Many types of assistance programs exist that can help individuals reach down payment and closing costs. Many times these programs are based on your income.
The process of obtaining a credit approved loan is more complex than obtaining a pre-qualified loan. A lender is always going to look at a variety of elements in order to qualify you. The three most important variables in this process are 1, your employment history; 2, your income; and 3, the debts that you currently owe.
To start, let's discuss employment history. A lender will generally want to investigate your past two years of employment. During this investigation, a lender is primarily looking to see how long you've been at your current job and what type of work you do. They are also going to see if there have been any gaps in your employment over the last two years. In today's workforce there are a variety of circumstances that might define your employment status, so let's discuss a few.
If you just started a new job, a lender will look to see if you're still in a probationary period. If so, this may affect your candidacy because the risk of non-payment of the loan is much higher. You might also be in the process of starting a new job. If your new job is in the same line of work, you'll need a letter from your employer stating your start date, income, and position. You'll also need to receive your first paycheck within thirty days of the closing.
If your new job is in a new line of work, a lender may not count this income until you've been on that job for at least six months. You might also be a seasonal employee. If this is the case, you may have to be on the job for a minimum length of time before the lender will count that income for qualifying purposes. This minimum length varies, but it's usually one to two years.
Often times individuals supplement their full-time job with a part-time job income. In order for your part-time income to be considered, you may need to be at your part-time job for at least a year. However some loans will require one to two years on average. For a lender to count this income, you also need to show that you can handle the added pressure of two jobs over an extended period of time.
If you happen to be a recent graduate, you will need to show the lender a copy of your transcript or diploma showing your course of study. If you're self employed, you'll need to provide a lender with two years of personal income tax returns, two years of business tax returns, a year-to-date profit and loss statement, and a balance sheet.
Lenders will also use a two year average for the net income for qualifying purposes. They want to see that your net income has remained the same or increased over a two year period. If your income has decreased, you'll need to explain why.
Once a lender has validated your employment history, they will then begin to evaluate your income. A lender will use numerous tools to compute your income contribution. Typically they add up the monthly income for each job, or income source, and use that figure to arrive at a qualifying monthly payment you can afford.
There are a variety of ways in which employees are paid and that determines how the lenders arrive at a figure. Let's discuss a few ways that you can determine your qualifying monthly payment. If you're paid a set salary per year, you'll need to divide your total salary by twelve to get your monthly income. Let's say you have a $25,000.00 salary. If you take $25,000.00, divide that by twelve, you'll arrive at the qualifying monthly income of about $2,083.00.
If you're paid every two weeks, multiply your bi-weekly pay by twenty-six pay periods to arrive at your annual pay. Then take your annual pay and divide that by twelve to get your monthly income. For example, if you make $800.00 every two weeks, multiply $800.00 by twenty-six pay periods which would give you your annual wage of $20,800.00. Then take $20,800.00 and divide that by twelve in order to get a monthly income amount of $1,733.00.
You might also be paid hourly. In this instance, you'll need to know your hourly wage and how many hours per week you're guaranteed. Let's say you're paid $9.00 per hour and you're guaranteed to work forty hours per week. You need to multiply $9.00 an hour by forty hours a week, and then multiply that by fifty-two weeks per year to arrive at an annual salary of $18,720.00. You then take the $18,720.00 and divide that by twelve to arrive at a monthly income of about $1,560.00.
As you can see, there are a variety of salary scenarios. Be sure to take the time and effort to properly assess your projected monthly income prior to pursuing a home loan. You need to let a lender know what house payment is realistic in your monthly spending plan and it's important to remember that what you qualify for and what you can afford may be two vastly different figures.
Last but not least, a lender will be interested in what debts you have. To properly determine the amount of your monthly income you can contribute to a home loan, a lender must know what your monthly debt obligations are. These debts can include credit card accounts. These typically are your revolving debt obligations. Sometimes a lender will use a minimum payment even if your balance is zero. Due to this trend, you should close any open accounts that you do not intend to use.
Next we have installment loans. Installment loans are fixed payments and term debts such as car payments, student loans, or child support. In this instance, a lender will be concerned with what the monthly payment is as well as the current balance and number of payments left.
Finally, we have the collections or judgments. These debts are typically those that you defaulted on and are required to pay in full. A lender doesn't want to give money to someone who's behind on a current debt and will often wait to approve a loan until accounts in collection have been cleared.
If you have a dispute in collection account, you may not need to pay it off prior to obtaining a loan if you can 1, document the dispute; 2, show that you don't owe the money; or 3, demonstrate that you're pursuing a course of action to remove that collection. However, the decision ultimately belongs to the underwriter as to whether or not the dispute will have to be cleared prior to closing.
Please note that there are a variety of debts that a lender will not include in computing your monthly debt. These bills include your insurance bills, utility bills, television costs, medical bills, and in some instances childcare.
After computing your monthly debt, a lender has all of the information they need to compute a ratio. For mortgage lending, there are usually two ratios, or relationships, that need to be considered. These ratios are the housing ratio and the debt, or backend, ratio.
Let's first look at the housing ratio. A housing ratio is the relationship between your gross monthly income and your new house payment, More commonly known as P.I. T.I. Let's take a closer look at your P.I. T.I. ratio. The P and the I stand for principal and interest which is your monthly loan payment. The T stands for taxes. This will account for the monthly amount you pay to cover your property taxes and the I represents insurance. Insurance is the monthly amount you pay to cover homeowner's insurance coverage and other mortgage insurance premiums.
Insurance can become a variable expense because several different forms of insurance may be applied to your loan. First you have to have homeowner's insurance which covers hazards such as fire and theft. You'll be required to carry homeowner's insurance as long as you have a mortgage on your home. In the event that you need to file a claim on your homeowner's insurance, a check will be issued to you and the lender and repairs usually have to be done before they'll sign off on that check.
Next, you might need flood insurance. This coverage will protect you against flood damage and if you live in a federally designated flood zone, you'll be required to carry this insurance. You might also have mortgage life insurance. Some lenders and insurance companies offer this policy. It's designed to pay off your mortgage loan in the event of your death.
Next, you might have mortgage insurance otherwise known as PMI. Mortgage insurance is a policy that you carry for the lender that protects them against you defaulting on the loan. If you've made a down payment of less than 20%, this policy will reduce the risk to the lender.
An important note about mortgage insurance is that federal law states that a lender must allow you to drop the monthly mortgage insurance policy once you've reached 20% equity in your home. Remember that equity is the difference between what you owe on the home and the market value of the home. You build your equity by paying down your loan. Ultimately it's in your best interest to drop your mortgage insurance because it will save you money and lower your monthly payment. To do so, you'll need to contact the customer service office where you make your payments.
Finally, if you choose to purchase a townhouse or a condominium, you may have homeowner association dues which cover the cost of insurance on the building, but does not cover the contents. You'll need to purchase separate insurance to cover your possessions.
An important note with regard to insurance and taxes is that a lender may require that you set up an escrow account. When a lender does this, they collect the taxes and insurance costs each month as part of your monthly mortgage payment. This money is placed in a separate holding account known as an escrow account until they come due. At that time, the lender will pay the taxes and insurance for you from the escrow account. If you choose not to escrow, you'll usually be charged a fee.
Once you have calculated your P.I. T.I., the rule of thumb in calculating your housing ratio is to have no more than 28 to 33% of your gross income allotted for a house payment. The second important ratio that lenders use is your backend or debt ratio. Your debt ratio is the relationship between your gross monthly income and the new house payment, plus any other debts you're already obligated to.
When calculating your debt ratio, take your gross income and multiply that by 41%. Then subtract your current monthly debt in order to find the maximum monthly house payment you can afford. For example, if your gross monthly income is $3,643.00 and you have a monthly debt payment of $600.00; you take your gross monthly income and multiply it by 41% to get $1,493.00. You then subtract $600.00 from $1,493.00 to arrive at your maximum monthly house payment of $893.00. Based on this calculation, a lender will know how much you can afford toward a monthly house payment.
As you can see, using ratios can become very complicated; however, ratios are important toward protecting you. Please remember that debt ratios are guidelines meant to limit how much you spend on your house so that you'll have money left for other living expenses. Moreover, it's your responsibility to make sure that you do not spend more than you can comfortably afford.
Also, please remember that debt ratios are not usually set in stone. Lenders can make exceptions; however, they must be able to make the case that you can afford a higher payment. Therefore, it's up to you to tell your lender about any other compensating factors that might help your case.
Well, that concludes Lesson Three of our home buying series. I'm Jewel DeDuca with American Consumer Credit Counseling. Please join us next time for Lesson Four when we'll discuss different types of home loans.