Applying for a home loan is a complicated process, and if we've learned anything from the recent round of foreclosures and the credit crunch, it's not a purchase that allows for unrealistic views of personal finances. Saving money for a respectable down payment is just the beginning of the planning process, so here are the things to consider before you apply for a home loan.
How much house can I afford?
Your income, debt and assets all have an impact when you're applying for a home loan. Several online calculators exist that can give you an idea of how formulas operate, but when you sit down with a professional mortgage broker or lender to do the real work, they'll be helping you to calculate two numbers critical to qualification for a loan: a front-end ratio and a back-end ratio, each based on a percentage of your gross monthly income.
The front-end ratio represents how much of your income is spent on monthly housing expenses, such as mortgage principal and interest, taxes and insurance. The back-end ratio represents your monthly debt spending, including auto loans, student loans, child support payments and credit cards. So, as an example, with a ratio tally of 28/36, 28 stands for 28% of gross monthly income devoted to front-end spending, and 36 stands for 36% of that same income spent on back-end costs.
What your mortgage broker needs from you
In order to calculate front-end and back-end ratios properly and find the best home loan for you, a mortgage professional will be doing some very thorough, very personal info gathering while looking into your not-so-distant future.
"Everyone's different, so what I do is meet with the customer face-to-face the first time, just to get as much information as I can," says Ken Gunther, president of First Interstate Financial Corp., a mortgage banking group based in Shrewsbury, New Jersey. "I ask them a lot of questions, like where they think they're going to be in five years and if something's going to change. In other words, will there be a job promotion, or are they getting married? You try to get as much information as possible so that you can steer them toward the right loan for them."
When applying for a home loan, you'll also need to be prepared with hard numbers for the following items:
- Your credit score, preferably in report form so that you can check for and correct any errors
- Your gross income
- Current records for all financial accounts (checking, savings, money market, etc.)
- Amount of monthly debt
- Information on long-term investments and reserves, including retirement accounts and owned properties
- Information on the source of funds to be used for a down payment, whether contained in an existing account or to be received as a gift from a family member
All of the above must be current, valid and based in the now, because using inflated numbers when you are applying for a home loan can end up bringing down the roof later. Says Gunther, "Someone may say, 'I'm making $70,000 a year,' and then you find out that they're really making $50,000, but they're anticipating a year-end bonus of $20,000 more that they've never received in the past. So, although they're going to get the bonus, we can't use it in the calculations because, technically, they haven't received it."
Similar specifics apply to debt payments, another possible point of confusion in the home loan application process.
"An applicant may say, 'I have this loan' or 'I have this charge card,' and again, we just have to make sure they're accurate in what they're reporting on that," adds Gunther. "They may quote their minimum monthly payment as $300, while their credit report says it's only $75. They're saying $300 because that's what they choose to pay every month, but that's not what we would count against them. We would only count the $75 according to the credit report information."
Knowing your own tolerance for risk
While applying for a home loan, you also need to think about all of the standard and sometimes surprise costs of owning a home. As well as taxes and insurance, there's the factor of contributions to a cash reserve that'll be ready to cover emergency repairs and seasonal needs. How much that reserve contains will depend on the age and condition of the home you're hoping to buy, and this is where a thorough, professional home inspection is critical. A deal on a fixer-upper may not be so hot if the after-purchase costs to make and keep it livable are beyond your means, so know what you can live with and stick to it. You'll then be able to enjoy the right home when it comes along, without becoming house-poor thanks to a home loan that's hard to pay back or struggling with a case of buyer's remorse.