Home buying: Prequalification? Debt ratios? Rent vs Buy?

Photo by Mike Birdy

Home buying can be daunting, even for those who’ve done it before. The question of getting loan approval can be tricky. Having your debt to income ratios evaluated for loan qualification is also confusing to some.

The Consumer Financial Protection Bureau (CFPB) has a good short description as to the difference between pre-qualification and pre-approval.  In short, there’s not much difference other than technical ones based on either the lender processes or your local real estate market. Loan officers and real estate agents should be aware of what aspects the letter needs to cover to give the seller the confidence they need you won’t have problems completing the lending process to buy their home.

Within that article is a link to their discussion as to what happens to your credit when lenders check it as part of your loan shopping and application process. In general, “inquiries” into your credit do lower your score a little, but won’t hurt your score that much if you’re smart about it. I quote their article in its entirety here for you so you don’t need to try to find it:

“What exactly happens when a mortgage lender checks my credit?

The credit check is reported to the credit reporting agencies as an “inquiry.” Inquiries tell other creditors that you are thinking of taking on new debt. An inquiry typically has a small, but negative, impact on your credit score. Inquiries are a necessary part of applying for a mortgage, so you can’t avoid them altogether. But it pays to be smart about them. As a general rule, apply for credit only when you need it. Applying for a credit card, car loan, or other type of loan also results in an inquiry that can lower your score, so try to avoid applying for these other types of credit right before getting a mortgage or during the mortgage process. Learn more about credit scores.

You can shop around for a mortgage and it will not hurt your credit. Within a 45-day window, multiple credit checks from mortgage lenders are recorded on your credit report as a single inquiry. This is because other creditors realize that you are only going to buy one home. You can shop around and get multiple preapprovals and official Loan Estimates. The impact on your credit is the same no matter how many lenders you consult, as long as the last credit check is within 45 days of the first credit check. Even if a lender needs to check your credit after the 45-day window is over, shopping around is usually still worth it. The impact of an additional inquiry is small, while shopping around for the best deal can save you a lot of money in the long run. Note: the 45-day rule applies only to credit checks from mortgage lenders or brokers – credit card and other inquiries are processed separately.

You can check your own credit with no impact on your score. When you check your own credit – whether you’re getting a credit report or a credit score – it’s handled differently by the credit reporting agencies and does not affect your credit score. If you are applying for a mortgage and haven’t already checked your credit report for errors, do so now. You can get a free copy of your credit report at www.annualcreditreport.com. If you find any errors, get them corrected as soon as possible.”

 

Part of the loan application process is an evaluation of your amount of debt relative to your income and relates to an individual’s ratio of debt to their gross income … or referred to as Debt to Income (DTI) Ratio.

The lower your debt relative to income the better … so that would be what you refer to as a “good” debt ratio. As it approaches certain limits, depending on the kind of debt there is, it can become “bad” because the debt load is so high creditors extending credit worry your basic needs will be paid and their loan will not.

So the only time the ratio really matters is when you are seeking a new loan.

Here’s a general description: “According to studies of mortgage loans, borrowers who have lower DTIs are more likely to successfully manage monthly debt payments, so lenders prefer to see low numbers. In general, 43% is the highest DTI a borrower can have and still get qualified for a mortgage. A debt-to-income ratio smaller than 36%, however, is preferable, with no more than 28% of that debt going towards servicing a mortgage. While the maximum DTI will vary by lender, the lower the number, the better the chances that an individual will be able to get the loan or line of credit he or she wants.”

In other words, the above suggests that the maximum amount of your income that goes towards a mortgage should be 28%. The additional difference between 28% and 36% would include all other debt you have (cars, credit cards, etc). 43% is the very highest total debt to income ratio suggested by the government

How to calculate your personal Debt to Income ratio is explained in the short article here.

 

Please note that this is an educational piece meant to provide you a brief “big picture” on what a couple of key considerations are in the borrowing process for buying a home. I am not a mortgage expert and you should consult with one or more, along with your real estate agent, who do have the expertise to navigate you through the entire process.

 

Here’s a post on the question of whether you should rent or buy, which brings you to three calculators (towards the end of the embedded article within the post) you can use in tandem to answer your question based on your situation. 

Photo by Mike Birdy on Stocksnap.

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