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What Banks Look at When Approving a Home Loan

Mortgage Application | Home Buyer Guidance

Are you ready to buy a house, or in the planning stages of a home purchase?  Either way, it helps to know what banks look for when they evaluate your loan application. Banks need to make sure you’re likely to repay a home loan according to the terms of your mortgage agreement. In making this assessment, they consider a variety of factors related to your past and present financial situation.

What specific financial information will the banks look at? Here are a few items virtually all lenders consider before approving a home loan:

1. Credit Score

Also known as your FICO score, this number between 300 and 850 helps banks get a handle on your past credit history. The higher the number, the better. A low credit score tells banks you’re a risky borrower, and it could be harder to receive a loan.

How is your credit score calculated? By using a variety of metrics such as:

– Payment history. Do you pay off your credit cards every month or carry a balance? Payment history influences your credit score more than any other factor. A history of timely payments will help your score stay high.

– Credit utilization. This is the amount of credit you use versus the credit you have available. Let’s say your credit card has a $9,000 limit. A balance of $1,800 indicates 20% utilization while a balance of $8,100 indicates 90% utilization. The former is better for your credit score as 90% utilization suggests you’re too overextended to pay bills on time.

– Length of credit history. The longer your history of paying balances and paying back loans, the higher your score is likely to be.

Factors such as the number and types of new credit accounts opened also impact your score, albeit to a lesser degree. Check out FICO’s rundown of credit score metrics for more on how your score is calculated.

2. Income

As far as banks are concerned, how much money you make isn’t nearly as important as your monthly income with respect to total monthly housing costs. You don’t necessarily need a high income to qualify for a home loan, but your income will influence the loan amount for which you’re approved.

To ensure you have sufficient income to cover monthly mortgage payments, lenders will consider your total monthly income from all sources. This total will include salary and bonuses as well as income from dividends and interest.

A good rule of thumb is not to purchase property when the monthly mortgage payment, insurance, and property taxes add up to more than one third of your monthly income. Banks are more likely to approve home loans if the monthly payment falls at or below that range.

3. Current Loans

Do you have long-term, ongoing debts for things like car payments and student loans? Lenders will look at whether such payments could affect your ability to pay back a mortgage.

Having these loans isn’t necessarily a bad thing—especially if you demonstrate a history of timely payments—but banks do want to get a handle on the extent to which the expense already eats into your income. If you don’t have much left over after making those payments each month, it could affect your loan eligibility.

4. Down Payment Percentage

Homebuyers ready to put down 20% stand a better chance of receiving a loan. And if you can come up with more than that—even better!

Gone are the days of easy, tiny down payments. Banks want you to have significant equity from the get-go, and 20% is generally the standard for proving you’re a serious, capable buyer.  You should also learn what escrow is and how it impacts your down payment.

Remember: The 2008 financial crisis showed how damaging it can be for banks to extend home loans to borrowers whose ability to repay is suspect. That’s not to say you won’t receive a loan if you can’t put down 20%—you might still be approved—but keep in mind that banks are much more risk averse than they used to be.

If you aren’t ready to pay a 20% down payment, there are government insured programs that allow you to pay less up-front.  Borrowers can get a Federal Housing Administration (FHA) loan for as little as 3.5% down.  FHA loans require the borrower to pay for mortgage insurance, which gives the lender confidence should the borrower default.

Speak with an FHA-approved lender to learn more.

Getting the Approval

Approaching a bank for a home loan means being prepared. An attractive credit history, sufficient income to cover monthly payments, and a sizeable down payment will all count in your favor when it comes to getting an approval.

Ultimately, banks want to minimize the risk they take on with each new borrower. Having your finances under control removes a lot of risk from the equation—not just for the banks, but for you as well.

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