Most home buyers, especially first time buyers, will not have enough cash sitting in a bank account to be able to pay cash for their house. This means that they will need to get a mortgage. The process of getting a mortgage is made up of two primary parts, which I will call the personal side and the house side. The personal side is the process of the lending institution checking out your financial situation and verifying that they would be willing to give you a loan to buy a house, and how much they would be willing to loan you. Your financial picture includes items such as your income, job stability, credit scores, assets, and debt. Your loan officer will review these items in accordance with the policies of the institution to determine whether they would be willing to loan you the money that you need. It may sound a bit harsh, but they are trying to evaluate the likelihood that you will faithful in repaying your loan.
One of the most critical items in their analysis is your credit. Your credit scores are currently tracked and provided by three private companies: Experian, Equifax:, and Transunion. As you live your normal life, making purchases, paying bills, etc. many of those transactions are reported to these credit companies. If you pay your bills on time, that is reported. If you miss payments, or are habitually late with payments, declare bankruptcy, or have any kind of financial judgment lodged against you, those things are also reported.
These companies compile all of your credit history and calculate a credit score. This is what is then reported to the lending institution when you apply for a loan. If your scores are too low, you may not be approved for a loan. The definition of “too low” varies significantly with the overall financial environment and with the policies of each lending institution. Your loan officer can provide specific details for your personal situation.
Credit scores are used to determine not only whether or not you will get a loan, but also what kind of interest rate you will get. The better your credit scores are, the better (lower) risk you are considered to be, and the better loan terms you will get. Of course, the reverse is true for bad credit scores. Lower scores will mean that you will have to pay higher interest rates.
Because credit scores are so critical in determining your loan status, it is very important for you to develop sound financial practices in your every day life. Prudence, discipline and living within your means will provide major benefits to you when it comes to applying for a loan (as well as enjoying life in general!). Some of the primary things to be sure and do include:
- pay your bills on time (especially mortgages and car loans)
- do not run your credit card debt up to the maximum and let it stay there
- do not have any more credit cards than you really need.
- Regularly monitor your credit scores to see what is being put there
- Do everything you can to resolve any negative issues on your credit report
Sometimes, a person’s credit score may prevent them from getting a loan not because they have bad credit, but simply because they have no credit. This is particularly common for young people who are just starting out in their adult life and just have not had sufficient time to build up a credit history. For this reason, many financial advisors recommend that everyone have at least one credit card and use it, in order to build a history of paying bills on time that will be reported to the credit companies.
In this situation, it is generally best for the buyer to deal with a smaller hometown bank that knows the family and therefore is willing to take a risk on the new buyer. Smaller banks will frequently be able to make the loan decisions in-house and thus are more able to take into consideration special circumstances. Again, if you are in this situation, speak with your loan officer and seek their recommendations as to how to proceed.

How much house can you afford?
One very useful result of the pre-approval process will be the bank’s feedback as to how much they would be willing to loan to you to buy a house. It is very important for you to know this before doing any serious looking! What you do NOT want to do is to start looking for a house and find your dream home, only to be turned down for a loan because the bank will not loan you enough money to buy that home. At that point, your expectations will have been raised to a level that is unattainable, and it will now be very difficult to find anything in your price range that meets those expectations. It is a very good idea to know your limits before you even start looking.
This does not mean, however, that once the bank gives you your upper limit, that you must spend that much! Most people would be well advised to buy a little less than the maximum that they can afford. That provides some breathing room in their budget for other things. It also provides some protection against unforeseen negative financial events such job cuts, unexpected medical bills, etc.
In addition to your credit scores, one of the major items that the lending institution will consider is the ratio of your debt to your income. Your income will include any regular income that you can verify with documents, such as your pay stubs. If you can’t document the income or it doesn’t show up on your tax return, then you probably will not be able to use it to qualify for a loan. However, you can use unearned sources of income, such as alimony. You can sometimes also use an estimate of the income generated by your real estate or stocks.
Your debt includes credit cards, installment loans, car loans, personal debts or any other ongoing monthly obligation like child support. Remember: you may not have to consider a debt at all if it is scheduled to be paid off in less than six months. Add all this up to determine what’s called your “monthly debt service.”
Now, divide your total monthly debt service, including your projected monthly mortgage, to get your debt to income ratio. This ratio should not exceed 36%. If it does, the likelihood of your home loan being approved is very small. In fact, many financial advisors say that your monthly housing expense, including taxes and insurance, should not exceed about 28 % of your gross monthly income.