The following is presented for informational purposes only and is not intended as credit repair.
Perhaps you’re dreaming of your first home. Perhaps you already have a home, but it’s not “the one.” Dreaming about your ideal home is all well and good, but if you ever want to make that dream a reality there are a few actual, proactive steps you should be taking to make yourself the kind of borrower lenders dream of working with.
Use credit and use it correctly
First, let’s establish two crucial facts. One, lenders hate risk. And two, mortgages – by the simple nature of their size – are risky.
Lenders are looking for low risk applicants. They’ll almost certainly dive into your financial history and employment status to get an accurate picture of how reliable you may be, but that deep dive usually begins (and sometimes ends) with your credit report and score.
Having a low credit score will often disqualify you immediately from many types of loans (and certainly from most loans with favorable terms). If you’re interested in buying a home someday – even if that day is years in the future – start using credit wisely today. The only way to build a strong credit history is by using credit. You don’t have to carry a balance and you don’t have to go into debt. You simply need to have a few open credit accounts that you use regularly and repay immediately.
Keep all your accounts in good standing
Lenders want to feel confident that you can be relied upon to pay them back as promised. There are a lot of factors they’ll consider on that front, but perhaps the most critical bit of evidence is whether or not you’ve been reliable in the past. That extends to all financial obligations. Have you made your required payments, on time and in full?
Minor slip-ups happen, so one mistake doesn’t mean you’ll never get that dream house. But the more thoroughly you can demonstrate that you take your obligations seriously and follow through on your commitments, the more comfortable lenders will feel giving you a mortgage without astronomical fees and sky high interest rates.
Reduce or eliminate your other debt obligations
Repaying your debts (and not creating new ones in their place) serves two purposes. It usually helps build your credit score, and it will reduce your debt-to-income ratio. We’ve already discussed why having a higher credit score can help you, so here’s what you need to know about your debt-to-income (DTI) ratio:
Debt-to-income ratio captures the percentage of your monthly income that’s eaten up by debt repayment. If you have a lot of debts and they take up a high proportion of your income, that makes you risky to potential lenders. When debts already consume so much of your paycheck, it becomes more and more likely that you’ll eventually falter and struggle to repay all those debts.
Many lenders may even have pre-established cutoffs, where if your DTI goes above a certain percentage (over 40 percent is usually a red flag for most lenders), your application will be automatically denied. That’s why it’s a good idea to focus heavily on debt repayment before getting ready to purchase a new home.
Be financially consistent
Financial fluctuation is not your friend – at least not when you’re trying to buy a home. Lenders prefer applicants that make a consistent income, with consistent expenses, living a consistent financial lifestyle. That kind of consistency (preferably over a stretch of two or more years) make it easier for lenders to forecast your ability to repay.
If you’re self-employed and find that money tends to come and go, buying a home is not impossible. It just means you need to do your best to strengthen the other six areas discussed in this article.
Stay in your job
As an offshoot of financial consistency, it helps quite a bit to be stable in your employment. The longer you’ve been in your current job, the better (from an underwriting perspective).
Of course, the job market isn’t quite what it once was (Americans now stay in a job for an average of less than five years – and even that is continually shrinking), and it’s relatively rare for anyone to stick with a job from day one to retirement. So don’t fret and worry that you need to stay in a less than ideal job situation for the sake of your dream house. Just keep in mind that if you just started a new job, you may want to wait at least six months (if not the recommended two years) before applying for a mortgage.
Bring cash – loads of it
Having cash up front is a great way to reduce a lender’s risk and earn more favorable terms for yourself. How much do you need? Well, as much as you can reasonably afford.
Having a large down payment can help you on two fronts. First, if you have at least 20 percent of the loan’s value to put down up front, you can avoid having to purchase private mortgage insurance (PMI). Lenders require PMI (on top of your regular homeowners’ insurance) in instances where the borrower has less than 20 percent equity in their home. As with most things “loan”, this is done to help mitigate the lender’s risk.
Secondly, a borrower with plenty of cash on hand is just generally more appealing for a lender. The more equity you can start with, the less risk there is for the lender. Of course, you don’t want to invest more up front than you can reasonably afford, and you definitely don’t want to sink all of your available savings into your home. You can’t easily access that equity if there’s ever an emergency, so make sure you’ve got an adequate emergency savings built up and close at hand.
I know we’re talking about “dream homes” here, but you can do yourself a big favor by keeping your dreams at least somewhat restrained. Ultimately, when a lender is considering whether or not to extend you a mortgage, they’re asking themselves, “Will this person be able to repay the debt on time, in full, and as agreed upon?” The bigger, grander, and more expensive the house, the more likely it becomes that you may one day struggle to make your payments.
So while it’s okay to dream, try to dream in moderation. If you look at the costs of your dream home, grit your teeth, and say, “I think we can make this work”, it might be in your best interest to keep looking until you find something a little less expensive.
If you're interested in one-on-one coaching, reviewing the ins and outs of homeownership and the true costs of being a homeowner, MMI is proud to offer pre-purchase housing counseling.