The first step to purchasing a new home is applying for a mortgage. This part of the homebuying process may initially seem intimidating. However, when you properly prepare and meet with a lender, you will be a little bit closer to closing on the house of your dreams.
Know how your credit score impacts a mortgage
Of course, a bad credit score can impact whether you are approved for a home loan. However, knowing how your credit score impacts the interest rate for your home mortgage is also valuable information to consider.
Those with scores ranging between 760 and 850 will likely nab the lowest mortgage rates. If your score is 620 or lower, you will likely be considered subprime. When identified as a subprime borrower, your interest rate will likely be higher and you will not have access to as many loan options.
Your credit score is one crucial component lenders will consider when you're applying for a home loan and improving it should be a priority, according to Bankrate.
"The key to having the best FICO score possible is following three rules," says Jeffrey Scott, spokesman for FICO. "Pay all your bills on time, every time, keep your credit card balances low and only open new credit when you need it."
Having a deeper understanding of how different debts may alter your credit score is another way you best focus your efforts to increase your score.
Everyone has some type of debt. Whether you owe your friend a couple bucks for drinks last week or you're still paying off student loans, we all face debt.
It's important to know the types of debt you owe and how they might impact your credit report, because your score influences whether a lender approved your application for a home mortgage.
When you owe this type of debt, the lender can take back an asset if you are unable to continue making payments, according to Trulia. These types of debts provide creditors with a sense of security when providing a loan. A mortgage is an example of this type of debt. If you stop making payments, the property can be repossessed and the lender will not necessarily lose out as much.
On the other hand, unsecured debt entails that a lender cannot reclaim anything if you as a borrower do not make payments. Credit card debt is one example of this. As you charge your card for various purchases, the bank or credit union cannot reclaim what you are purchasing.
This is a riskier loan than a secured one.
How different debt impacts your score
Secured and unsecured debt may impact your credit report in different ways. An auto loan is an example of secured debt. Your car is an asset that can be reclaimed if you can no longer afford your monthly payments. This type of debt can be beneficial when applying for a home mortgage because it diversifies the types of debt you owe.
In addition, auto loans typically require a more qualified buyer when compared to someone who is approved for a credit card. Lenders may look more favorably on you than someone with just a credit card when applying for a new mortgage.
Pre-existing mortgage loans are another example of secured debt. However, missing payments may make a lender less confident in your ability to pay off an additional landlord.
Student loan debt is unsecured, but that does not mean it will negatively impact your credit score. Paying off loans on time regularly can actually help boost your score substantially. However, while paying on time can be beneficial, it can impact your debt-to-income ratio, which can have a negative impact on your ability to qualify for a mortgage.
Understanding your debt-to-income ratio
According to the Consumer Financial Protection Bureau, your debt-to-income ratio is an important factor lenders consider during the home loan application process. To find this percentage, add up all of your existing monthly debt and divide it by your gross monthly income.
For example, if you owe $1,000 each month for student and auto loans and you make $5,000 every month, you would divide your debt by your income. Your debt-to-income ratio would be 20 percent.
Typically lenders will not approve buyers who have a debt-to-income ratio higher than 43 percent, according to the CFPB.
While credit scores are important and you should work to improve yours as much as you can before applying for a home loan, they are not the ultimate obstacle. There are options available that can help you with mortgage approval despite a lower credit score as long as other factors prove you to be a qualified borrower.
Reach out to a lender and start the conversation today to help as you embark on the journey toward homeownership.