In order to get approved for a fixed-rate mortgage loan, homebuyers must understand how lending institutions determine the risk (or credit-worthiness) of a potential borrower.
Credit Report and Credit Score
The first thing you should do is obtain your credit score. In general, mortgage lenders do not approve fixed mortgages for borrowers with scores below 620. It will most likely be a challenge to secure a good interest rate on a fixed mortgage if your credit score is low ― you may need to bring in a co-signer (such as a parent or spouse) with a higher credit score. Since the mortgage lender may look at all 3 of your major credit scores, it is recommended that you request your credit report from all 3 reporting agencies: Experian, Equifax, and TransUnion.
Before applying for a fixed-rate mortgage, check for inconsistencies on your credit report (including fraud, debts that have been paid off, and any errors or omissions). If you discover an old debt that has not been settled, you may negotiate with the creditor to have the history of that debt removed from your record once it’s repaid ― otherwise, it can lower your credit score. Additionally, any debts that are inaccurate or cannot be verified (within 30 days of the discrepancy) must be removed, according to the Fair Credit Reporting Act (FCRA).
Debt-to-Income Ratios
If you are applying for a fixed-rate mortgage, you should also take a look at your debt-to-income ratios. These ratios compare your monthly income to your monthly debt, which helps lenders measure your financial strength. There are two standard ratios: the “front-end ratio” and the “back-end ratio.”
The front-end ratio, also known as the “housing expense ratio,” is used to show how much of your income would go towards paying the mortgage. It is calculated by dividing your monthly housing expenses by your monthly gross income. To be approved for a conventional fixed mortgage, you will need a front-end ratio no higher than 28%.
The back-end ratio, also known as the “total debt-to-income ratio,” is used to show how much of your income would go toward all your debt obligations. It is calculated by dividing your total monthly debt by your monthly gross income. To be approved for a conventional fixed mortgage, you will need a back-end ratio of no more than 36%
It is important to review all your income and debts, and take steps to make sure you are in an acceptable range for loan approval. Depending on the type of fixed-rate mortgage, other criteria may also be required.
Steady Employment
How long have you been with your current employer? The FHA (Federal Housing Administration), which guarantees home loans issued by FHA-approved lenders, requires borrowers to be steadily employed for at least 2 years. Lenders in general want to see that you have a stable source of income and the ability to repay the mortgage loan on time.
Down Payment
How large is your down payment? Since your home will be used as collateral to secure your loan, lenders are more likely to approve borrowers who can make large down payments. The bigger your down payment is, the less risk the lender is taking by supplying you with a fixed mortgage. A down payment of 20% (of the home’s purchase price) is ideal because it provides the lending institution with security in the event that the borrower defaults on the loan.
Bankruptcy
If you have ever filed for bankruptcy (Chapter 7 or Chapter 13), consider how long it has been since your filing. The FHA requires at least 2 years of good credit history following a Chapter 7 bankruptcy.
Foreclosure
If you experienced a foreclosure in the past, consider how long it’s been since it occurred. Homeowners who defaulted on their loan because of economic hardship (e.g., job loss or divorce) may have to wait 2 to 5 years before they can be approved for a new fixed mortgage. Borrowers who chose to “walk away” from a mortgage they could still afford may have to wait 7 or 8 years before applying for a loan.