Buying a home is the major financial step, and it’s not something you can go into without understanding what the process involves. Since the housing bubble burst back in 2008, home-buying has transformed into a completely different ballgame.
I bought my first home with my now ex-husband in 2009 when the economy was just beginning to tank but before a slew of tighter lending restrictions came along. When we split in 2014, he assumed ownership of the home, and I became a renter once again.
Earlier this year, I decided to make another foray into home ownership, but I’ve found the process to be much different the second time around. Today, I’m sharing what I’ve experienced so far as a guide for anyone who’s thinking of buying a home in 2016.
Different loans require different credit scores
When I first started shopping around for a lender, I had a vague idea of what my credit score was, but I couldn’t pin it down exactly. I knew it was neither terrible nor perfect, so I was confident approval wouldn’t be an issue based on that alone. I was interested in applying for either an FHA or a conventional loan but I wasn’t sure where the cutoff was credit-wise.
Once a lender ran my credit, they gave me the rundown on what kind of scores are needed for different kinds of loans. For a conventional loan backed by Fannie Mae, the minimum is set at 620. For a USDA loan, however, which requires no down payment and is designed for people who live in rural areas (like me), the minimum credit score rose to 640.
With an FHA loan, the minimum was lower than I expected at 580. While my credit score is nowhere near that range, I was surprised to learn that it’s possible for someone with a score that low to even get a mortgage. The lesson? Lenders are willing to cut you a break on credit, but as I soon found out, they’ll hold you to higher standards in other areas.
Only one of your credit scores counts
Credit scores are based on your credit report, of which you have three—one each from Experian, Equifax and TransUnion. While I knew I had a range of credit scores going into the application process, I didn’t realize that only one of them would factor into the lending decision.
The mortgage broker I’m using told me that lenders drop the highest and lowest scores and use the one in the middle to decide whether you can get a loan and what interest rate you’ll pay. What that means for borrowers is that no matter how high your highest score is, it’s not going to work to your advantage all that much if your middle range score is several points lower.
Your savings isn’t as important as your income
The last time I bought a home, the lender wanted to see down to the penny how much money my ex-husband and I had in our checking, savings and investment accounts. This time around, however, it was a different story.
I pulled statements for all of my bank accounts, retirement and investment accounts and even my kids’ college funds only to be told by the lender that all they needed to see was my checking account statement and my tax returns. The money that I had worked so diligently to save for the home purchase didn’t matter as much as my ongoing ability to cover the mortgage payment.
Self-employed savers face additional challenges
As someone who’s been self-employed for several years now, I’ve learned how to keep records of my income, generate profit and loss statements and handle the added paperwork at tax time. While my meticulous recordkeeping helps me stay on top of running my business, it hasn’t done that much for me where getting a mortgage is concerned.
The reason? Self-employed homebuyers are required to submit their tax returns for the previous two years and lenders use your average income for that period to qualify you for a mortgage. In years past, I only worked part-time but in 2015, it became a full-time effort. My earnings have increased month over month since then, but because 2014 was a lower income year, it dragged down my average monthly pay.
While that didn’t disqualify me for a loan, it’s created a problem because of how it affects my debt-to-income ratio. If you don’t know, this is the amount of your income that goes towards paying debt each month. My mortgage broker told me that lenders today want to see this number go no higher than 41%. Anything over that and you’ve got virtually no shot at getting a loan, no matter how great your credit is.
Currently, the only debts I have in my name alone are my student loans. The house that I bought with my ex-husband, however, still has my name on the note. (Fortunately, he’s in the process of refinancing into a new loan as we speak.) In the meantime, the monthly mortgage payment for that house is counting against me in the DTI ratio calculation.
Even though my current monthly income puts me well below the 41% mark when the old mortgage, the new one and my student loans are included, the lender’s only looking at the average income from my last two year’s tax returns. Before the housing bubble collapse, it was possible to get a loan without showing any income at all, but I’ve realized firsthand that in today’s lending market, it all comes down to what you can prove.
Bottom line? Lenders are playing it safe, so you need to have your i’s dotted and your t’s crossed before venturing into the mortgage market.
Credit tips for getting a mortgage in 2016
While mortgage rates are still near historic lows, there’s no guarantee they’ll stay that way through the end of 2016 and beyond. If you’re set on buying a home this year, you need to make sure your credit is up to snuff if you want to snag the best interest rate on a loan. Here are some essential credit must-dos to tackle if you want to get your score in tip-top shape:
- Check your credit reports and dispute any errors. Your lender’s going to check your credit when you apply for a loan, so it’s best to know what they’re going to see beforehand. Get a copy of all three of your credit reports and compare the information on each one.
Check to make sure that the balance and payment history for each account is being reported properly. If you spot something that you think is an error, dispute it with the credit bureau that’s reporting the information. Just make sure that any open disputes are closed before filling out a mortgage application.
- Stop taking on new debt and pay down your existing balances. Thirty percent of your FICO credit score is based on the amount of debt you owe versus your total credit limit. This is called your credit utilization ratio, and the better the ratio is, the more your score will benefit. If you’re using more than 30% of your available credit, hacking away at the balances can give your score a boost.
If you can’t pay the debt down quickly, opening a new credit card can help your utilization ratio as long as you’re not running up a balance. Don’t go overboard with credit applications, however; every new inquiry can knock up to five points off your score so shop around for the right card before pulling the trigger.
- Considering cleaning up old collection accounts. When you don’t pay a credit card or medical bill, your creditor may decide to charge the debt off. At that point, it’s usually sold off to a debt collector. Once a debt is assigned collection status, it can be extremely damaging to your credit score.
If you’ve got some old collection accounts hanging around on your credit report, settling up may a smart move for raising your score, especially if they’re medical debts. The latest FICO model, FICO 9, doesn’t count medical collections against you if the accounts are paid off. Spending a few bucks to wipe out those accounts may be worth it if it adds some points to your credit score.
- Pay your bills on time. Finally, the absolute most important thing you can do with your credit when you’re prepping to buy a home is pay your bills on time. Payment history accounts for 35% of your FICO score, and even a single late payment can drag your score down by dozens of points.
If you’ve struggled with late payments in the past, setting up account alerts or automatic payments can help you avoid missing your due dates. As a general rule of thumb, mortgage lenders want to see that your last late payment is, at least, a year old so if you had a missed payment more recently, you might need to wait a little longer for the impact on your score to lessen before applying for a loan.