Getting a great rate on a mortgage is about a lot
more than comparison shopping. It’s also about much more than just your credit
score. In fact, the mortgage industry examines a number of factors to determine
not only if you qualify for a mortgage, but also what interest rate you’ll pay.
There’s a
lot at stake. Mortgage rates can vary by several percentage points depending on
the factors we’ll look at below. The difference can mean a much higher or lower
monthly payment and tens of thousands of dollars in interest payments over the
life of the loan.
If you
hope to get the best mortgage rates possible, you’ll need to make sure that you
are well-qualified. Below are some of the key criteria that mortgage lenders
evaluate, as well as some tips you can use to improve your current standing.
Credit Scores
Mortgage
lending today is based on tiered pricing, which means that rates are adjusted
based on various criteria. One of the main criteria used is your FICO
credit score. Your credit score will help to determine whether you qualify for
the loan and what rate you’ll pay on your loan, and there is an inverse
relationship. The higher your credit score, the lower your mortgage rate, all
other things being equal. The best mortgage rates are available to borrowers
who have credit scores of 760 or above. As your score goes lower, your interest
rate goes up. With some exceptions noted below, the lowest score needed to qualify for a mortgage is 620. At today’s mortgage rates,
however, a score of 620 will qualify for a rate of 5.022%, while those with a
score of 760 or higher will enjoy a lower rate of about 3.433%.
You can, in theory, qualify for a
mortgage with a credit score as low as 500. It will require a minimum
down payment of at least 10%. In order to get maximum financing on an FHA loan
(a 3.5% down payment) you need a minimum credit score of 580.
If you
don’t meet the minimum credit score requirements, or if you want to improve
your chances of getting the best rates, you’ll need to begin monitoring your
credit scores (you’ll find several free option shere) and making improvements where necessary. This
can include paying down or paying off loans, paying past-due collection
accounts, and cleaning up any errors you discover on your credit report.
Employment and Income Stability
Mortgage
lenders prefer candidates that can prove steady employment for at least the
past two years. Long periods of unemployment won’t bode well for your
application, and neither will a pattern of declining earnings. In a perfect
world, you have been on the same job for at least the last two years, or have
made a job change to a higher paying position in that time.
Lenders tend to be especially strict when it comes to self-employment
income. According to Bankrate, they will require that you document your
business income with income tax returns for the past two years. And they will
generally have you execute IRS Form 4506, which will enable them to obtain a
transcript of your returns in order to verify they are the same ones you sent
to the IRS.
Debt-to-Income Ratio
Debt-to-income
ratio – also called DTI – comes in two forms. The back-end ratio measures the
total of all of your monthly minimum debt payments, plus your proposed new
housing payment, divided by your stable monthly gross income. The front-end
ratio focuses just on your housing costs, excluding all other debts.
Historically, banks have wanted to see a front-end ratio of no more than 28% and
a back-end ratio of no more than 36%. Depending on the type of mortgage and
other factors, however, these ratios can go higher.
For example, the maximum back-end DTI is 43% for an FHA loan. There may be
some flexibility, however, if you meet certain criteria. For example, the
mortgage lender may allow you to exceed the limit if you are strong in every
other area of your loan application. Further, a lower DTI may result in a lower interest rate.
Down Payment
As a
general rule, you’ll need a minimum down payment of 20% of the purchase price
of your home in order to get the best mortgage rates. Since mortgages are price
adjusted based on risk factors, a loan with 5% down is considered higher risk
than one with 20% down, and will carry a higher interest rate.
But that isn’t the only reason to save
up 20%. When your down payment is less than 20% of the purchase price, you will
likely have to pay PMI, or private mortgage insurance.
On a conventional loan with a 5%
down payment, mortgage insurance will effectively add .62% to your payment (assuming
a credit score of between 720 and 759). On a $200,000 mortgage, this will
translate into an annual premium of $1,240, adding an additional $103.33 to
your monthly house payment.
Cash Reserves
In the mortgage world, cash
reserves are measured in terms of the number of months worth of house payments
you have saved in cash. The reserve includes money saved in checking or savings accounts,
money market funds, or certificates of deposit. However, it generally does not
include funds in a retirement plan since that money can only be withdrawn after
paying taxes and penalties.
The
standard requirement for cash reserves on a mortgage is two months – as in you
must have enough liquid cash after closing to cover your new mortgage payment
(principal, interest, taxes, and insurance) for at least the next 60 days. On
higher risk mortgages, the cash reserve requirement may be higher.
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