By Ramsey Judah
If you are not buying a home with cash, then you’ll most likely get a loan. But what does that mean? What is the process? Is it all very complicated? The short answer: kind of.
Credit Score and History
When a loan officer (the person who approves you for a loan) begins the process, they start by running your credit. That means you give them your social security number and they pull up your credit score and credit history.
Both your score and history are very related. A good history of paying bills on time and keeping low credit balances raises your credit scores. On the other hand, if you have high credit card balances and only pay the minimum amount every month, then your credit scores will be lower.
A good loan officer can actually tell you what you can do to raise your scores if need be and the difference could reflect as quickly as 15-30 days.
The next thing a loan officer will look at is your debt-to-income ratio. This is the percentage of all your monthly payments versus the income you make every month. For instance, it would look like this:
- Credit Cards: $425
- Car Loan: $318
- Student Loan: $450
- Total Monthly Expenses: $1,193
- Monthly Income: $4,200
- Debt Percentage (monthly expenses / monthly income): 28%
So why does this matter? Well, banks have a limit for your total debt-to-income ratio they allow when giving you a loan and this will affect your buying power.
How it Affects Your Buying Power
If a bank’s total debt limit is 55%, then that means the person in the above example could only be able to afford a home payment of $1,134 (27% of debt-to-income) which has to include taxes, insurance and PMI. That payment could buy a home around $200,000.
Now imagine if the example above had no debt. The buying power would go up substantially because their home payment could be $2,310 (55% of debt-to-income). That payment could buy a home around $400,000.
The difference is substantial and could mean a house double in size and give the buyer the way more options in purchasing a home.
How Much Can You Put Down?
After looking at the numbers and finding out what your buying power is, the next question involves how much of a down payment can you afford to make. FHA loans require a minimum down payment of 3.5%. So the down payment would look something like this:
- $100,000 = $3,500
- $200,000 = $7,000
- $300,000 = $10,500
- $400,000 = $14,000
- $500,000 = $17,500
Down payments are definitely a roadblock for many people considering the middle class has shrunk to all-time lows. Saving money when you’re living paycheck-to-paycheck is incredibly difficult. The majority of millennials are also having problems purchasing homes due to this very roadblock since jobs are plenty but incomes generation is low. But even if the down payment is a roadblock, make sure you borrow responsibly if possible.
Responsible Borrowing is Beyond Important
We all have emergencies, responsibilities and spending habits. But credit is not a fixed thing. It can be changed quickly if it is done correctly. The general rule is to keep your balances under 30% of your total credit limit.
I have had clients able to buy a home twice as big after a couple of months of responsible budgeting and lowering credit balances. I have also had a client destroy their buying power by going out and buying an expensive car after being pre-approved for a home loan. Taking control of your credit history now will allow you to make big changes later on.