Everyone knows that income and credit play a role in the mortgage application, but do you know exactly what role they play? Just having a large amount of income or an exceptionally high credit score is not enough to get you approved for a loan. Even people with a 700+ credit score have been turned down before. The key is understanding the role of each factor so that you can optimize your mortgage application and ensure that you get the loan you want for your home purchase.
Income Versus Debts
The largest role your income plays in the mortgage application is how much money is left after your monthly debts are paid. When you apply for a mortgage this means all debts including:
- Credit cards
- Installment loans (car, personal)
- Student loans
- Mortgage payment including principal, interest, taxes, and insurance
The money left over after your monthly debts are paid is called your disposable income. VA loans focus on that number, but most other loans do not. What they focus on instead is the debt ratio. They want a particular percentage of your income to go towards your monthly debts, leaving the remaining percentage up to your discretion. Every loan program has its own maximum debt ratio. For example, conforming loans typically want a debt ratio to be 28/36, which means 28 percent of your monthly income goes towards your housing costs and 36 goes towards the total monthly debts including housing and all other debts. FHA debt ratios are a bit more liberal – they allow percentages of 31/43, giving you a little more leeway with your income.
What your income determines is the amount of money the bank can safely lend you. It is not the only determining factor regarding the type of loan, interest rate, or even loan approval – it is strictly what determines what you can afford. It also means that you have a little say in how this goes down. If you have a lot of outstanding debt, you can choose to pay it down before you apply for a mortgage. How do you know what to pay down to increase your borrowing power? It’s simple – the lender looks strictly at the minimum required payments that report on your credit report. So rather than paying off the debts with the highest interest rates or highest balances right away, find out which debts have the highest minimum payment and get rid of those first as they will directly impact your debt ratio the most, giving you more borrowing power.
Credit Score and Interest Rates
Your credit score, which most people know, plays a vital role in your loan approval, directly impacts your interest rate. In general, you have to have a minimum credit score to apply for any loan. The following are the basic guidelines for most loans:
- Conventional loans – The minimums can vary, but the general consensus is 680, which some lenders allowing scores slightly lower.
- FHA loans – The minimum credit score to put down the low 3.5 percent down payment is 580, but a score of 500 or higher can still get approved with a 10 percent down payment.
- VA loans – The general minimum is 620, although the VA is less focused on credit score and more on credit history.
Given the minimum interest rates for each loan type, you can know what type of loan you might be eligible to receive. In addition to the program you are eligible for, however, is the interest rate you are charged. Generally, the higher your credit score, the lower the risk you pose to the bank so the lower your interest rate becomes. On the other hand, if your credit score is on the lower end, you are a higher risk for the bank and your interest rate will increase accordingly. Typically, credit scores and interest rates are directly related – banks have a specific calculation they use. For example, for every 10 points your credit score goes down from the average, a certain percentage is added to your interest rate. Every lender will differ in how they adjust for credit score, so it pays to shop around to find a lender that adjusts your interest rate the least.
Knowing how your income and credit score impact your mortgage application will help you get the most out of your loan. There are numerous programs that you can apply for depending on the circumstances of your loan application, so make sure to shop around to determine what is right for you and your situation, giving you the most for your borrowing power.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.
