Buying a home can seem like a confusing, complicated process, and many people who are more than well-qualified for home ownership may shy away from the process as a result. While the loan process can take a few weeks to complete in most cases, the reality is that it may not be as complicated as you might think. Pre-qualification is the first step in the loan process, and by learning more about it, you can gain a better understanding about what it takes to get approved for a home mortgage.
What Is Pre-Qualification?
When you purchase a home, you generally must prove to the underwriting team at your lender’s office that you have the financial means to afford the home. Lenders take on risks when extending a loan to you. Therefore, they have created certain ratios and requirements that you must meet. It is not enough to simply document your budget and show that you can afford to make the mortgage payments. Instead, the lender will review your income, debts, credit rating and assets to confirm that you meet their minimum lending requirements. Through pre-qualification, the lender will screen you in each of these areas to ensure that you meet their basic qualifications. Some of the information provided during pre-qualification, such as your income, may be stated. After the pre-qualification process ends and the loan moves into the loan processing stage, you will be required to document all aspects of your financial situation by providing pay stubs, tax returns, bank statements and other documents.
How Your Income Is Calculated
You will typically provide a stated income figure on your loan application, and the pre-qualification will be based off of this. You ideally want your stated figure to match the income that the lender later verifies through your documentation. Therefore, it is important to know how the information will be documented later. After the pre-qualification phase, most lenders will review your last two to three months’ pay stubs to determine your income, and they may also contact your employer as further verification. If you are self-employed, your tax returns for the last two to three years may be reviewed. Most lenders will use your net income rather than gross business income to generate self-employed income data. Other sources of income, such as alimony, rental income and more, may be reviewed in different ways. Ask your lender how these will be calculated before you fill out the loan application.
What You Need to Know About Debts
Your income will be analyzed in conjunction with your current debts and the projected mortgage payment. First, a ratio will be calculated based on your income and your mortgage payment alone. Second, a ratio will be calculated with your income as well as your mortgage payment, credit card payments, student loans, car payments and other debts. These debts are listed on your credit report. Utilities, cell phone bills and more are not included in this calculation. Ratio requirements vary by lender, but most lenders want this final ratio to be 45 percent or less.
The Importance of Your Credit Rating
Even if you have excellent finances, your credit rating must also meet the lender’s requirements. Most lenders have a minimum credit score requirement that you must meet, and they may also have a graduated scale that issues better interest rates for higher credit scores. Because of the importance of having a good credit rating when applying for a mortgage loan, it may be wise to improve your rating to 680 to 700 or better before you apply for a loan.
How Your Savings Balances Impact Your Pre-Qualification
The lender also wants to verify that you have enough cash available to pay the down payment and closing costs. More than that, most lenders also require that you have a reserve of funds available after closing. In most cases, this reserve of funds may equal two to three months’ worth of mortgage payments. You will need to verify that the entire amount of funds has been available in your account for the last two to three months. The lender may review your bank statements and may require explanations for any large deposits. If you plan to receive a gift of funds, such as from a family member, verify with your lender up-front if they will accept this arrangement. Not all lenders allow a gift of funds.
As you can see, a lender will review a considerable amount of information during the pre-qualification stage. Some of this information, however, may simply be stated. Most lenders will simply ask you to complete a loan application and allow them to pull your credit report for the pre-qualification, so the entire process may only take a few hours to complete in some cases. If you are ready to move forward with the home buying process, research lenders who you want to work with as a first step.