If you have read any articles about buying a house, you have heard to shop for a mortgage first, house second. Looking for a house before getting approved for a mortgage is a recipe for heartbreak. So where would you start to qualify for a mortgage? There are many different programs available to help but there are several factors that are important across the board. Down payment + debt-to-income ratio + income = mortgage. Down payment, debt-to-income ratio and income are all required pieces to qualify for a mortgage. Beyond that, the better each piece is, the lower your mortgage rate will be.
Credit
Credit is the key, not just to being able to buy a house but to make the house as affordable as possible. At first blush, it seems the price of the house is the most important thing to consider when determining if you can afford a home. But that isn’t the total picture. Interest rates also play a big part in determining whether your payment will be affordable. Let’s look at an example to illustrate.
Let’s say you are buying a $250,000 home with an interest rate around 4% (we will set aside the other major costs for now). A $250,000 mortgage with a 4% interest rate on a 30 year mortgage = $179,673.77 of interest paid! That means a $250,000 house will cost you $429,673.77 in total. The interest would account for about 40% of the loan!
So what determines the interest rate which will account for nearly half your overall mortgage payments? That’s right, your credit score!
Let’s look again at our $250,000 home purchase and how credit affects the cost.
| FICO® Score | APR | Total Interest Paid |
| 760 to 850 | 4.306% | $195,701 |
| 700 to 759 | 4.528% | $207,515 |
| 680 to 699 | 4.705% | $217,045 |
| 660 to 679 | 4.919% | $228,694 |
| 640 to 659 | 5.349% | $252,516 |
| 620 to 639 | 5.895% | $283,535 |
As you can see in this table, the higher your score, the less you pay. On average 150 points make a difference of about $100,000 over the course of a loan.
Increasing your credit will save you huge bucks.
Savings
Credit is just one of the major factors that affect mortgage terms. How much you have saved also makes a big impact. Besides the obvious cost of a down payment, there are other costs associated with buying a house that you will need to save up for. 20% has long been considered the standard down payment amount for a house. Though these days there are programs available that allow for $0 down payment, they come with a cost. Any mortgage with a down payment of less than 20% requires purchasing private mortgage insurance, commonly known as PMI.
| Down Payment % | Down Payment $ | PMI | Monthly Payment |
| 20% | $50,000 | $0 | $1,184 |
| 15% | $37,500 | $78 | $1,317 |
| 10% | $25,000 | $111 | $1,409 |
| 5% | $12,500 | $150 | $1,508 |
| 3% | $7,500 | $198 | $1,592 |
| 0 | $0 | $204 | $1,634 |
As you can see, the smaller the down payment, the higher the PMI payment, the higher the monthly payment.
Besides the cost of PMI, a below standard down payment can also affect the interest rate on the mortgage. Mortgage lenders use risk-based pricing when determining the terms of a mortgage. This means they charge more when they believe there is a higher risk they may not get paid. The amount of down payment compared to the total price of the home affects the amount of equity in the home and the borrower’s debt (more specifically something called debt-to-income ratio).
Debt
Debt is another big factor the bank looks at when deciding if you are creditworthy enough for a loan. The more debt you have in comparison to your income, the harder it will be to qualify for a loan. When the bank is deciding whether or not to give you a loan they are trying to decide whether you will be able to make your mortgage payments. In the bank’s eyes, if you have a lot of payments to make you probably won’t have enough money left to pay your mortgage.
This calculation is called the debt-to-income ratio. There are 2 different aspects the bank considers here: front-end ratio and back-end ratio. The front-end ratio refers to the debt-to-income ratio related solely to housing costs like mortgage payment, property taxes, and insurance. The back-end ratio looks at total debt-to-income including all loans and debts. A good rule of thumb is to keep the back-end ratio below 40%. It’s easy to calculate:
Total monthly debt payments / Monthly gross income = DTI
Bottom Line
Better credit, a low debt-to-income ratio, and healthy savings will not just help you qualify for a mortgage but will get you the best rates. Master this formula and you will lock down a more affordable mortgage.
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