Qualifying for a Home Loan

Accurately determine how much house you can afford, and learn why a good credit score and loan preapproval are critical.

It's essential to consider how much you can afford to pay before you look for a house. Considering affordability early on will save you time and money because you won't bid on unattainable houses or apply for loans that are out of your ballpark. It will be easier to get a loan and, if necessary, you will be able to take creative steps toward improving your financial and credit profile.

How Much House Can You Afford?

As a broad generalization, most people can afford to purchase a house worth about three times their total (gross) annual income, assuming a 20% down payment and a moderate amount of other long-term debts, such as car or student loan payments. With no other debts, you can probably afford a house worth up to four or even five times your annual income.

Lenders have traditionally wanted you to make all monthly payments using no more than 28% to 38% of your monthly income. (If you have an excellent credit record, however, they might allow you to go more deeply into debt.) In other words, if your monthly income is $2,000, the lender would want you to pay no more than $760 (.38 x $2,000) toward all your debts. The percentage depends on the amount of your down payment, the interest rate on the type of mortgage you want, your credit history, the level of your long-term debts and other factors. Generally, the greater your other debts, the lower the percentage of your income lenders will assume you have available to spend each month on housing. Conversely, if you have no long-term debts and a great credit history and will make a larger than normal down payment, a lender may approve carrying costs that exceed 38% of your monthly income.

Online Mortgage and Financial Calculators
Dozens of websites offer calculators to help you quickly determine monthly payments on different size mortgages so you can learn how much house you can afford. All calculators are not created equal -- but all of them are free. Sample several and pick the one that gives you the information you're looking for in the format you prefer.

Check Your Credit History

When reviewing loan applications and making financing decisions, lenders typically request that the credit bureaus reporting your file -- Equifax, Experian, or TransUnion -- provide your credit risk score (also known as your FICO score, named after Fair, Isaac & Company, which developed many of the computer scoring models). This seemingly mysterious number represents a statistical summary of the information in your credit report, including:

  • your history of paying bills on time
  • the level of your outstanding debts
  • how long you've had credit
  • how many credit cards and loans you have
  • your credit limit
  • the number of inquiries for your credit report (too many can lower your score, though they've refined the program so this is less of a problem than it once was), and
  • the types of credit you have.

The higher your credit score, the easier it will be to get a loan. If you routinely pay your bills late, you can expect a lower score, in which case a lender may either reject your loan application altogether or insist on a very large down payment or high interest rate to lower the lender's risk.

Because your credit history has such an important effect on the type and amount of mortgage loan lenders offer you, always check your credit report and clean up your file if necessary -- before, not after, you apply for a mortgage.

How to Get a Copy of Your Credit Report

You can order your credit report by mail, phone or directly from the websites of the three major national credit bureaus:

Equifax, http://www.equifax.com
Experian, http://www.experian.com, or
TransUnion, http://www.transunion.com.

You'll have to pay a fee of between $2 and $13 for a copy of your credit report, except under the following circumstances when it's free:

  • You have been denied credit because of information in your credit file. You must request your copy within 60 days of being denied credit.
  • You are unemployed and planning to apply for a job within 60 days following your request for your credit report.
  • You receive public assistance.
  • You believe your credit file contains errors due to someone's fraud, such as opening up accounts by using your name or Social Security number.

If you find any wrong information, take steps to correct the errors. If the information in your file is accurate, but unfavorable, your best strategy is to clean up your credit before seriously trying to purchase a house. Any problems may delay -- or even jeopardize -- your loan.

Loan Preapproval vs. Loan Prequalification

Once you've done the basic calculations and completed a financial statement, you can ask a lender or loan broker for a prequalification letter saying that loan approval for a specified amount is likely based on your income and credit history. Prequalifying lets you determine exactly how much you'll be able to borrow and how much you'll need for a down payment and closing costs. Many of the mortgage websites have prequalifying calculators to help with this task.

Unless you're in a very slow real estate market, with lots more sellers than buyers, you will want to do more than prequalify for a loan: You will want to be preapproved -- that is, guaranteed -- for a specific loan amount. This means a lender has already checked your credit and evaluated your financial situation, rather than simply relying on your own statement about your income and debts. Preapproval means that the lender would actually fund the loan, pending an appraisal of the property, title report and purchase contract. Having a lender preapprove you for a loan is crucial in a competitive market -- without it, you stand little chance of your offer being accepted.

Copyright 2004 Nolo