For many deserving people, the dream of homeownership is just that; a dream, and turning that dream into a reality is turning out to be much more difficult than many ever expected. If you have never purchased a home before, it may seem daunting, if not impossible. Here are some things you can do to prepare for home ownership.
Pre-Approval or Prequalified?
You will hear these terms a lot when you are going about buying a home. You may even hear differing opinions as to which is better, or carries more weight. Here is the skinny on both terms.
- Prequalification: This is the process of talking with a loan officer or mortgage consultant and making an educated guess as to your ability to buy a home. They’ll try to determine what you can afford given the limitations of your income and your debt to income ratio. Your credit report is not usually pulled so they will go on the assumption that credit is not an issue. Prequalification letters do not carry much weight.
- Pre-approval: The pre-approval letter carries much more weight, and sellers will take you and your offer seriously because they know you can afford the home and are able to get a loan to buy it. A loan officer will do many of the same things as in the prequalification process, but they will also pull your credit, look at your W-2’s or whatever you will be using to qualify for the income part of the process. They’ll look at their rate sheets and calculate what your payment would be, etc… The pre-approval letter certifies that you are able to afford the house and that you have a lender who will loan you the money to buy the home. Most lenders will not charge anything for the whole process except for a nominal fee for pulling your credit report. If you are serious about buying a home, you have to get a pre-approval letter.
Proving your Income
This can be the most difficult part of the home buying process. You can have stellar credit, but if you don’t have the income you’ll have a tough time buying a home. The fact is, many people who do have enough income just have a hard time documenting that income. Not everybody has W-2 income. Many are self-employed and get a W-9 at the end of the year. Other people may have a combination of both, or even get paid under the table. These people should still be able to buy a house. For many people the bank statement in lieu of W-2’s solves the problem right there. In a nutshell, you add up all your deposits for a year and divide by 12. That figure will be used as your monthly income amount for qualification purposes and there is usually no rate hike penalty for those who qualify this way. Some lenders still allow Stated Income or Limited or No Doc loans, but those numbers are shrinking and have nearly disappeared since the housing bubble burst. Your debt to income ratio is very important and will be the determining factor in whether you will be able to get a loan or not. You simply take your total debt payment number (that’s your monthly bills you pay) and divide that by your total monthly income. That figure is your debt to income ratio. For example, if your monthly debt is $5,000 and your monthly income is $10,000, you have a debt ratio (DR) of 50%. The lower that number is the better. For prime lending that number usually has to be around 45% or lower. For non-prime lending, that number can sometimes be as high as 55%.
Not everything you pay on a monthly basis is included in the debt to income ratio figuring. Things that do count are things like auto installment loans, credit cards or any other revolving debt, rent, child support payments, and school loans. Things that are not usually factored in are things like cell phone payments, monthly food bills, gas, or most other payments you make that do not show up on your credit report. When it comes to adding up your income be sure to include the obvious, your income from your job(s), but also include any court mandated alimony or child support you have been receiving, as well as interest payments or dividends you get from stocks and bonds.
You Should Know…
There is some confusion sometimes when it comes to whose credit score gets used to calculate the interest rate a borrower(s) will have to pay. Banks and other lenders always use the credit score of the borrower who makes the most verifiable income. Sometimes this can cause a problem because the primary breadwinner does not always have the highest credit scores. It is not all that uncommon for a loan to fall apart because the interest rate borrowers qualify for makes their debt to income ratio too high. If only the wife’s credit score could have been used…The better prepared you are the better chance you have of getting a loan, especially if you have some credit issues and cannot qualify for prime lending. Try to figure how you’re going to qualify when it comes to how to show your income, and what your debt ratio is. That way you may be able to head off any problems before a loan is submitted and an underwriter sees the issue. Once that happens, it’s too late to fix the problem. Educate yourself. As the saying goes, the more you know, the more you know.
About the Author: Bill More provides smsf advice to individuals and business to secure their wealth for the future. Bill has been practicing in the industry for several years and believes superannuation funds are over looked due to the complexity, which can be outsourced to a knowledge advisor.
If you are looking to buy a home, having pre-approval can definitely work in your favor. Talk to your real estate agent about your situation in addition to learning more about the above points because a pre-approval could mean that you have more negotiating/bargaining chips on the table vs. the next guy.