“Am I ready to buy a house?” is a question that most first-time home buyers ask themselves at some point in the process. The answer is never the same for everyone. However, there are three important numbers you should know before you buy a home, as they provide a snapshot of your financial profile and your ability to carry the debt associated with a new home. These numbers include your credit score, debt-to-income ratio, and loan-to-value ratio. If your numbers are on-target, then you can feel confident about starting your home buying journey.
When you apply for a mortgage — or any loan, really — potential lenders will pull your credit report and review your credit score. Your score tells lenders how credit-worthy you are and how comfortable they can feel in lending you money. Your credit score is calculated based on a number of factors:
- Payment history
- Amount of debt owed
- Length of credit history
- Credit mix
- New credit
Credit scores scale from 300 – 850 and where you land on the scale can impact how much it will cost you to repay your loan. For example, if your credit score ranks as Very Good (690-739) or Great (740+), then you will have more loan options available to you, including lower interest rates and fees, and better loan terms. On the other hand, a credit score that ranks below 649 would most likely require a larger down payment, collateral, and higher interest rates.
When your interest rate rises even 1%, it can cause you to repay thousands of additional dollars in interest over the course for your mortgage. This proves how important your credit score really is! If you’d like to improve your score, follow the steps in our blog: How Can You Improve Your Credit Score to Buy a House?
Lenders will also evaluate your debt-to-income (DTI) ratio when determining whether or not they will lend you money for a new home. They use your debt-to-income ratio to determine your ability to manage the repayment of your mortgage.
The debt-to-income ratio formula is:
Monthly Expenses / Pre-Tax Income = Debt-to-Income Ratio
As an example, if your monthly expenses are $1,500 and your pre-tax monthly income is $4,500, your debt-to-income ratio equals 33%. When calculating your DTI, be sure that your monthly expenses include your proposed new housing expenses, not your current housing expenses.
What is a good debt-to-income ratio? Although it varies by program, a DTI ratio of 43-45% is typically recognized as the most that lenders will allow when applying for a qualified mortgage. If you find that your debt-to-income ratio is higher than 45%, you may want to slow down on house hunting until you put time into paying down some of your monthly expenses (car payments, student loan payments, or credit card balances.)
“Having sufficient assets, credit history and being able to prove affordability are all required in order to qualify for a mortgage. If even one of these three things are lacking, then there’s a good chance the application can’t be approved. For example, a borrower may have perfect credit and show affordability, but without sufficient funds to put down and to cover closing costs, most likely their application would be denied,” explained Ben Huard, Sr. Real Estate Originator at Diamond Credit Union.
The final number you should know before buying a new home is the approximate loan-to-value (LTV) ratio of a potential home. The LTV ratio is another assessment of lending risk.
You can use the loan-to-value ratio formula below when evaluating new homes:
Property Price – Down Payment = Mortgage
Mortgage / Property price = Loan-To-Value Ratio
If you wanted to purchase a home valued at $250,000 and had a $50,000 down payment, your mortgage would be $200,000. Dividing your $200,000 mortgage by the $250,000 home value, your LTV would be 80%.
The higher your LTV is, the higher the risk you pose for defaulting on your mortgage. A typical loan-to-value ratio is 80%. At or below 80%, you will have a full array of mortgage options available to you, at lower interest rates. If your LTV ratio is above 80%, you can still qualify for a mortgage, but it may be necessary that you carry private mortgage insurance (PMI) until your ratio falls below the allowable limit.
One way to improve your LTV ratio is to save a larger down payment before you start making offers on a new home. A larger down payment will decrease the amount you borrow on a mortgage loan, which will lower your ratio. Another option is to investigate lending options that require a smaller down payment, including FHA or VA loans, or by looking at properties with a lower purchase price.
If you are a first time home buyer, many lenders offer special programs or look into the Home Possible and HomeOne programs which have lower down payment requirements than FHA.
What other information should you have at your fingertips before buying a home and applying for a mortgage? Ask the mortgage experts at Diamond Credit Union for professional guidance.