A pre-approval is an essential step in the homebuying process that can help you determine the price range of homes you can afford. While a mortgage pre-approval isn’t required before you start searching for homes, it can give you several distinct advantages when you’re ready to commence the house hunt.
(By the way, if you’re looking for an even more powerful pre-approval, we recommend a Platinum Credit Approval — which allows you to make the next-best thing to an all-cash offer and helps your loan close quickly after your offer is accepted.)
So, what are the factors that impact your pre-approval? It can be very helpful to understand them before you start the loan application process. While the pre-approval process varies slightly, depending on the lender you choose, these are the three most critical items that ultimately determine your mortgage pre-approval.
Credit Score and Credit History
A credit score is a three-digit number that represents an individual's credit history and creditworthiness. Most credit scores range from 300 (very poor) to 850 (exceptional); and a “good” credit score falls between 670 and 739, according to the Fair Isaac Corporation (FICO).
Lenders use credit reports to determine the risk associated with lending to a homebuyer and to make informed loan decisions.
To build or maintain a strong credit score, you’ll need to show a positive payment history. Making consistent, on-time payments for loans and credit card bills will not only boost your credit score, but it also shows lenders that you would probably be a responsible borrower of their funds.
Credit utilization is another important factor that determines your overall credit score. This is the comparison of your credit card balance to your credit limit. For example, if you have a credit card with a monthly limit of $10,000, and you regularly charge $4,000 in expenses on it every month, your credit utilization for that specific card would be 40%.
While some financial experts recommend keeping your credit utilization below 30%, FICO advises keeping it below 10% and making sure that you’re paying it off on time.
To take advantage of the best interest rate possible for their home loan, all homebuyers should focus on improving their credit score. A high credit score could also help you have lower monthly mortgage payments (because of the lower interest rate) and could open the door to more loan choices — giving you the best fit for your financial situation.
Qualifying Ratios
Another key factor that mortgage lenders consider when evaluating a mortgage application is the homebuyer’s debt-to-income ratio (DTI). This is an important measure of your ability to manage your debt and repay a mortgage. It compares your monthly debt obligations to your monthly income. (Basically, the comparison of how much money you have going “out” versus how much money you have coming “in” every month.)
Your monthly debt payments include any payments you make toward credit card debt, car loans, student loans, or any other outstanding debts on a regular, monthly basis. Your estimated monthly mortgage payments should also be included in this total amount.
To calculate your DTI ratio, add up your monthly debt payments and divide that number by your gross monthly income. Use this easy formula:
Monthly Debt Payments ÷ Gross Monthly Income x 100 = Debt-to-Income Ratio
For instance, if your gross monthly income is $6,000, and your total monthly debt payment is $2,500, you would calculate your debt-to-income like so:
2,500 ÷ 6,000 x 100 = 41.67%
It is important to note that most lenders prefer a debt-to-income ratio that is below 45%, according to Bankrate.com. This means that your monthly debt payments should make up less than 45% of your gross income per month.
If your debt-to-income ratio is higher than 45%, you may need a co-applicant to qualify for a mortgage. A co-applicant (or co-borrower) is someone who applies for the mortgage loan along with the primary borrower and shares in the responsibility of repaying the loan.
By including all relevant monthly payments in the calculation and working to lower your debt-to-income ratio, you can increase your chance of obtaining a mortgage pre-approval.
Employment History and Income
The third important factor that determines your eligibility for a home loan is your employment history and income. A lender will evaluate these two factors to ensure that you earn enough to afford a new mortgage payment and any associated monthly housing expenses.
Your employment history is one part of your background that helps a lender discern your ability to repay the loan. The lender will ask for your employer's name and contact information, your job title, and dates of employment. They may also request a verification of employment from your employer to confirm your income and employment status.
Next, the lender will review a more detailed breakdown of your income, to determine if it is stable and reliable. This includes your job salary, commissions or bonus income, and any other income sources, such as rental income or investment income.
If you’re self-employed, the lender may request additional documentation from you, so they can get a better understanding of your financial picture.
The Bottom Line
While each of these three factors play a crucial role in your ability to get pre-approved for a mortgage, it’s important to remember that requirements vary from lender to lender — and from loan program to loan program.
For instance, some loan programs may allow for a higher debt-to-income if you have a more significant down payment amount. In this case, if your debt-to-income was slightly higher than desirable, but you had a solid amount of money saved for your down payment, you could still qualify for the loan amount you’re hoping for.
In another case, you may have a credit score that could use some improvement, but your income and employment history make you otherwise financially ready to own a home; a reputable lender will take this into consideration.
All this is to say: it’s important to consult with a qualified loan professional about your unique situation. While these financial factors are generally an important part of the mortgage pre-approval process, regulations and qualifying figures aren’t universal for all loans. A trustworthy lender will look at your full “financial picture” and use their expertise to suggest various loan solutions that are specific to your unique circumstance and goals.
Then, with your pre-approval in hand, you’ll feel confident and ready to start the home search process.
In accordance with federal regulations, consumers are not required to provide verifying documents until they have submitted an application, received a Loan Estimate Disclosure, and stated their intent to proceed with the loan transaction.
