We’re officially into home buying season, and with that comes an influx of questions regarding the process of purchasing or building a home. Some of the key factors to understand when attempting to qualify for a favorable mortgage include knowing the different types of mortgages, private mortgage insurance (PMI), down payments, loan-to-value ratio, credit scores, and debt-to-income ratio. We will break these down in further detail to help make sure you’re as prepared as possible when the time comes to begin shopping for a new home.
There are many different types of mortgages, but for this discussion, I’m going to focus on conventional vs FHA as these are two of the most common. A conventional mortgage is going to be your traditional mortgage. Most of them require a 20% down payment (80% loan-to-value as we will discuss later), a strong credit score (generally at least a 620, but sometimes higher) and a strong income history. In exchange for meeting all of these requirements, buyers are rewarded with lower interest rates, with the lowest rates generally being offered to those with a credit score over 760.
Borrowers who do not meet all of the requirements for a conventional mortgage aren’t necessarily excluded from being able to purchase a home. Many may be eligible for what is called an FHA loan. FHA loans are loans insured by the US Federal Housing Administration. These loans allow for a much lower down payment, often as low as 3.5, and have a much lower minimum credit score of 580. This all sounds great, but in exchange for these lower requirements borrowers are required to carry private mortgage insurance, commonly referred to as PMI. PMI is insurance on the mortgage which covers the lender if the borrower were to default. The cost generally runs between .5% and 1% of the loan amount, which doesn’t sound like much but can really add up over the duration of the loan. For example, if you were to put 3.5% down on a $200,000 home with a PMI cost of .75% you will have paid over $12,000 in PMI premiums before you are eligible to have the PMI removed.
There is often a lot of confusion regarding the loan-to-value ratio (LTV) vs down payments. The LTV ratio refers to the amount of your mortgage in relation to the market value (appraised value) of the home. So if your LTV ratio is 100% that means that your loan amount is equal to the value of your home. For most conventional mortgages banks want to see the LTV ratio at 80%, so your down payment is going to be the amount needed to get down to that point. As an example, if you purchase a house for $95k and the appraised value is $100k then your LTV is at 95%. In order to get to the golden 80% mark, you will then need to put 15% down. Debt to income ratio is another critical mortgage factor, and is the measure of your payments on all forms of debt that you have vs your income. It is also sometimes a difficult factor to prepare for as the standards may vary from bank to bank. As a starting place for your preparations, 28% on the front end (just your mortgage payment vs your income) and 36-43% on the back end (all debt payments vs your income) seem to be very common standards that lenders are using.
Here’s the hard part, in some cases actively trying to improve one of these factors can have a negative impact on another. As an example, if you were to pay off a piece of debt to improve your debt to income ratio your credit score may actually take a dip in the short term. The key is to keep in mind that making strong long-term strong financial decisions is going to improve your overall eligibility for a favorable mortgage when the time finally comes to purchase a new home.
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Cody Austin
Austin Wealth Solutions