If you’re ready to take the leap and become a home owner, that usually means you’ll have to get a mortgage. Unfortunately, not everyone who wants to buy a home can qualify for a mortgage because lenders try to make certain you’ll pay back your debt before they allow you to borrow.
Depending on the lender and the type of loan, you’ll likely need to provide a lot of documentation to prove you’re qualified for a home loan.
Knowing in advance what to expect when applying for a mortgage is important so you can start preparing your finances for home ownership long before you visit an open house or talk with a real estate agent. You also can begin getting documents together for potential lenders to examine and determine whether they’ll approve you for a loan.
Not exactly sure where to start? The Motley Fool offers this guide to explain everything you need to qualify for a mortgage.
Different loan types have different rules
Loan qualification requirements depend on which type of loan you receive, so you’ll first need to understand different categories of mortgage loans. Home loans can be broadly divided into two different categories: conventional loans and government-backed mortgages.
• Conventional loans are issued by private lenders without any government guarantees. Some, but not all, conventional loans are resold to government-sponsored entities.
• Government-backed mortgages are issued by private lenders, but are guaranteed or insured by the government. If you don’t repay the loan in full, the government makes the lender whole.
Each of these categories also can be broken down into various individual loans:
A few different government agencies insure or guarantee mortgages to help would-be homeowners get approved for loans. Some agencies cater to specific populations. Government-backed mortgages include:
• FHA loans – The Federal Department of Housing and Urban Development (HUD) manages a mortgage insurance program operated by the Federal Housing Administration. FHA loans are some of the easiest mortgages to qualify for, especially as the down payment requirements are as low as 3.5 percent.
But borrowers must pay for mortgage insurance both up front and over time, making it potentially more expensive than the private mortgage insurance that comes with the low-down-payment conventional loans.
Mortgage insurance, which protects the lender by ensuring full recovery of lost funds in case you default, costs 1.75 percent of the loan amount up front and 0.80 percent to 0.85 percent of the borrowed amount per year. FHA loans are especially popular with first-time borrowers, but anyone can get an FHA loan.
• VA loans – The Federal Department of Veterans Affairs (VA) guarantees loans for current and former members of the military and their families. VA loans provide very favorable terms to eligible borrowers and have limited qualifying requirements.
You can get a VA loan with no down payment as long as the home isn’t worth more than you pay for it, and there’s no minimum credit score to qualify.
You also don’t have to pay for mortgage insurance, although you do have to pay an up-front funding fee of between .5 percent and 3.3 percent of the loan amount unless you fall within an exception for disabled vets or military widows or widowers.
• USDA loans – The Rural Housing Service (RHS) operates under the federal Department of Agriculture to guarantee loans for rural home-buyers with limited income who can’t obtain conventional financing. The upside is that USDA loans require no down payment.
The downside is that they charge a steep up-front fee of 1 percent of the loan amount (which can be paid off over the entire loan term) and an annual fee of 0.35 percent.
To get an FHA, VA or USDA loan, you apply through private lenders who participate in the government programs. You don’t get a loan directly through the government. You can expect relaxed requirements to qualify, but there are still certain hurdles you’ll need to clear.
For example, the home will need to be inspected to ensure it’s in good condition and appraised to ensure that it’s worth the amount you’re borrowing. If a home does not meet minimum standards for health and safety, repairs may be required before a loan will be granted.
Conventional loans can also be broken down into different categories, including the following:
Conforming loans adhere to a specific set of guidelines set by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are government-sponsored entities (GSEs) that buy mortgages from the original lenders that issued them.
Many mortgage lenders don’t want to keep loans they’ve issued for many years. Instead, they resell the loan to Fannie Mae, Freddie Mac, or some other entity that buys mortgage debt.
Fannie and Freddie (and many other mortgage buyers) won’t buy non-conforming loans that don’t adhere to established standards. For example, borrowers typically need credit scores of at least 640, and their total debt, including mortgage payments, can’t exceed about 43 percent of income.
Non-conforming loans are loans issued by private lenders that don’t adhere to guidelines set by Fannie Mae and Freddie Mac.
The most common type of non-conforming loan is a jumbo loan, which is a loan that’s bigger than what Fannie and Freddie would buy. For example, in 2018, Fannie and Freddie would not buy loans totaling more than $453,100 (or $679,650 for loans issued in Alaska, Guam, Hawaii, or the U.S. Virgin Islands). Loans are also considered non-conforming if they don’t meet eligibility requirements set by Fannie or Freddie.
Qualified vs. non-qualified loans
When you apply for loans, they’ll fall into two broad categories: qualified and non-qualified loans. Conventional and non-conforming loans could both be either qualified or non-qualified, depending on whether the lender meets the requirements for a qualified loan.
Qualified loans meet requirements established by the Consumer Financial Protection Bureau to ensure lenders do their due diligence to determine whether a borrower is qualified.
Qualified loans also can’t have risky features. For example, a lender can’t give you a loan with payments so low that they only cover interest, as paying interest only never reduces the amount you owe, and the loan is never repaid.
Non-qualified loans don’t meet CFPB guidelines. That doesn’t necessarily mean they’re bad, but it does mean borrowers should do more research to make sure these loans don’t have unfair terms. Non-qualified loans may have more relaxed requirements to get approved than qualified loans.
Must-haves to qualify for a mortgage
Some of the basics you’ll need to be approved for any type of home loan include:
• A reliable source of income
• A debt-to-income ratio that falls within permissible guidelines
• A fair or good credit score
• A down payment
Let’s take a look at some of these key requirements, the specifics of which vary based on loan type:
A reliable source of income – One of lenders’ biggest concerns is your cash flow. Lenders want to know you have money to pay back your loan, which means you need a steady source of verifiable income. This can come from:
• A salary from work
• Bonuses and commissions
• Self-employment income
• Alimony or child support
• Social Security income
• Qualifying investment income, including income from interest and dividends
• Income from rental properties
In most cases, lenders will only allow you to count income if you have documented proof that you’ve received the money for at least two years. If you get a one-time bonus, there’s no guarantee you’ll get this money again, so lenders don’t consider it when determining whether you can borrow and how much you can borrow.