NEW YORK (MainStreet)—The requirements needed to obtain credit have toughened since the financial collapse of 2008, which was largely caused by homeowners who were given mortgages they could not afford.
For a bank or lender to approve you for a mortgage, your financial house needs to be in perfect shape. Getting your finances on track takes time, but here a few steps you can take to make your situation more attractive to lenders:
1. Credit history
Your credit score keeps track of how well you manage other people's money. And if you have a poor credit score (below 700), the banks won't even talk to you, since that means you haven't managed money well in the past. In fact, most of the banks will be checking your FICO score, which is a slightly different formula.
To raise your credit score, for three to six months, pay your bills on time and pay your credit card balances off in full, instead of simply paying the minimum payment.
A higher credit score will also allow you to be approved for a lower interest rate on the home loan – and this will result in a lower monthly payment. Lower credit scores result in higher interest rates, since the lender has to be compensated for the additional risk involved in approving you for a mortgage.
Debt is toxic to your credit score and affects your utilization ratio (that's how much debt you have vs. how much credit you have access to).
But if you're close to paying off your debt, the lender may be willing to throw you a bone. "Lenders do not count debt against a potential borrower when they have less than ten payments left on the loan," says Malcolm Hollensteiner, director of lending sales and products at TD Bank. "Though for those with $25,000 in debt or more, this can take years."
3. Proof of income
The reasons why consumers were given mortgages they could not afford pre-financial crisis was because there was no due diligence on the bank's end to verify if the consumer had the income needed to pay back the loan. Times have changed and expect lenders to conduct a thorough vetting process of your finances.
"Home buyers often need to furnish previous W-2 forms, pay stubs and tax returns," says Debra Goodrich, executive vice president of home loans at Sterling Bank. "If making a significant down payment, a lender may want to verify bank or investment company statements as well as any large deposits."
4. Down payment
The more money you can put down on the home purchase, the less money the bank has to lend you, which means you'll owe less money.
Increasing your down payment shows the banks how your financial situation is more secure and they'll be more willing to lend you a smaller amount.
Banks want to see that you have some skin in the game, too.
5. Stay off the credit cards
Once your mortgage has been approved, you'll still have a few weeks, if not months, before closing on the new home. During this time, the banks will continue to monitor your finances – and any drop in your credit score could jeopardize your mortgage.
Just because you've been approved, doesn't mean you can revert back to irresponsible financial habits.
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