Getting Pre-qualified for a Loan

Before you progress too far into the home-buying process, it's a good idea to talk with a lender about pre-qualifying for a loan. Pre-qualification will let you know how much money you will be able to borrow, so that you know your price range for your home search. Having a pre-qualification letter also assures sellers that you are a serious potential buyer.

What you can afford will depend on your income and your debt. In general, lenders don't want borrowers to spend more than 28 percent of their gross monthly income on a mortgage payment (your "housing expense ratio") or more than 36 percent on all debt payments combined (your "debt-to-income ratio.") They will define your total mortgage payment as the sum of your principal, interest, taxes, and insurance (known by the acronym PITI), and they will define your long-term debt as any monthly payments which will take ten months or more to pay off.

Low housing expense and debt-to-income ratios do not guarantee that you will qualify for a loan; neither do high ratios always signal a denial. In addition to your gross income and your current debt, potential lenders will consider these factors to determine how much you can borrow:

• The amount of cash you have available for the down payment investment, closing costs and necessary reserves
• Your credit history
• The type of mortgage you are considering
• Current interest rates
• It is true, however, that the more you increase your other debt, the less borrowing power you have for a mortgage.

Follow these steps to get a general idea of how you will pre-qualify:

• Calculate your gross monthly income.
• Multiply your gross monthly income by 28% (.28). This is your maximum monthly housing expense payment.
• Multiply your gross monthly income by 36% (.36). This is your maximum allowable total debt payment.
• How much do you owe each month on long-term debt payments (e.g., credit cards, loans, child support payments, etc.)? Enter that number here.
• Subtract line 4 from line 3 to determine the maximum amount you can spend on debt. This is the income you have available for your monthly mortgage payment.
• Use the smaller of line 2 and line 5 as your maximum housing payment. Multiply that number by 75% (.75). (This assumes that 25% of your payment would be spent on taxes and insurance.)

Line 6 is the maximum monthly principal and interest you can afford. The following table will show you how the monthly payment relates to your loan amount.

What Lenders Need to See

We said earlier that potential lenders will consider six factors to determine how much you can borrow:

• Your gross income
• The amount of cash you have available for the down payment investment, closing costs and necessary reserves
• Your current debts
• Your credit history
• The type of mortgage you are considering
• Current interest rates
• To verify your income, you will need to provide your lender with
• Recent pay stubs
• Two years of W-2 statements
• Two years of federal tax returns
• To verify your available cash, your lender will want to see your two most recent bank statements for both your savings and checking accounts.

To verify your current debts and your credit history, your lender will order a copy of your credit report. Even if you don't anticipate any problems, it's a good idea to order a copy of your report before you begin the loan application process. This will give you time to clean up any errors or problems that may show on the report.

You can obtain a copy of your credit report from one or all of the three credit reporting agencies:

• Trans Union (www.transunion.com / 1-800-888-4213)
• Equifax (www.equifax.com / 1-800-997-2493)
• Experian (www.experian.com / 1-888-397-3742)

You can also look in the yellow pages under "Credit Reporting Agencies" for a location near you. The reports should cost under $10 each, and it's a good idea to get a report from all three companies since they may not be exactly the same.

Correcting Credit Problems

Your first credit problem may be lack of a credit history. You can approach this problem in a couple of ways. First, you can begin to build your credit by getting a credit card and charging small amounts on it. By paying it off each month, you will be establishing a positive credit history without incurring finance charges. Second, you can ask your lender to establish a non-traditional credit history which uses payment information from monthly obligations other than loans: utility bills, rent payments, telephone bills, etc.

If you have a credit history, the credit report will list all of the consumer credit that has been extended to you in the last seven years. For each account, it will show:

• A comment about the account such as current or delinquent (and if delinquent, for how long)
• The status of the account: positive, non-evaluated or negative
• The date the account was opened
• Scheduled monthly payment amounts
• The date the last payment was made
• The type and terms of the account
• Your payment history over the last 12 months
• The original loan amount, credit limit or original amount charged to loss
• The balance owing and amount past due, if any
• If a payment was over 30 days late one time, it might not show on the report. If, however, payments were over 60 days late four times, over 120 days late two times, or over 180 days late one time, your credit will be seriously affected, and this will impact your ability to borrow money.

Sometimes problems will crop up on a credit report because there has been a misunderstanding or error. If you find such a problem on your report, contact the billing department for that account and have them correct it. Keep written copies of your correspondence and keep notes of phone conversations which include the names of the people with whom you have spoken, the dates of the calls and the outcome of each call. Write a letter explaining the error to the lender and attach it to the credit report. Submit copies of your written correspondence and notes from conversations with the creditor as further documentation. If a poor credit rating is the result of past problems, you need to be aware that there are no quick fixes for a poor credit history. Be patient, and improve your credit rating by:

• Contacting each creditor and explaining your situation. Send a good faith letter demonstrating your willingness to pay off the account and include at least a partial payment, if possible.
• If credit problems are associated with a specific incident such as a car accident, sudden illness or loss of a job, write a letter of explanation to the credit bureau explaining the circumstances.
• If you have outstanding collections or judgments against you, take steps to pay them off. Contact the creditors and begin making regular payments, however small.
• Always include your name, address, telephone number, and account names and numbers on any correspondence with creditors, credit bureaus and lenders. Let them know when and where you can be reached.
• As a last resort, get professional assistance from a nonprofit credit counseling service, but be aware that they are primarily representing your creditors' interests. They will make arrangements with your creditors to pay off a percentage of your debt, spread over a longer period of time so that your monthly payments are lower. Then they will arrange with you to pay a higher percentage of the debt, and they pocket the difference. They do nothing to resolve the bad credit history that drove you to them in the first place.
• There is hope even if your credit rating is not what it needs to be. Remember that negative credit information is only reported in your credit file for seven years (with the exception of bankruptcy which can be reported for ten years). After that, it drops out and cannot even be considered, and you have essentially a clean slate.

Additionally, lenders are much more concerned with how you have handled your credit recently than with what happened several years ago. If you had problems in the past but have paid your bills on time since, you may qualify for a loan after as little as two or three years.

Some lenders have begun offering risk-based pricing. In other words, even if you have slightly damaged credit, you may still be able to get a loan; you'll just pay more for it.

Next >>