If you’re confused about what’s needed to get a mortgage, you’re not alone. Mortgage rules are a tricky topic, and the details can vary from situation to situation. However, the requirements you need to meet to get a loan can be summed up with “The Three Cs”: credit, capacity and collateral. Here’s what the Three Cs entail and how you can follow them to get ready for your next mortgage.
The first C, credit, refers to your reputation for paying back borrowed money. Your mortgage creditworthiness is usually evaluated based on your FICO credit scores and the presence of any negative events on your credit history.
Higher credit scores are better. While mortgages may be available for those with FICO credit scores as low as 500, a minimum score of 580 is required for popular loan programs such as the FHA 3.5 percent down loan. Other programs may have higher minimums, and the lowest interest rates are usually available for those with scores of about 760.
Having a credit report with few or no negative marks is also best. Negative items can include foreclosures, bankruptcies, liens, judgements, delinquencies, repossessions, collections or charge-offs. Borrowers may be required to wait as long as one to seven years after a short sale, foreclosure or bankruptcy before obtaining a new mortgage.
The second C, capacity, concerns your ability to pay for your home purchase and loan. Your capacity is assessed based on your anticipated income ratios (e.g. total debt to income ratio), your stability of income (e.g. employee vs. self-employed and salaried vs. commission-based), your available funds for the down payment and closing costs and your cash reserves.
Lower income ratios are more favorable. This is typically measured with a debt-to-income ratio (DTI). One way to calculate this is to divide a borrower’s total anticipated monthly obligations after obtaining a loan by their total monthly gross income. For example, a borrower with a monthly gross income of $4,000 and expected monthly obligations of $1,450 (e.g. $1,000 for a mortgage payment, $100 for homeowners insurance, $200 for real estate taxes and $150 for a car payment) would have a DTI of 36% (1,450/4,000 = 0.36). Maximum DTI limits for mortgages typically range between 36 and 50 percent.
Lenders prefer to see stable income rather than unpredictable income. Therefore, those who are self-employed or paid on commission are generally required to show additional documentation as proof of their income.
Borrowers are also required to provide proof that they have the funds to pay for their down payment (typically between zero and 20 percent of the home’s purchase price) and closing costs (typically between 2 and 5 percent of the price). Gift funds or other assets may be allowed for these requirements in some cases.
Cash reserves are usually not required for the average borrower, but several months’ worth of mortgage payments may be a prerequisite for situations such as financing a multi-unit property.
The third C, collateral, is the property you pledge to the mortgage holder should you be unable to pay back your loan according to your contract. In the case of a mortgage, that property is the home itself. Collateral considerations include the home’s value, your total equity (value of the home minus the amount you owe) or down payment, the property type (e.g. 1-unit or 2- to 4-unit detached property, condominium unit or manufactured home) and occupancy status (e.g. primary residence, second home or investment property).
Homes with greater equity, 1-unit single-family homes and primary residences typically come with the least financing restrictions from a collateral standpoint.
Before a loan is approved, the lender will have an appraiser assess the home’s value, and the appraised value will be compared against the loan amount and the requested mortgage program to ensure that the loan meets approvable guidelines.
Making a down payment of 20 percent usually allows for the most financing options, but down payments as low as 3 or even 0 percent are available with some home purchase loans.
How to follow The Three Cs
Speaking with your mortgage professional is the best way to learn the mortgage requirements for your specific situation. However, The Three Cs can provide you with good general guidance for how to prepare. Here are some basic tips on how to get ready for the credit, capacity and collateral requirements of a mortgage:
- Maintain strong credit scores
- Avoid negative credit events
- Avoid accumulating excessive debt
- Avoid career changes ahead of getting a mortgage
- Save up for your down payment and closing costs
In addition to these strategies, adding a second person with additional income or stronger credit to your mortgage can also boost your ability to fulfill The Three Cs.
To learn more about how to get mortgage-ready, contact us at any time for a free mortgage consultation.